Churn matters. Even a 2.0% or 1.954% rate of churn matters. It is one of two metrics released each quarter that measures the unwillingness of the listeners of Sirius XM Radio (NASDAQ:SIRI) to pay to listen to satellite radio. The other metric is the conversion percentage. The two measures showed 1,975,665 listeners to the service decided not to pay for the service last quarter. They are called "Deactivated Subscribers" in the Sirius XM 10Q and the quarterly earnings press release.
It is a number that, in all likelihood, would have resulted in more than 2 million subscribers being deactivated if it had not been for an increase in retention discounts that resulted in a churn rate of only 1.82% in the month of September. In fact, it is likely that far more than 2 million listeners made a decision not to pay in the third quarter. Deactivated Subscribers both overstates and understates the unwillingness of listeners to pay for the service. How can it do both?
Unpaid Trials and Deactivated Subscribers
There are a significant number of trials that go unreported each quarter. During the Q3 Conference Call, David Frear, Sirius XM EVP and CFO stated:
We entered the year with nearly 5.5 million trials in the conversion funnel. Growth in new and used car sales has led to consistent growth in the inventory of trial subscriptions, which now exceeds 6.2 million.
And, since we know from the 10Q that there were 4,323,864 Paid Promotional Subscribers at the end of Q3, that means that there were approximately 1.9 million unpaid, or free, trials outstanding at that time. These 1.9 million trials, an increase of 0.4 million from the 1.5 million unpaid trials at the start of 2012, are mostly from certain OEMs that do not pay promotional trial fees and the used car programs. They are not counted as Gross Subscriber Additions unless and until they convert to Self Pay Subscribers. Although it is not explicitly stated that the reported Gross Subscriber Additions do not include unpaid trials, one can infer this from the 10Q discussion of the increase in subscribers (note the bold phrase stating that it is the conversion of unpaid trials that increased gross subscribers, and not an increase in unpaid trials):
The improvements were due to the increase in gross subscriber additions, primarily resulting from higher new vehicle shipments and light vehicle sales, as well as an increase in conversions from unpaid promotional trials and returning subscriber activations, including consumers in previously owned vehicles.
We also know that in the Q1 conference call, CEO Mel Karmazin stated, "... the 1 million used-car additions, you should think of as a gross additions figure ..." and that past statements by management indicated that used cars trials would be expected to convert in the mid-30% range.
The point is that there are significantly more listeners of the Sirius XM service that choose not to pay than are actually reported. None of the listeners that get free trials and choose not to convert to self pay subscribers ever get reported as deactivations. And, if these listeners that don't find value and refuse to pay are under-reported, where is the over-reporting?
Churn measures all deactivations from the Self Pay Subscriber population. Some of these deactivations come from satisfied listeners that are trading in their old car and buying a new one with a free trial. This was an observation made in the first article I wrote on Seeking Alpha when I decided to start digging into the behavior of subscribers:
... as Sirius self-pay subscribers trade in their cars and buy new ones with a free trial, there is the potential for an INCREASE in churn. Why wouldn't the car buyer cancel the current subscription and take advantage of the new free trial?
Is this good or bad for Sirius XM? Churn overstates the unwillingness of Self Pay Subscribers to continue to pay for the service, so from that perspective it's a good thing. However, as I also noted in that article, there is a downside:
I expect that turnover of cars will eventually drive churn higher... ...if the current OEM arrangements continue, at some point Sirius will be hurt from both a revenue and a cost perspective. [Sirius XM] will be subsidizing the cost of the radio in the new car, receiving less revenue from the paid promo sub than they were receiving from the trade-in vehicle and sharing more future revenue from the new vehicle with the OEM.
Bottom line, it is increasingly more expensive to offer free trials (and lost revenue) and/or subsidies and revenue sharing to the OEMs when many of the "new" listeners are really former Self Pay Subscribers.
Conversions and Penetration
Conversions, or more precisely, New Vehicle Consumer Conversion Rate, is defined as:
...the percentage of owners and lessees of new vehicles that receive our service and convert to become self-paying subscribers after an initial promotional period. The metric excludes rental and fleet vehicles.
As the penetration rate of new vehicles - those OEM vehicles that come equipped with satellite radios - has increased, the conversion rate has declined. In 2010, the figure was 46%, followed by 45% in 2011 and 44% through the first three quarters of 2012. And, arguably, this took place during an improving economy. If fewer listeners are converting, it is an indication that more are unwilling to pay.
Also, consider the observation about a portion of churn being caused by listeners willing to pay, but canceling because they purchased a new car with a free trial. It these current subscribers are an increasing portion of churn, then they are also likely to be an increasing portion of conversions. And yet, conversion percentages are declining. Doesn't this indicate that the target market for the trials is rejecting the idea of paying for radio at a level much greater than 56%?
Where are Deactivations Headed?
Deactivated Subscribers will be increasing. Q3 of 2011 was the first time in the history of the company that the figure exceeded 1.8 million (1.804,448) in a quarter. It happened again in Q2 of this year when a new record of 1,858,962 was set, and it didn't last long as in Q3 the figure was 1,975,665. As more and more Self Pay Subscribers trade in their cars and get new or used vehicles with a free trial, the number of Deactivated Subscribers from that component of churn will increase.
If penetration continues to increase as it has done for the past several years, it seems likely that the conversion percentage will also decline. Even if penetration and the conversion percentages remain constant, increasing new vehicle sales will result in increased deactivations.
Whether or not the reported number of Deactivated Subscribers exceeds 2 million in the fourth quarter, it seems likely that the reported figure will exceed 8 million in 2013.
Subscriber dissatisfaction, as I use the term, is a measure of the listener's willingness to pay. It is an important area for Sirius XM investors to consider. Clearly, the overwhelming majority of those exposed to the service are unwilling to pay the full price. Some are willing to pay less, as is evident from the company's extensive use of retention discounts. Many are just unwilling to pay for radio.
The level of dissatisfaction does not mean that the company won't continue to grow revenue, earnings and free cash flow or add subscribers for the next few years. It does, however, indicate that the rate of growth will be difficult to maintain. Where will most of the growth come from?
As the new vehicle sales increase, the used vehicle program gains traction and the price increase continues to be rolled out to the other 40% of self pay subscribers, revenues will rise. However, extensive use of retention discounts and the continued rise in deactivated subscribers will be headwinds that need to be overcome.
On the cost side, Karmazin has discussed how the renewal of OEM agreements will be on terms more favorable to Sirius XM. Revenue Share and Royalties is the single largest expense item for Sirius XM, with about half of that amount Revenue Sharing. Subscriber Acquisition Costs, subsidies for the OEMS to place radios in their vehicles, is the second largest expense for Sirius XM. To the extent these and other costs (i.e. Programming and Content or Interest expenses) are reduced, earnings and FCF will improve. These will be partially offset by increased costs in Sales and Marketing and Customer Service and Billing expenses as the number of subscribers rises. And, there is the wild card of the future royalty costs which should be known next month.
There are risks, uncertainties and opportunities for Sirius XM. It is probably the reason that there is a wide disparity in the price targets of the 14 analysts that follow the stock on Yahoo!Finance and the reason that the mean is only $3.14 and the median only $3.10 despite the recent high of $2.97.
Disclosure: I am 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 have $3 January 2013 covered calls against most of my Sirius position, as well as some $2 and $2.50 January 2013 and $2.50 December covered calls. I may initiate (or close) a buy stock/sell option position in Sirius, at any time. Also, in addition to long term holdings, I have recently begun day-trading 10,000 share blocks of Sirius XM and may continue to do so.