Sirius XM (SIRI): A Look Ahead (Part 3 of 3)
by Dennis “Cos” Costa
This is the third installment of a three part series on Sirius XM Radio (NASDAQ: SIRI), which in July 2008 received final merger approval from the FCC. The intention of the series has been to give current and future investors an in depth, fact-based review of this unique media company’s struggles and successes since the merger. The series is a chronological archive of macroeconomic events and their impact on the internal financial operation of the company.
The first installment, Part 1 – A Look Back, discussed the period between the FCC merger approval to a time when the company’s debt maturities, together with the global banking crisis, made it necessary for the company to strike a deal with John Malone’s Liberty Media (NASDAQ: LCAPA, LCAPB, LINTA, LINTB, LSTZA, LSTZB). In the second installment, Part 2 – The Recovery, the time-frame reviewed was from March through December of 2009. This was a critical period for the company, which rebuilt investor confidence when they returned to subscriber growth, displayed product pricing elasticity when increased subscription costs resulted in manageable customer churn, outperformed projected operating expense reductions from merger synergies, and ended the year free cash flow positive with a net income of $14M.
In this third installment, Part 3 – A Look Ahead, the company’s financial performance in the first quarter of 2010, their current and future commitments to debt, and a review of their capital expenditures will be assessed. The company’s unique business model of providing subscription based premium content on a unique delivery system of satellites and terrestrial repeaters, and their associated costs will be reviewed. To sum it up — Part 3 will be a detailed review of how debt, capital expense, revenue growth, and operating synergies with unique premium content will impact future returns to investors.
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A Brief Review:
In assessing the company’s ability to generate cash from operations from mid 2008 (the merger) through early 2009, events were identified as contributors to the company’s inability to generate sufficient cash to meet maturing debt obligations.
•The company’s past practice of refinancing debt was crippled by the macro-economic pressures brought on by the global credit crisis in September 2008.
•The extended 17 month FCC and DOJ merger approval process, and debt maturing for Sirius and XM six months after the merger, made it impossible for the combined company to generate adequate cash from operations to satisfy the impending need.
•Offering common shares for debt also proved inadequate, while the process diluted existing shareholder equity, with its failing nearly driving the company to a bankruptcy filing at the end of February 2009.
In the end, it was a combination of diluting shareholders and restructuring the company’s debt with a bailout from John Malone’s Liberty Media (NASDAQ: LCAPA) which avoided the bankruptcy filing. Although Sirius XM repaid the Liberty outstanding notes, and terminated all lending agreements within five months of their origination. Liberty retained a 40% Preferred Share equity position, and a proportional number of Board of Director seats on the company’s board for their efforts.
Throughout the rest of 2009, the company executed its business plan effectively, realizing merger synergies which reduced expenses by 20% year-over-year, represented by an improvement of $509M. They grew revenue by 4%, or $90M to $2.527B, primarily by initiating several revenue generating programs affecting most existing and all new subscribers. This increased revenue came from the U.S. Music Royalty fee introduced in the third quarter 2009, the sale of “Best Of” programming, and rate increases to the company’s multi-subscription and Internet packages.
These expense-side efficiencies and revenue generating efforts, resulted in the company’s first full year of Free Cash Flow (FCF) of over $185M, and a year-over-year improvement in income from operations of ~$600M. In the fourth quarter of 2009, on a Generally Accepted Accounting Principle (GAAP) basis, the company earned its first time ever profit of $14M, compared to a loss of ($246M) in the same 2008 quarter. These notable efforts by management, allowed the company to pay debt of ~$83M maturing in 2009, and $58.8M maturing in 2011 with cash on hand, and without any further dilution to existing shareholders. They also finished 2009 with ~$380M of cash and cash equivalents, reflecting their ability to generate cash from operations – while also meeting current debt due obligations.
Year to Date 2010: Debt and Capital Expense
In the first quarter of 2010, Sirius XM continued to make progress towards managing its balance sheet, while continuing to grow its subscriber base. With a combined debt-tower coming due in 2013 of ~$1.8B, and more than $588M due in three tranches in 2011 and 2012, the company made significant strides towards addressing its debt issues in the first quarter. On March 19th 2010 the company filed an SEC Form 8K, which outlined the issuance of $800M aggregate principal amount of 8.75% Senior Notes due 2015. The notes were used to repay the company’s Senior Secured term loan of ~$244M due 2012, which also resulted in the termination of this loan’s associated term credit agreement, deleveraging the Sirius’ satellite assets held as collateral in the process. The remaining proceeds of the $800M Senior Notes went to pay all of the $500M of 9.625% Senior Notes maturing in 2013. With this one balance-sheet restructuring event, the company pushed out the maturity dates on a significant amount of its debt, while also reducing the interest rate on two-thirds of it.
