A Look At The Growth Of Sirius XM's Connected Vehicle Services Business

| About: Sirius XM (SIRI)

Summary

Sirius' management seems reluctant to reveal details of its CVS business.

Difficult to find any growth.

Management still hasn't determined an economic business model.

I have written regularly on the Connected Vehicle Services ("CVS") business of Sirius XM Holdings (NASDAQ:SIRI) for several years. This is the business that Sirius acquired from Agero towards the end of 2013, and it is a business that has struggled to show any meaningful growth. Has it been meeting the company's - and investors' - expectations? In February of 2014 Both CEO Jim Meyer and CFO David Frear made what they probably thought were conservative predictions. These comments included:

Meyer:...We expect connected vehicle services to deliver close to $100 million of revenue this year, and we expect to grow this at strong double digit rates over the next many years. ...

As an early stage growth business, we expect the connected vehicle services product line to contribute at or near breakeven on an EBITDA basis in 2014...

Frear: In 2014, we expect connected vehicle services, excluding our existing traffic business, to approach $100 million in revenue. In the course of the next three years, we expect connected vehicle service revenue will double, and will continue to grow at high rates for many years to come.

It is a business unit where the company doesn't offer too much insight or information about the results. However, since I have written consistently about some of the figures, an update is in order. As I have stated in the past, when calculating Average Revenue Per User, or ARPU, the company notes that it excludes CVS revenue from the calculation.

ARPU is derived from total earned subscriber revenue (excluding revenue derived from our connected vehicle services business), net advertising revenue and other subscription-related revenue.

This quarter the difference between total subscriber revenue of $998,775,000 and ARPU subscriber revenue of $973,347,000 is $25,428,000, the amount attributable to CVS. That brings the total for 2015 to $98,453,000. Here are the quarterly figures for the past two years:

($000):

Quarterly Connected Vehicle Services Subscriber Revenue ($000's)

Q1 2014

Q2 2014

Q3 2014

Q4 2014

Current Quarter

18,632

22,314

22,421

24,884

YTD 2014

40,947

63,368

88,252

Current Quarter

Q1 2015

Q2 2015

Q3 2015 Q4 2015

23,089

24,766

25,170 25,428

YTD 2015

47,855

73,025 98,453

As a side note, it should be pointed out that the company owned the business for a bit less than the final two months of 2013. The difference between Subscriber Revenue and ARPU Subscriber Revenue for that partial year was just under $12 million. That number, nearly $6 million per month, is consistent with the $18.6 million generated in the first quarter of 2014.

According to the 2015 10K there is also CVS revenue included in the Revenue line item labeled "Other Revenue".

Other Revenue includes amounts earned from subscribers for the U.S. Music Royalty Fee, revenue from our connected vehicle business and our Canadian affiliate and ancillary revenues.

Since we know that ARPU includes "other subscription related revenue" it becomes necessary to break out the non-subscription related revenue from the rest of Other Revenue to estimate how much CVS revenue might be included in Other Revenue. To begin, we know that Other Revenue (in thousands) was $512,050, $421,150 and $344,574 for 2015, 2014 and 2013, respectively. We also know the amounts of Other Revenue used in the ARPU calculations: $410,644, $336,408 and $290,895. That means that the difference between the two figures is comprised of certain CVS revenues, the Canadian affiliate revenue and perhaps some or all of the unidentified "certain ancillary revenue". Those differences are $101,406, $84,742 and $53,679. The Canadian affiliate revenue from the 10K was:

For the Years Ended December 31,

2015

2014

2013

Canada Revenue

$

56,397

$

49,691

$

48,935

So, after removing the Canada Revenue component of Other Revenue, the figures that remain for CVS and ancillary revenue are: $45,009, $35,051 and $4,744. Unfortunately, at that point, it became challenging to determine the CVS component. For instance, examining the 2013 10K, which included the years 2012 and 2011, one finds there is no mention of CVS revenue either in the description of Other Revenue or as a reason for the growth of Other Revenue in 2013:

Other Revenue includes amounts earned from subscribers for the U.S. Music Royalty Fee, revenue from our Canadian affiliate and ancillary revenues.

• 2013 vs. 2012: For the years ended December 31, 2013 and 2012, other revenue was $344,574 and $283,599, respectively, an increase of 22%, or $60,975. The increase was driven by revenues from the U.S. Music Royalty Fee as the number of subscribers increased and subscribers on the 12.5% rate increased, and higher royalty revenue from Sirius XM Canada.

• 2012 vs. 2011: For the years ended December 31, 2012 and 2011, other revenue was $283,599 and $274,387, respectively, an increase of 3%, or $9,212. The increase was driven by revenues from the U.S. Music Royalty Fee as the number of subscribers increased, and higher royalty revenue from Sirius XM Canada.

We expect other revenue to increase as our subscriber base drives higher U.S. Music Royalty Fees and as the revenue of our Canadian affiliate grows.

