Sirius XM Radio (SIRI) is nearing the end of its multi-year agreement that resulted from hearings before the Copyright Royalty Board (CRB) and set the rates the company had to pay for the right to broadcast music. The current agreement was reached in 2007, with the rates beginning at 6% of revenues for 2007 and 2008, and increasing by 0.5% per year to its current rate of 8%. According to SoundExchange's motion to dismiss the current Sirius XM anti-trust suit, SoundExchange noted the following with respect to those prior negotiations:
Both Sirius and SoundExchange participated in the CRB proceeding that set the statutory rates for the 2007-2012 license period. That proceeding involved over 26 trial days, 230 exhibits, 7700 pages of transcripts, and over 400 pleadings, motions and orders. ... In a lengthy written opinion affirmed by the D.C. Circuit, the CRB set the rate for 2007 at 6% of a satellite radio provider's gross revenues, rising each year to 8% in 2012.
The current rate proposals the two sides are offering are very wide apart. Sirius XM has proposed rates of 5%-7%, while SoundExchange is looking for an immediate jump to 13% and escalating to 20% of revenue over the five year period from 2013 through 2017. Obviously, most Sirius investors are hoping for a rate closer to those proposed by Sirius XM.
Using History to Predict the Future
Reading the 2007 "lengthy written opinion" or "Final rule and order" of the CRB can provide a great deal of insight into how it could set rates for the next five years. The CRB outlined the four major considerations in determining royalty rates:
("A") To maximize the availability of creative works to the public.
("B") To afford the copyright owner a fair return for his or her creative work and the copyright user a fair income under existing economic conditions.
("C") To reflect the relative roles of the copyright owner and the copyright user in the product made available to the public with respect to relative creative contribution, technological contribution, capital investment, cost, risk, and contribution to the opening of new markets for creative expression and media for their communication.
("D") To minimize any disruptive impact on the structure of the industries involved and on generally prevailing industry practices.
When establishing the rates, the judges also noted that they were required to consider what rates would have been negotiated by a willing buyer and a willing seller, whether the actions of the copyright user promoted the sale of records, and the relative investments of the parties.
The SoundExchange proposal called for monthly fees that were the greater of 8% of revenues or $0.85/subscriber for up to 9 million subscribers, increasing to the greater of 23% of revenues or $3/subscriber for 19 million subscribers. In addition, there were CPI adjustments to the per subscriber fee, as well as subsequent proposals for fixed fees per recording per play per subscriber. Sirius XM countered with 0.88% of Gross Revenue or $1.20 per play, indexed to the number of subscribers.
For a variety of reasons, the CRB decided that a percent of revenue was the best alternative and rejected both the per play or per play per subscriber proposals. Not only was a percent of revenue a metric that the parties had used in the past and minimized administrative costs, but the alternatives failed to differentiate between subscribers and listeners.
Considerations in Setting the Rate
The CRB decided since there was not a definitive proposal that could "tie payment directly to actual usage of the sound recording by the licensees," each of the proposals became "proxies for a usage metric at best." The opinion cited precedents that had found percentage of revenues were acceptable, and, since the parties had previously used revenue based models, and since none of the parties involved had objected to a revenue based model, the CRB concluded that the evidence presented "weighs in favor of a revenue-based fee structure."
The CRB decided that despite the weaknesses in the revenue models presented, there were elements in each of the proposals that could "serve to identify the parameters of a reasonable range of rates" that would meet the four requirements. The CRB determined that the upper boundary for a reasonable rate was 13% and the lower boundary was 2.35% of revenues. It also noted that a reasonable rate would be far closer to the upper boundary than the lower boundary:
Based on the record of evidence in this proceeding we have determined that the 13% rate identified hereinabove marks the upper boundary for a zone of reasonableness for potential marketplace benchmarks. We have also determined that potential marketplace benchmarks cannot be less than or equal to the SDARS' musical works rates (i.e., 2.35% of gross revenues).
... Therefore, based strictly on marketplace evidence, a rate close to the upper boundary is more strongly supported than one close to the lower boundary.
The CRB went on to list reasons why the full 13% would not be reasonable, citing the economic environment and the financial condition of the companies, including how this relates to items (B), (C), and (D) above. (Note that Sirius and XM were separate companies at the time of the proceeding.)
The CRB recognized the necessity of launching satellites during the five year period of the license in order to make their product available to the public. It further recognized it as a cost that could not be postponed, and the imposition of a royalty that was closer to the 13% market rate could have a "disruptive impact on the structure of the industries involved." Under the same minimizing disruption objective, the judges also decided that an immediate raise from the then-current rate of 2.35% directly to 13% would be harmful.
To ameliorate the disruptive impact, the CRB decided to choose a rate within the boundaries that is "lower than the upper boundary most strongly indicated by marketplace data."
The Judges further find that over the period of time marked by the license period, the potential for disruption will diminish, allowing for some reasonable escalation of the initial rate we set herein.
What does this History Suggest?
At the time of the prior agreement, there were two competing satellite radio companies, Sirius and XM, that were part of the proceedings. Each was trying to achieve critical mass and become profitable. The CRB found that a 13% royalty rate was "strongly indicated by the market." It also found that the jump of more than 10% would be disruptive to the businesses of Sirius and XM, and the need to launch satellites was important to the success of the satellite radio business.
During 2006 and 2007, the combined companies had losses of $1.823 billion and $1.247 billion, and free cash flow of ($1.234) and ($0.504) billion, respectively. These factors are no longer at issue. Compare them to current free cash flow guidance for 2012 of $700 million or net income of $0.4 billion in 2011.
With the survival of the companies no longer at stake and lower capital expenditures required during the next license period, future rates that could be set by the CRB could easily be higher and much closer to, or even above, the 13% rate.
Fans of the SiriusXM service frequently cite the commercial free music as one of the key differentiators of the service. The company has been paying the artists that wrote and performed the songs license fees that the CRB recognized were below market rates.
Now that the company is generating significant free cash flow and earnings, investors may want to consider that the company will have substantially higher royalty expenses. If, as I expect, there will be a substantial hike, Sirius XM faces three choices: pass the entire cost on to the subscribers through an increase in the Music Royalty Fee, absorb the cost or some combination of the two. Each alternative has drawbacks.
Passing on the entire fee right after the price hike on January 1 of 2013 could cause an upturn in cancellations and a reduction in free cash flow and earnings. Absorbing the cost immediately reduces free cash flow and earnings. Taking a middle ground position could cause less of an impact on subscriber numbers and on the bottom line.
For those that like to look under rocks for conspiracies and secret deals between Liberty Media (LMCA) and Sirius XM and share buybacks, consider this. If Sirius were to announce a share buyback as opposed to reducing debt as it has recently announced, SoundExchange would have additional bullet points in its presentation. If Sirius XM has funds for a share buyback, it can certainly afford increased royalties.
Regardless, Sirius XM could have another significant decision coming up in the next few months.
Disclosure: I am long SIRI.
Additional disclosure: I have $3 January 2013 covered calls against most of my Sirius position, as well as some $2 and $2.50 January 2013 covered calls. I may initiate (or close) a buy stock/sell option position in Sirius, at any time. I have no positions, or any plans to open positions in the next 72 hours, in any of the other companies mentioned in this article.