Interestingly enough, Liberty Media also decided to increase its investment in Sirius XM by 54% in the first quarter by buying $150M of the 8.75% Senior Notes on the open market, increasing its total Sirius XM debt holdings from $279M to $429M. It would appear John Malone continues to see the longer term value of Sirius XM as a good investment, even as the interest rate on money invested has been reduced. It can easily be seen that Sirius XM’s financial condition is more stable now than in March of 2009, warranting a lower risk premium paid by the company in its debt offerings. With the risk-equation for default having been significantly reduced, it would appear that the company’s debt is now getting increased attention from early-entry investors, as evidenced by participation in its latest 8.75% Senior Note offering. This offering went to market originally placed at $550M and was later increased to $800M apparently because of the demand.
In addition to these significant efforts in restructuring the balance sheet, Sirius XM announced on April 28th 2010 that on June 1st they would be redeeming all outstanding 10% Senior PIK Secured Notes maturing in 2011. These notes have a long history, and were originally $400M of XM’s 1.75% Convertible Notes due in December 2009, prior to the merger. The Bondholders who held these notes have been rewarded generously over their restructuring history. They have received common shares and higher interest rates with each restructuring for their willingness to accept risk. In a statement from the company:
“Our strong cash position, strong first quarter subscriber growth and the improving outlook for the economy have put us in position to retire these notes a year ahead of schedule. The early retirement of these notes will reduce interest expense and increase our free cash flow.”
David Frear, Executive Vice President and Chief Financial Officer of Sirius XM
What is not commonly known about these 10% PIK Notes is that Sirius XM was paying a premium interest payment of 2%, for the June and December 2010 payments, making this a 10% plus 2%, or a 12% interest expense for 2010. In December 2010, the premium was to change again to 4%, making the expense 14% for the remaining six months through maturity on June 1st 2011. Paying these notes early removed premium payments for December 2010 and June 2011 in their entirety. This is another example of the company’s commitment to using cash-on-hand to reduce carrying costs on more expensive debt obligations. This practice of using cash to pay for debt represents management’s confidence that the business model is sufficient enough to meet future commitments, and reflects an important change for investors.
Investors and analysts expressed some concern in the first quarter when the company reported negative free cash flow of ($127M), especially with the company simultaneously reporting net positive subscriber additions of 171K. A deeper look at the numbers reveals that management again used cash on hand to make several lump sum payments. The cash payments were made to reduce interest expense, and their associated fees, that came with operating expenses which were previously paid for over time. There was an early repayment of $61M for changes to operating assets and liabilities deferred from 2009, and scheduled to be repayed beginning in April 2010 through March 2011, at an interest rate of 15%. Additionally, a lump sum programming payment was executed in the quarter, which had been paid in 2009 over-time. Bonus payments were also made in cash instead of using common stock, as had been the practice in 2009. First quarter free cash flow was also reduced by increased capital expenditures by an additional $27.8M, which was primarily due to increased satellite spending.
Sirius XM’s infrastructure of satellites and terrestrial repeaters, required to deliver content seamlessly to Sirius and XM subscribers, have been responsible for a large percentage of the company’s debt, and will be reaching a point of full deployment over the next 12-18 months. The company has been paying for the production of XM5, which will be used for the XM constellation, and FM6 for the Sirius constellation of satellites. The company entered into an agreement with International Launch Services (ILS) to secure a satellite launch for XM5 on a Proton rocket launch later this year. The company has estimated the remaining cost to complete these deployments, and supporting terrestrial repeater infrastructure, to be $232M over the next five years. The majority of these costs will occur in 2010, and next year in 2011, at an expense of $138M and $67M respectively. The remaining $27M will be spread out for the remainder of the 5 year projection.
