What's Wrong With Sirius XM?

| About: Sirius XM (SIRI)

Summary

Shares prices have plunged 23% in three months, despite record performance by the company.

Sirius self-pay monthly churn and new vehicle conversions negatively impacted by FCC ruling.

Re-affirms rate of share buybacks.

Company is in no hurry to leverage up to four times.

This past week Sirius XM Holdings (NASDAQ:SIRI) held its earnings conference call after officially reporting its fourth quarter and full year results for 2015. It was a report where the company pronounced one record after another, and despite that, the shares continued a downward spiral from its post-merger record of $4.20 per share set just over two months ago. Even worse, that particular high was barely above its previous post-merger high of $4.18 set on October 23, 2013.

The records for 2015 included:

  • Both Q4 and annual revenue (+9%)
  • Free Cash Flow ("FCF") of $1.32 billion (+14%) for the year and FCF/share of 24.2 cents (+23%)
  • 29.6 million (+8%) total subscribers
  • Q4 and full year "new and used car conversions"
  • Penetration rates of 74.5% for the year and 78% for Q4
  • Q4 ARPU of $12.75 (+2.1%)

And the list goes on. With the share price ending the week at $3.42, down 23% from that $4.20 high, is it any wonder that one of the more frequent comments about the share price is "What's wrong with Sirius?" The investors may want to look at the analyst questions rather than the records where management would like us to focus our attention. Here are three that may be a cause for concern.

Leverage

It seems as though every time the company gives a presentation, the question of leverage comes up. How high will it go? How quickly will you get there? This question is usually tied to the share repurchase program which has been largely funded with debt. The Q4 earnings call was no different, with the following question posed to management:

...regarding leverage, you're about 3.3 turns. You've talked about four turns in the past. Really, you decelerate the buyback a little, given the prices in 4Q. How do we think about shareholder returns going forward, and if leverage is really the right way to think about this or is it more in dollar terms?

The analysts have been asking about how quickly and how high leverage was going to rise, and despite prior comments by CFO David Frear that the company was in no hurry to get to its stated leverage targets (whether 3, 3.5 or 4 times), or that the company would probably want to keep some of its borrowing capacity available for potential acquisitions, and that the buybacks would continue at ~$2 billion per year, the questions don't go away. This is because the analysts try to project the share count several years into the future. If the company doesn't move towards "four turns," their models understate the number of shares outstanding and overstate the future earnings per share numbers.

Here is Frear's answer:

...the four times we've had out there is a target that we don't - we've always indicated no rush to get there, and we're always looking for opportunities to acquire things. And one of the things we look to acquire when it's a bargain is our own stock. But there are other things out there as well. So, I'm not inclined to drive our leverage to four times just on the back of the stock buyback because I think, it then limits our flexibility for dislocation in asset prices that we might be interested in acquiring.

For a long time, we've talked about roughly a $2 billion a year capital return program. Maybe we'd be up a little bit from that, maybe we will be down a little bit. I think that's what you can expect absent us finding something cheaper to buy in the market.

Frear's response almost seems to begin with "that we don't" expect to get to four times. But even if that's not what he was going to say, it's clear that his intention is to limit the buybacks to ~$2 billion per year, regardless of whether it will move leverage up towards 4 or whether the dollar level would allow leverage to decline from its current level. He also states the $2 billion limit is for a "capital return program". A capital return program could include dividends and possibly acquisitions.

Conversions and Churn

There were also questions about the new vehicle conversion rate and self pay monthly churn. The conversion rate declined from 41% in 2014 to 40% for all of 2015, and to 39% in Q4. In the past we have seen that as penetration rose, the new car conversion rate declined:

Year

2009

2010

2011

2012

2013

2014

2015

Penetration Rate

55%

62%

67%

68%

70%

71%

74.5%

Conversion Percentage

45.4%

46.2%

45%

45%

44%

41%

40%

Click to enlarge

Data Source: Conference calls, interviews, presentations and company 10Ks.

Usually the explanation was that as penetration rose, it meant that satellite radios were being installed in lower priced models. As that occurred, the conversion rates could be expected to decline. However, this time there was an additional reason. The 10K notes the following:

The decrease in conversion was primarily due to an increased vehicle penetration rate and the effect of the suspension of certain outbound calling efforts by our vendors as they evaluated the Federal Communications Commission's July 10, 2015 order relating to the Telephone Consumer Protection Act of 1991, partially offset by improvements in converting previously active subscribers during a trial.

CEO Jim Meyer also spoke about this during the call, noting that competition was not having an impact. He then added:

...there are two things driving it. One, as we have driven our penetration, and think about it, we're almost 80% in the fourth quarter, we've gone deeper and deeper into lower and lower trim levels that certainly has an impact on the number.

This was the effect illustrated in the above chart. He continued:

...the changes that were made in the outbound telemarketing laws this summer, as we reviewed those and absorbed those, we made a lot of changes in our cadence in the way we go about those things. And we haven't gotten back to where we were before those changes. We're deeply focused on that. I would like to think we're going to get back to 40%. I think we're probably going to be in the 38% to 40% range here for the foreseeable future.

Investors should note that the rising penetration rates that occurred in Q3 (75%) and Q4 (78%) were accelerating from the 71% in Q1 and 72% in Q2. The rising penetration rates that occurred in the second half of the year would not yet have fully impacted the new vehicle conversion percentage, whether it was caused by increased penetration to lower priced vehicles, or the FCC ruling, and I would expect further deterioration, quite possibly to levels lower than the 38% projected by Meyer.

