Sirius XM and the Law of Large Numbers

| About: Sirius XM (SIRI)

I have to admit I'm a bit blown away today. As long as I've been covering Sirius XM Radio (NASDAQ:SIRI), I've never felt a need to rewrite that, which at some point in the past, I had already explained. Sirius XM's ascent from penny-stock status however, has brought with it a new breed of investors, some of whom frankly have little to no understanding of how Sirius XM's subscription model works.

Unbelievably, a commenter took a single line item from Sirius XM's balance sheet and attempted to put a negative spin on the data. The focal point is the number of deactivations reported by Sirius XM each quarter, which is a metric known as "churn." All subscription businesses experience churn, including my own. Sirius XM has one of, if not the, lowest churn rates in the industry, at less than 2%. With a subscriber base of 20 million-plus, however, the number of deactivations can be presented as misleadingly high, especially without considering how that number compares to the overall growth rate.

As noted here:

The Law of Large Numbers says that in repeated, independent trials with the same probability of success in each trial, the percentage of successes is increasingly likely to be close to the chance of success as the number of trials increases.

To assume that every person exposed to Satellite Radio will immediately subscribe to the service is never to be expected. Over time, however, as the service grows in popularity, there is a snowball effect in which even many of those who resisted subscribing initially will eventually subscribe. As an example, I personally resisted buying a smart phone, CD player or laptop initially. As these devices grew more popular, however, I succumbed to the law of large numbers.

People with sales backgrounds know the law of large numbers well, having been trained in many cases to understand the sales funnel. Early in my brokerage career, I would make up to 400 phone calls a day, out of which I would make appoximately 50 contacts. Forty of those would hang up before I could finish my first sentence; 10 would have a conversation with me. The net result was a goal of a single new client for the day's work. [Click image to enlarge]

These principals are what all businesses are based upon. The goal of any business is to increase its conversion from prospective customer to satisfied customer. Sirius XM is no different in this, and the conversion rate from trials to self-paying subscribers demonstrated surprising increases in 2010. This increase came as auto sales lagged, consumer credit was sketchy at best, the threat of a double dip recession loomed and unemployment rose to levels not seen since World War II.

The top part of the funnel represents leads, which in Sirius XM's case are trial subscriptions that in some cases are paid for by auto manufacturers; in others, they are offered without payment. Leads create sales opportunities. Without these leads, opportunities for growth disappear. The number of subscribers in paid promotional trials through the first three quarters of 2010 increased each quarter. These are in addition to the trials that are offered free, such as is the case with Honda (NYSE:HMC) and Toyota (NYSE:TM).

[Click to enlarge]

Sirius XM began 2010 with 18,772,758 subscribers, and we know that the company has surpassed the 20 million mark in the previous quarter, perhaps by a large amount. Deactivations have declined, as has the percentage of deactivations. In other words, the law of large numbers is taking hold. As long as the number of gross additions exceeds the number of deactivations, Sirius XM will continue to grow.

The law of large numbers: Never bet against it.

Disclosure: I am long SIRI.