The steps that Sirius XM have taken in 2010 to restructure its balance sheet in the first quarter have resulted in ~$744M of near term maturing debt being extended out two additional years to 2015. They have prudently used cash to pay off the remaining $114M in 10% PIK debt due in 2011. The debt was costing 12% and was going to increase to 14% for the reamaining 6 months to maturity. The company also used cash on hand to pay lump sum payments for deferred 2009 expenses, and 2010 programming and content costs. This eliminated a 15% interest expense and fees that would have been incurred otherwise. They have also paid cash for bonuses in the first quarter instead of utilizing common shares, which had been past practice, and would have diluted shareholder equity. All of these measures show notable improvement in Sirius XM’s ability to generate cash to meet obligations as they become due, and in some cases before.
Given the debt payments made in the second quarter, the company will account for one-time loss on the extinguishment of debt of ($31.8M). This number is accounted for in two sums, one for the early repayment of the $500M Senior Notes of ($27.7M) and the other for the $114M PIK Notes of ($4.1M). This non-cash expense is all of the anticipated debt repayment for 2010, and will reflect a year-over-year improvement in this non-cash expense category of $137.6M for the full year. While this will not effect the company’s adjusted income from operations, it will impact the company’s net income and full year results on a GAAP basis.
In the second quarter of 2010 reporting, the numbers will reflect an improvement of over $75M, from last years ($107M) in the ”loss on the the extinguishment of debt” category. Also in the second quarter, there will not be a restructuring impairment charge of ($24.2M) for loss attributed to a counter-party bankruptcy, as was reported in the same period of 2009. The impairment charge was attributed to money prepaid for the launch of an XM satellite. These two non cash expenses will total a net improvement of just under $100M in the second quarter on a year-over-year basis. Do not expect these year-over-year improvements to be the focus of analysts when the 2nd quarter numbers are reported. It is my opinion that the one time charges described above, and the 10% PIK repayment of $114M plus interest in cash, will be the primary drivers of both negative net earnings and free cash flow for the second quarter when reported.
A Look at Operations
As has been reviewed above, debt and restructuring of the company’s balance sheet have been a primary management focus, and understandably so since the combined company’s formation, and throughout the financial crisis. The benefit of the company’s relationship with its automotive OEM partners has helped to continue to generate new subscribers. Even in the worst of times in 2009, when the company reported a net subscribers loss of over (580K) for the first six months, the business model still managed to be cash flow positive and reported over $240M of adjusted income from operations. In the last half of 2009, the company returned to net subscriber growth, adding more than 339K subscribers and another $221M to adjusted income from operations, totaling $461M for the full year 2009. Adjusted Free Cash used in operations was reported as a positive $185M.
During the first quarter conference call management maintained guidance of achieving net subscriber growth of over 500K and positive Free Cash for the year, disappointing analysts and investors as reflected in a pull back in the company’s equity. Less than two weeks later on May 17th, the company released revised guidance, increasing full-year total net subscriber additions to 750K and positive free cash to $100M for 2010. Analysts and investors were caught off guard when on July 7th the company announced the results of net subscriber additions for the second quarter of 583K, attaining the company’s six week earlier revision of over 750K subscribers in the first two quarters of 2010. In the company’s press release, they also revised the company’s full-year 2010 net subscriber additions from 750K to over 1.1M.
The second quarter net subscriber addition number gave investors a reason to celebrate, while also giving them pause to assess the impact on operating expenses, as subscriber growth comes with a double edged sword. The additional subsription numbers will increase subscriber revenue, and improve net income and free cash flow in future quarters, but the cost of acquiring such a large number of subscribers will impact operating expense significantly in the quarter which the growth occurs. Investors sometimes confuse the operating metric of subscriber acquisition cost, as adjusted, per gross subscriber addition, with the actual subscriber acquisition cost (SAC) that is reported on the company’s income statement. The confusion comes in thinking that a decrease in the metric of per subscriber addition has any impact on the actual increase in the expense associated with the growth. The metric is a function of the net subscriber additions acquisition expense, and not the other way around.
The metric for SAC, as adjusted, per gross subscriber addition reported in Q1 was $59. This metric is derived from taking the net subscriber acquisition cost, $100M in Q1, and dividing it by the total subscriber additions for the quarter, which was ~1.7M in Q1. The metric of $59 can fluctuate up or down as subscribers are added, but effective operational management of this expense should result in a fairly flat per-subscriber add result over time, as efficiencies in providing equipment in OEM production reach peak. With that being understood, an increase of net subscriber adds of 583K could easily result in an additional cost of $10-$14M for Q2, bringing net SAC to $110-$114M, or more, depending on the ”mix” of subscribers added. It is also possible that the costs would be less if used cars, having equipment already installed, made up a significant portion of the net adds. Smartphone streaming applications also have much lower acquisition costs. The conservative approach would be to continue to value a majority of these new subscribers as being generated from the existing OEM channel, until otherwise noted by the company’s reporting. With the vehicle manufacturers being committed to managing their inventories in a manner which reflects consumer demand more accurately, satellite radio equipment costs should reflect proportionately, the increases in the OEM production schedules going forward. The days of languishing inventories of vehicles equipped with satellite radios as parking lot subs should be behind, with improvements coming as part of the industry’s restructuring over the last year.