The reason that the full impact has not been reflected in the conversion rates is due to the lag from the start of a free trial to conversion. Not only do we need to wait until the free trial expires - a trial that can last anywhere from three months to three years [we know that Ford (NYSE:F) and Chrysler routinely offer trials up to one year and certain luxury cars could be longer], but one also needs to understand the way that Sirius calculates conversions. The company allows the full trial to end PLUS it adds another 30 days before considering the trial subscriber as lost. That means that none of the conversions resulting from Q4 sales would be part of the calculation until 2016 (or later) and only a small portion of those trials that resulted from Q3 sales would be part of the Q4 conversion rate.

The 10K also had a citation about the FCC ruling when it discussed subscriber net adds in 2015 compared to 2014 and the impact on self-pay monthly churn:

The increase in subscribers was primarily due to increases in original and subsequent owner trial conversions, as well as increases in shipments by OEMs offering paid trials and activations of inactive radios, partially offset by higher deactivations related to vehicle turnover and non-pay churn resulting from changes in telemarketing practices following the Federal Communications Commission's July 10, 2015 order relating to the Telephone Consumer Protection Act of 1991.

Self-pay monthly churn has been somewhat erratic during 2015, starting the year at 1.8% (the company's best first quarter since the merger) and then dipped to 1.6% in Q2 ("one of the best results in the company's history", before rising to 1.9% in Q3 and Q4, bringing the churn rate for the full year to 1.8%. When the issue of whether the self-pay monthly churn was going to improve came up during the Q&A portion of the conference call, Frear proceeded to give a lengthy response:

...we use a lot of outbound telemarketing. Jim just talked about it from the impact on [conversion] perspective. We use outbound telemarketing in collection efforts on credit cards that don't clear when they first go through. And the FCC put out a very expansive definition of what constitutes an automated dialing system last summer. They put it out with no notice and it literally was effective the day it was released.

And so, it has taken months for us to readjust our call center vendors, because they actually have to manually dial every single number now. So, it's like literally pushing buttons. And what you've got is that it's a different way for people working. And so, it doesn't sound like a big deal. But the way their work day goes is radically different now. And it's taking a while for the change in practices on the desktop to show up in the same kind of statistical results across hundreds of thousands of calls on both the conversion side as well as the collection side.

And it's one of the, sort of, gritty operational issues that you just have to slug through day after day after day after day. So, we think we'll get there. We think things will improve. I would say that we have filed a suit to overturn or at least get re-reviewed the FCC's definition here. I think everybody in the industry looking at it thinks that it is overreaching and we'll see how that goes.

In addition to the response by Frear, Meyer added:

I just want to make one point on the outbound telemarketing and that is, there are many, many elements that go into our marketing strategies. And we performed pretty damn good through most of those in the fourth quarter. There's a reason why many direct marketers use telemarketing and that's because it works. But I understand your question and I've tasked our marketing organization for the mid-term and the long-term, what other tools can we develop to supplement, and maybe one day take away some of the efforts that we've put into that area with other types of marketing? And you should assume we're going to invest and keep working there.

What's wrong with Sirius?

There is not much wrong with Sirius, the company, as many of the record results would indicate. But that's not what investors really want to know. They are more interested in why the share price isn't moving higher. It's easy to place the blame on the overall market declines, but that's not totally valid, with Sirius falling 2% over the past two years while the NASDAQ 100 has risen 12%. Besides, the company should not be impacted too much by the slow-down in economies outside the US, and the collapse in the natural resource sector could provide a benefit to the company because of low fuel prices. A report published last month noted the following:

Monthly data show gasoline consumption in the United States increased by 2.8% during the first 10 months of 2015 compared with same period in 2014. U.S. gasoline consumption growth reflects increases in employment and lower gasoline prices.

Although average fuel economy ticked down slightly (from 25.1 MPG to 25.0, less than 0.5%) for vehicles sold in 2015, the average fuel economy of the entire fleet of US vehicles continues to increase. Combine this with gasoline consumption increasing, it indicates more time is being spent in cars. That would suggest that a subscription to satellite radio is somewhat more valuable. Equally important is that the significant decline in fuel prices (about half of what it was 2 years ago) should be leaving more disposable income in the pockets of drivers who are also potential subscribers.

It's not just the lower gasoline prices that has put more money in consumers' pockets. The cost of electricity, natural gas or oil used to heat, cool or operate one's home have also fallen. That doesn't mean that those dollars will necessarily go to a Sirius subscription, but it is clear that the number of subscriptions has risen.

Summary

While the market looks at past performance, it is always more concerned about the future when it prices a stock. It's the future revenue, earnings and cash flow of the company that are important factors, and how quickly each of those will be growing. With Sirius, there were issues raised on the conference call about churn and conversion percentages and whether these will continue at levels in Q4 or deteriorate in the future. Those answers weren't particularly reassuring.

There were also issues raised once again about how quickly the company will leverage up the balance sheet and proceed with the buyback. Once again, the answers appeared to be less aggressive than the analysts expected. It's certainly plausible that the market has reacted negatively to all these factors.

It also seems likely that the market has overreacted to these same factors, failing to recognize the stability of the current revenue stream even if its growth may be less than previously expected. And, while it is possible that the share prices could fall further, the current level does present an attractive entry point based current and projected FCF per share.

Disclosure: I am/we are long SIRI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may write $4 or $4.50 covered calls against my long Sirius positions, or sell all or a portion of my Sirius holding at any time. I have no positions in any of the other companies mentioned in this article.