I must admit I was surprised when SiriusXM reported that it had added 452,000 subscribers, exceeded 21 million for the first time and was increasing its forecast of Subscriber Net Additions for 2011 from 1.4 million to 1.6 million. And, yes, I was wrong last month when I wrote that Sirius would not increase subscriber guidance. So, what happened and why was I surprised?
There are many factors which drive subscriber growth. Gross subscriber additions come primarily from new light vehicle sales in the US. To a lesser extent there are also gross subscriber additions from the Sirius Certified Pre-Owned (or CPO) program, reactivations of canceled or lapsed subscriptions, retail sales of SiriusXM radios, Internet subscriptions and activations in by buyers of satellite radio equipped used cars. Then there are the deactivations, or subscriber cancellations. When these cancellations are from the Self-pay Subscribers, Sirius calls it Self-pay Monthly Churn, or more simply, Churn. The remainder of the deactivations are from the Paid Promotional Subscribers and Sirius provides that information indirectly with a metric referred to as the Conversion Rate - the percentage of Paid Promotional Subscribers that become Self-pay Subscriber at the end of the paid promotional period (or trail). The cancellation rate for these trials is 1 - (Conversion Rate).
Sirius showed improvement in both the Gross Subscriber Additions and improvement in all the metrics that drive deactivations. For me, the biggest surprise was in a metric referred to as "penetration," the percentage of OEM vehicles equipped with SiriusXM radios. This number increased to a record of more than 65%. As Mel Karmazin stressed on the conference call, "Over 65% in the second quarter, our penetration rate has never been higher, and I think it highlights how satisfied auto makers are with our service and the broad demand shown by consumers. Just to repeat, over 65% of all new vehicles manufactured for sale in the U.S. had a factory-installed Sirius or XM Radio in the dash." The record penetration level helped to offset sluggish new vehicle sales in Q2, as Karmazin also noted "And gross adds were up 6% sequentially despite a 7% contraction in the auto SAR number from first quarter to second quarter."
The surprise was not so much that Sirius was able to place their radios in nearly two out of every three cars. After all, Sirius is subsidizing the OEM's cost to place these radios in the dash and they share the revenues when the trials convert. The surprise was that this is very different from the guidance Karmazin provided on the Q4 2010 conference call when he said, "And our penetration level has been picking up a little bit actually, so we're in the low 60% and we don't see that changing." Previously David Frear had spoken at a UBS conference where he discussed that Sirius and the OEMs would be focusing on placing radios in those vehicles with the highest likelihood of conversions. Does this spike represents a strategy change or an unusual mix of vehicles in the second quarter? Is it important? Should the investor take note? Consider this: Each 1% change in penetration places an additional 125,000 radios before potential Self-pay Subscribers at a SAAR level of 12.5 million. 4% (from 61% t0 65%) represents an extra half million Gross Subscriber Additions. That's significant.
Not only was there good news on the OEM front, but Karmazin also commented that "Our growth was also helped this quarter by a contribution from second owners of vehicles." Another positive for Sirius investors.
The good news on Gross Subscriber Additions was accompanied by equally good news on the deactivation side of the ledger. Churn declined from the 2.0% rate in Q1 to 1.9%. Again, on the surface a small number. But when 0.1% is multiplied by an average of 17 million self-pay subscribers over three months, it indicates that there may have been 50,000 less cancellations in Q2. And, the improvement in the Conversion Rate to its best level since Q3 2010 was just one more driver to the healthy growth in subscribers.
So, why hasn't the market reacted more favorably to this great Subscriber news? Perhaps it was the fact that the ARPU declined from $11.81 last year to $11.53. This should have been expected since the MRF was being reduced, but Frear also noted that "...and increased subscriber-retention programs all contributed to the change in ARPU." During the Q&A on the CC this issue was raised by the analysts looking for more information about the level of the retention discounts and whether it might impact SiriusXM's ability to raise prices next year. Is SiriusXM growing subscribers by lowering prices? What are the implications for a 2012 price increase?
I confess to being convinced not to cancel certain services when the provider agreed to meet competitor's pricing or extend my introductory/promotional pricing. From my perspective as an investor, selective discounting is a useful tool. But analysts and the market don't like surprises, and the uncertainty makes it difficult to forecast revenues.
One last item to consider. If the penetration rate has permanently changed to a level above 65%, what are the implications? Clearly, Gross Subscriber Additions and total subscriber acquisition costs will be higher than previously anticipated. And, if these extra Gross Subscriber Additions are going into vehicles that are less likely to convert, the conversion rate may be lower in the future.
Disclosure: I am long SIRI.
Additional disclosure: I have $3 January 2012 covered calls against most of my Sirius position. I may add to my long position of SIRI at any time and might close or open covered call positions at any time.