While there are the costs associated with the net subscriber additions, there are the revenues derived from the base subscriptions, the activation fees, the music royalty fees, and any add-ons each subscriber may select, that is at the heart of the company’s business. “Best Of” programming and premium Internet streaming content also add revenue to the company, offsetting each quarter’s operating expenses with higher margin services. In the second quarter the company will receive the benefit of the first quarter’s additional subscriber revenue. All subscriber revenue is aportioned monthly for the duration of its use. For estimating purposes, about half of the first quarter additions can be fully weighted in the second quarter. The reason for this is that not all subscribers become active, generating revenue on the first day of the quarter. The other half of these Q1 subscribers are already part of the first quarter’s revenue base. It can be estimated that this will also be the case in the second quarter for the same reason. Subscription revenue always lags, and the expenses to acquire the subscription are upfront. This method of estimating the impact of newly added subscribers results in a fully-weighted subscriber addition in the second quarter of 377K subscribers. Using average revenue per subscriber of $11.50, we can estimate an increase in subscriber revenue in the second quarter of $13M. If we add in an increase in equipment revenue of ~$2M, and another $3M for an increase in net ad revenue as this metric improves, total subscriber revenue will increase to ~$688M from the first quarter reported revenue of $670M.
Second Quarter Estimates
To summarize, the estimated impact of increased operations expense derived in support of subscriber growth, and one-time charges incurred on the early repayment of debt, need to be combined to estimate their impact on net income. This provides a total estimated increase in Q2 expense, compared to Q1, of ($42M-$46M). Combine these expenses with the estimated increase in revenue for Q2 of ~$18M and the result is a change in net income of a negative ($24M-$28M) for the second quarter, or an EPS of (0.0-.01) per share. When the actual numbers are revealed, other operating expenses, including revenue share and royalty, programming and content, and sales and marketing, may have impact to net income which either improves or diminishes these projected results.
When estimating adjusted income (loss) from operations, an important metric reported by the company as a measure of operating performance, the one-time expenses of ($31.8M) will not be included. In the first quarter 2010 the company reported just under $158M of income from operations, and in the second quarter, given the increase SAC expense, an estimate of adjusted income from operations of ~$140M can be supported. From the company’s own footnotes in reporting this metric they state:
“We also believe adjusted income (loss) from operations is useful to investors to compare our operating performance to the performance of other communications, entertainment and media companies. We believe that investors use current and projected adjusted income (loss) from operations to estimate our current or prospective enterprise value and to make investment decisions.”
When looking at Free Cash Flow in any of the company’s quarters, there are many variables which make this number difficult to estimate with any accuracy. The company itself has given guidance that they will achieve more than $100M of free cash by the years end, and did not change that projection with its recent guidance revision. Given the apparent front-loading of expenses in the form of lump-sum payments for operating and programming expenses in Q1, and the use of cash on hand to pay for the 10%PIK notes at a cost of $114M plus interest on June 1st 2010, there is little reason to be optomistic that the free cash number will turn positive this quarter. With the subscriber net additions recently reported, there is reason for optimism that Q3 and Q4 may provide the catch-up free cash flow necessary to meet the company’s target.
A Look Forward
With new subscribers of 583K reported by Sirius XM in their press release, and estimates placed on what that will mean for company earnings in anticipation of reporting the actual financial results for Q2, the explanation of what has changed to cause this surge in new subscribers is what analysts and investors will be listening for. The second quarter automobile numbers were good, showing improvements in many areas and stability in others. Many have been aware of the efforts the company is making in the Certified Pre-Owned (CPO) vehicle markets, the partner incentive program with AAA Insurance, and the free trial period to all deactivated and installed radios in cars. What is not known is what caused this upside surprise in subscriber additions here in the second quarter. Management will be letting investors know in their conference call, estimated for the first week of August 2010. The company has been known for under promising and over delivering in the past, but these numbers appear to have taken even the company by surprise, with such a disparity between their mid quarter revision and the actual performance in adding customers.