However, since we also know that there was no specific mention made of the CVS revenue included in Subscriber Revenue in 2013, it is possible that the CVS component of Other Revenue was also considered a trivial amount for the two months of 2013 and that it was also not worth mentioning. And, it appears that it was not expected to be a meaningful contributor in 2014. I infer the latter by its omission from the last sentence in the above descriptions. Obviously, that appears to have changed somewhat in 2014, when the 10K notes:

Other Revenue includes amounts earned from subscribers for the U.S. Music Royalty Fee, revenue from our Canadian affiliate and ancillary revenues.

• 2014 vs. 2013: For the years ended December 31, 2014 and 2013, other revenue was $421,150 and $344,574, respectively, an increase of 22%, or $76,576. The increase was driven by revenues from the U.S. Music Royalty Fee as the number of subscribers subject to the 12.5% rate increased along with an overall increase in subscribers, by a change in an agreement with a rental car company and the inclusion of a full year of other revenue generated by our connected vehicle business.

• 2013 vs. 2012: For the years ended December 31, 2013 and 2012, other revenue was $344,574 and $283,599, respectively, an increase of 22%, or $60,975. The increase was driven by revenues from the U.S. Music Royalty Fee as the number of subscribers increased and subscribers on the 12.5% rate increased, and higher royalty revenue from Sirius XM Canada.

We expect other revenue to increase as our growing subscriber base drives higher U.S. Music Royalty Fees.

So, while CVS revenue wasn't even mentioned in the overall description of Other Revenue in the 2014 10K, a full year of CVS revenue was noted as one of the reasons for an increase from 2013 to 2014. It was, however, again omitted as a reason to expect an increase in future years. The 2015 10K (below) now includes CVS revenue as a component of Other Revenue in the description, and also shows there was another increase in 2015. It was still not listed as a reason to expect an increase in Other Revenue during 2016:

Other Revenue includes amounts earned from subscribers for the U.S. Music Royalty Fee, revenue from our connected vehicle business and our Canadian affiliate and ancillary revenues.

· 2015 vs. 2014: For the years ended December 31, 2015 and 2014, other revenue was $512,050 and $421,150, respectively, an increase of 22%, or $90,900. The increase was driven by revenues from the U.S. Music Royalty Fee as the number of subscribers subject to the 13.9% rate increased along with an overall increase in subscribers, higher revenue generated from our connected vehicle business, and increased revenue from our Canadian affiliate.

...

We expect other revenue to increase as our growing subscriber base drives higher U.S. Music Royalty Fees.

Clearly, there is some inconsistency in the above descriptions, and the size of ancillary revenue vs. CVS revenue that was excluded from the ARPU calculation is still unclear. Note that the earlier exercise showed the amounts of non-Canada Other Revenue that were excluded from the ARPU calculation in the years 2013, 2014 and 2015 were $4,744, $35,051 and $45,009. Since 2013 only included 2 months of CVS revenue, it might seem reasonable to assume that the growth from $4,744 to $35,051 in 2014 was largely attributable to CVS revenue going from 2 months to 12 months. (I strongly suspect that it is a major reason for the increase from $4,744 to $35,051, but it is difficult to prove.)

Unfortunately we don't know too much about ancillary revenue and whether or not that also contributed to the growth. And that's where this exercise falls apart.

In order to try to get a better understanding of the size of ancillary revenues, I decided to look at Other Revenue for 2012. That year would have no CVS revenue, and the difference between Other Revenue on the income statement and Other Revenue used to calculate ARPU should be comprised of only ancillary revenue and Canada revenue. That difference was $45,731, and excluding the $39,477 of Canada revenue left $6,254 as ancillary revenue.

Should we assume that the ancillary revenue held constant from 2012 to 2013? Clearly that wouldn't be possible because excluding the Canada revenue from the non-ARPU Other Revenue left only $4,744 for both CVS and ancillary revenue, less than the $6,244 of ancillary revenue generated in 2012. At least the CVS Subscriber Revenue appears to make a little bit more sense.

Going from less than $6 million per month in 2013 to more than $7 million per month in 2014 and more than $8 million in 2015 was at least demonstrating year over year growth. That said, there are still some strange figures for a subscriber based business that should be growing rapidly. For instance, it is somewhat puzzling that there was a significant quarterly decline from Q4 of 2014 to Q1 of 2015, and that Q2 of 2015 was also below Q4 of 2014. Then, looking at the annual quarterly run rate exiting 2014

$24,884 * 4 = $99,536

we find that it is more than the total generated for all of 2015! Even looking at the growth of 11.6% from $88,252,000 in 2014 to $98,453,000 in 2015 isn't what I would characterize as growing at "strong double digit rates", and it remains to be seen if or when growth will finally pick up. This puts Meyer's comment at the October 2015 FBR Digital Media Thought Leaders Conference into perspective, when he said "It's going to take longer than I thought it would take."

