The subscriber guidance of 1.3 million net subscriber additions by Sirius XM (NASDAQ:SIRI) for 2012 was a surprise to many. After what was a successful 2011, and with the prospects of a fruitful 2012 on the horizon, a starting point that was so far below the 2012 performance seems at odds with where the company seems to be going.
Certainly there are many dynamics at play. Competition in the dashboard and on smartphones from the likes of Pandora (NYSE:P) and Spotify will be a growing issue, but at this point has not had a substantial impact on Sirius XM, and certainly with the dashboard connectivity being a fairly new phenomenon, it will be some time before any perceived threat becomes material.
So if it is not the competition, what is it that drives the company to guide to a very conservative 1.3 million net subscriber additions for 2012?
One simple answer is the pure math of the equation. If churn remains at a stable percentage, the absolute number of churned subscribers will be higher as each quarter passes. Thus, it takes more gross subscriber additions to deliver a similar number of net additions. I discussed this in a piece titled, The Debate Over Sirius XM's 2012 Subscriber Guidance.
One additional consideration is born out of the somewhat complex way Sirius XM counts subscribers. For many regular readers this will be a review, but for the newer readers it will be a valuable insight into a company that can, at times, be frustrating to figure out.
A TALE OF THREE SUBSCRIBER TYPES
Before Sirius and XM merged, they were in stiff competition for subscribers, content, and auto deals. XM struck first by bringing in the likes of GM and Honda (NYSE:HMC). Sirius countered with Ford (NYSE:F), Chrysler, Mercedes, and BMW. The XM partners were quick to get the ball rolling, while the Sirius partners were slow to the starting gate. This gave XM a distinct advantage in subscriber numbers, which then translated to advantages in content acquisition and more OEM deals. The XM deals were very expensive, as compared to the Sirius deals, but it got satellite radio on the map.
Sirius had to counter, and had to bolster their subscriber rolls quickly. Despite the fact that they had to pay less to the OEMs, their partners did not seem too eager to believe in the concept of satellite radio as a business model. The answer for Sirius came in an interesting way.
XM's OEM deals were structured such that a subscriber was born when a consumer bought a car. Once the car was purchased a three month promotional subscription (paid for in part by the OEM) started. This is what I term as a Point-Of-Sale subscriber.
Sirius structured their deals a bit differently in order to be able to count subscribers earlier in the process. Instead of waiting until a car was sold, Sirius received payment from the likes of Ford and Chrysler when the car was manufactured. This meant that a paid subscription was born possibly two or three months before a consumer was actually driving a car. In the case of Ford the promotional subscription was 6 months, and with Chrysler it was 12 months. The subscribers in these deals are something I call the Leading subscriber.
The benefit to Sirius was that they were able to count a Ford subscribers 6 month promotion for possibly 9 months (or a Chrysler for 15 months instead of 12). This happens if a car gets produced and a subscription is paid for, but the car sits in inventory for 2 months counted as a subscriber even though no one is driving the car. The consumer then buys the Ford and gets 6 months of service. Upon the expiration of the promotion, the company may take a month or so to "market" to the consumer. Remember, the mechanism for counting a subscriber is whether or not a subscription has been paid for, not whether it is actually being listened to.
The drawback of the Sirius method is that the money paid by the OEM goes into deferred revenue, a liability on the balance sheet. Another drawback is that during the months that the car is waiting to be sold, the company is getting no revenue, thus it carries a negative impact on ARPU. However, the name of the game at that point was getting impressive subscriber numbers to the plate. The "Leading" deals allowed that to happen.
The combination of counting the sub earlier and the longer promotional periods allowed Sirius to get subscribers on the tally quicker and keep them there (churn-proof) for a longer period of time. It was one of the factors, along with the signing of Howard Stern and Mel Karmazin, that allowed Sirius XM to close the gap.
The third category of subscribers Sirius XM gets from the OEM channel are what I term as Trailing Subscribers. This category is made up of car manufacturers that were late to adopt satellite radio. They do not get a share of the revenue, nor do they pay for the promotional subscription. Because there is no money that pays for a subscription these subscribers are not counted despite the fact that a consumer is listening to the radio for 3 months during a promotional period. The only way these radios are ever counted as a subscription is when the promotion ends and if the consumer elects to keep the service. As it happens, the used car deals Sirius XM has signed in the last year fit into this trailing category as well.