With the company projecting to add over 1.1M subscribers by the end of the year, after already adding 750K in the first half of 2010, what other surprises might be in store for the company as the second half of 2010 unfolds. Quite honestly, with churn being managed at under 2.0%, it is this author’s opinion that the new target is grossly understated, and subscriber total adds of between 1.4M and 1.8M could be seen by years end. Some of the factors to consider are:
•Howard Stern’s contract renewal is a must for the company to continue its momentum as a unique and premium content provider of audio entertainment. Love him or hate him, Howard Stern is a media personality that creates a ”buzz” wherever he goes, around everything he does. Failing to sign Stern could mean competing with him. As some media watchers have pointed out, the negative press and potential competition that would ensue is undesirable for Sirius XM at this time. Stern’s unique brand of programming is a product which brings much attention to satellite radio.
•A recovering automotive sector is essential to Sirius XM Radio’s continued growth, but not at any cost. The company has adequate sales data to review which models have the best conversion rates, and which ones do poorly. Working with their OEM partners to negotiate these issues, and reduce unecessary costs, creates an opportunity for refinement of their relationships and improving margins.
•Sirius XM is continuing to build traction in the CPO market, and the used car universe in general. An investment has already been made by equipping so many vehicles during the initial building of their OEM new car business. For every 12M new cars rolling off the assembly line, another 7.2M are equipped with satellite radios at 60% penetration, and of those ~3.3M leave the dealership without ever being turned on, using the current conversion rate of 46%. This is a high margin opportunity for the company — with equipment costs already paid. This is the most lucrative and growing inventory of product, presenting terrific sales opportunities. Developing innovative ways to capitalize on this investment is essential.
•Continued and increased partnering with expert software developers, for innovative and desirable smartphone applications for use on all cell phone carrier networks, will help create the ”stickiness” the company’s premium content will require. Making all means-of-delivery accessible will provide new and existing subscribers a more value-added experience. It also will be essential in managing churn, adding strength to locking out the competition, and for up-selling high margin products to new and existing customers.
With most of Sirus XM Radio’s debt issues resolved in the short term, and only $230M of 2011 debt still to be resolved, it would appear that the balance sheet is in stable condition through 2013. Capital expense in the first quarer reported a commitment for 2010 of $138M, and for 2011 of $67M. These capital expenses will complete the company’s in-orbit constellation of satellites for both company’s systems, with only $26M in capital expense required through 2015 and beyond. These eliminated capital expenditures will now contribute to the growth of Free Cash and Net Income — beginning in 2011.
Subscriber growth this year of well over 1.1M, as estimated above for 2010, will contribute dramatically in 2011 to Free Cash and Net Income. Total revenue is on track to reach over $2.9B by year end in 2011. Given the current stock price of the company, and the momentum building as the company becomes a growth story again, a share price of $1.45 – $1.75 could be supported by the end of this year. For 2011, as with every year since the merger, this nacent media company will have a few more surprises, as John Malone begins to give clarity to the longer term plans of Liberty Media Corporation, with their 40% ownership position in Sirus XM. In March 2012, the first opportunity for Liberty to acquire Sirus XM, with a full-tender-offer, will become available. There are other possibilities for Liberty, as reported by Demian Russian, Editor-in-Chief of Satellite Radio Playground, in his article discussing Liberty’s potential for a Reverse Morris Trust transaction with Sirius XM. The article explores options available to Liberty, discussed in Citigroup (NYSE: C) analyst Jason Bazinet’s upgrade report, which evaluates in depth, opportunities available for the companies to maximize Sirius XM’s valuable Net Operating Loss (NOL) assets.
Additionally, Sirius XM Radio’s restriction from raising its subscription prices, as outlined in the FCC merger contingency agreement, will expire on August 1st, 2011. The company has already shown pricing elasticity, when it was able to pass-through music royalty fees, inititiate a charge for premium internet subscription fees, and increase the cost for adding an additional subscription to an existing subscriber account. Will they attempt to raise the price of their base subscription next year when this restriction expires, growing revenue and free cash in the process? For the answer to this question, and other issues as they may develop, visit Satellite Radio Playground for factual information as it is announced, and for analysis of what those announcements may mean to investors.
Position: Long SIRI