Greg Maffei is the CEO of Liberty Media (NASDAQ:LMCA), the company that owns more than 62% of Sirius, and has expressed Liberty's interest in owning 100% of the company. He is also the chairman of Sirius, and made this disappointing comment in January:

I think we made great traction in building partnerships and good traction in building a platform and we have no business model yet for how we're going to get paid, or what it will ultimately mean.

He doesn't know how they are going to get paid? And he still wants to own the rest of the company? This past week Meyer spoke at the Deutsche Bank 2016 Media, Internet & Telecom Conference and the news wasn't much better. For instance, Meyer stated:

...the most immediate way to monetize those platforms is safety and security and convenience, to learn lock, press the button help, I have some kind of huge issue help me right now or automatic crash notification which is when you ask people one they care about them, like kids driving home, their by themselves you know everybody is petrify, the drive off the road and nobody knew and if the button went off that help them know exactly where to go. And we are monetizing that today and we'll get better at that, okay.

So, if this is so important and they are monetizing it today, why has the revenue not shown steady growth? But the real key for investors hoping that CVS will be the next leg of growth may lie in the following statement:

So the short answer, we're in the business for both offensive and defensive reasons.

I get concerned any time the CEO starts talking about being in a business for defensive reasons. It sounds like code for "we don't expect to make money on this, but it keeps a competitor from displacing us in the market and allows us to maintain market share." It's not necessarily a bad thing, but it does indicate that it is typically not a profitable business in and of itself, similar to a loss leader at the supermarket. It's okay to lose money on a particular product if the customer that was brought into the store purchases other products.

When Meyer was asked about the "economic model structure" and how Sirius would get paid, this was the answer:

We haven't. I can tell you, it's not a subsidy driven business it's different then the core audio business. And you know it's still finding its way and by that I mean you know these things going to be a feature that people pay for monthly or they going to be something automaker wholesales, they wants to build in the car for six years or ten years and that's though finding its way. So I want to be a little careful until we see what happens.

When asked about the company's investment in the connected vehicle space and whether the company would need to increase spending, Meyer responded:

...And third, we are investing heavily in the connected vehicle. But I think it's at the levels you are seeing right now, I don't think there is another, I won't promise you there is not but I don't see it right now.

I confess to being puzzled by this remark and several others made with respect to the acquisition from Agero because it is difficult to see where the company is spending very much in the way of development. The acquisition of the business was completed in early November of 2013. So, if one looks at the line item on the income statement labeled "Engineering, design and development", we find that the spending in 2012 - the year before the acquisition - was $48.8 million. It rose to $58.0 million in 2013 when only two months of the business were included and rose from $58.0 million to $62.8 million in 2014, the first full year of ownership by Sirius. (In 2015 the line item increased further to $64.4 million.)

Without detailed information provided by the company it is impossible to know with any degree of certainty how much is being spent on Connected Vehicle Services ("CVS") development. However, going from two months of CVS spending in 2013 to twelve months of CVS spending in 2014 resulted in an increase in the company's total development spending of less than $5 million, or $0.5 million per month. Even if all of that increase was related to CVS, it's only $6 million per year.

One other set of reference points to consider comes from the most recent 10K.

During the years ended December 31, 2015, 2014 and 2013, we recorded research and development costs of $54,933, $54,109 and $50,564, respectively. These costs are reported as a component of Engineering, design and development expense in our consolidated statements of comprehensive income.

This would show an even smaller increase in R&D, just under $3.55 million from 2013 to 2014. If that increase was all attributed to the 10 additional months of CVS expense, it would come to ~$0.355 million per month and only $4.3 million for the year.

Whether the figure is closer to $4.3 million or $6 million, it would appear to be inconsistent with other statements made by management, especially one made by Meyer in the Summer of 2013. At that time he noted that the company would be picking up an additional 140 software engineers. It's unlikely that the $6 million would be sufficient to cover the direct cost of those engineers, let alone the fully loaded costs that would also include benefits, travel, facilities, etc. And if it's only $4.3 million, it would be worse.

According to several studies, it seems that the fully loaded figure for a software engineer is close to $150,000, or $21 million per year for those 140 software engineers. One can speculate that some of that cost makes its way into cost of goods, whether through capitalized development costs or billing of professional services. Regardless, it's just one more piece of disconnected information.

For a company that describes its satellite radio business in much more detail, it is frustrating to have to go to so much effort to gain so little insight into its CVS business. As the year progresses, it will be interesting to see where the CVS subscriber revenue goes and whether the company doubles revenue and reaches $200 million. I have my doubts.

Then again, if Maffei has no idea how they are going to get paid and still wants to own the rest of the company, perhaps it shouldn't be too great a concern to the rest of the Sirius investors.

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: In addition to my long position, I have $4 covered calls written against a portion of my position and I regularly trade blocks of Sirius I also may sell $4.50 covered calls against my uncovered position at any time. Otherwise, I have no plans to trade any of the other companies discussed in this article over the next 72 hours.

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