SO WHAT DOES THIS ALL HAVE TO DO WITH SIRIUS XM'S GUIDANCE?
The answer to that question is somewhat complex, but I will try my best using one manufacturer from each of these categories. Ford is a Leading OEM, GM is a Point-Of-Sale OEM, and Toyota (NYSE:TM) is a Trailing OEM.
Last year there was a disaster in Japan that created havoc for the OEM channel, and a virtual nightmare for some specific OEMs. This disaster caused a distinct shift in the mix of these three categories.
In the past, sales in these categories tended to be divided rather equally, with each category representing about 33% of the new car sales. This tended to balance things rather well for satellite radio and made the OEM channel at least somewhat predictable as it related to Sirius XM.
Ford supplies subscribers at production. Thus, when the disaster in Japan happened, Ford had to actually produce more cars than normal to make up for the deficit in the car market. This provided more 6 month subscriptions than normal, which boosts the paid promotional category.
At the same time, GM saw a sales benefit during this period. That benefit delivered more Point-Of-Sale subscribers than normal. Again, because of the structure of the deal, these subscribers are in the prepaid category.
Meanwhile, Toyota suffered greatly because of the disaster. This meant they were selling fewer vehicles. Here it is important to remember the dynamics. It took months for the Japan disaster impacts to be felt in satellite radio. I was the only one to discuss how that disaster actually helped Sirius XM report more robust numbers in Q2 and less impressive numbers in Q3 because of how these deals were struck. There were some that were highly critical of that reporting, but in the end it proved to be very accurate.
Thus, 2011 was filled with a roller-coaster of events that actually saw the leading and point-of-sale categories deliver pre-paid subscriber numbers at levels that were not normal. In addition to that Chrysler saw a resurgence that delivers 1 year subscriptions to the company.
Now, in 2012, the disaster in Japan is finally carrying less impact. That creates a dynamic where it is quite possible that the makers that saw benefit in 2011 will actually see their market share decline in 2012 as the Japanese makers gain back lost share. This is in essence the longer term impacts of the disaster in Japan that happened almost a year ago.
Thinking more deeply, while car sales will indeed be up in 2012, the mix of those cars will differ and become more favorable for car manufacturers in the trailing category which supply no paid promotional subscribers. In simple terms think of it this way with the three manufacturers i used in the example above.
- EVERY Ford built with satellite radio will be counted as a subscriber for a minimum of six months
- EVERY GM built with a satellite radio will be counted as a subscriber for a minimum of 3 months
- ONLY about 45% of the satellite radio equipped Toyota's will be counted as a subscriber.
So in the end, and to continue the discussion on Sirius XM's low subscriber guidance for 2012, there are many factors to consider. The OEM mix is not the total answer, but is indeed part of it.
In my opinion, part of the low guidance is derived from Mel simply being conservative and low-balling the number. Part is from the company expressing concern about churn and the price increase (they spoke of 2.1% churn, 10% higher than the 1.9 we saw in 2011). Part is the law of numbers that dictates that it will require more gross additions to feed the machine only to deliver the same output. Part is the OEM mix. Part is the competitive landscape.
As you can see there are many things to consider, but in the end there is one unavoidable truth that we need to look at. The guidance is lower than many expected. This puts a focus on the longer term prospects of the company. Longer term prospects do carry an impact on valuation. This is unavoidable.
While Karmazin and company want investors to focus on revenue growth, EBITDA growth, and free cash flow growth, it is a fool that ignores where any and all of that growth comes from...SUBSCRIBERS. If you take your eye off of that ball, you will miss and do yourself a disservice.
No one will debate that certain stars have aligned for Sirius XM in 2012. No one will deny that the guidance on the other metrics are not impressive. But it is the savvy investor that remembers to look beyond. Yes, 2012 will deliver great things in many ways. Investors will certainly appreciate it. Just remember that a year devoid of capex spending, no debt service to really speak of, and a price increase does not happen all of the time. Enjoy 2012, but understand the long term.
Disclosure: I am long SIRI.
Additional disclosure: I have no position in Pandora