Is Telematics a Sirius Mistake?
Sirius XM Holdings (SIRI) placed a half billion bet on telematics last year when it purchased the connected vehicle services unit from Agero. It wasn't until the year end earnings call that investors in Sirius XM knew much about the purchase, and even now it remains shrouded in mystery. If one wants an idea of the "product" that Sirius purchased, one can watch this video that's more than a year old. If an investor wants to know about the financials and the profitability, it's much more difficult.
According to the company's 10k, the transaction closed on November 4th, and the acquisition makes Sirius a "leader in providing connected vehicle applications and services." Furthermore, it states that these services "are designed to enhance the safety, security and driving experience for vehicle owners while providing marketing and operational benefits to automakers and their dealers." (Subscribers to the services are not included in the company's reported subscriber count.)
It was obvious when Sirius failed to make any statements about the profitability or cash flow about the acquisition that it was not, and was not about to be, accretive to earnings or free cash flow. When companies make acquisitions that meet these criteria, they are typically touted as such in the press releases or presentations to analysts. During the last earnings conference call, the following statements about the acquisition were made by CEO Jim Meyer and CFO David Frear:
[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. We are in the process of fully integrating the CV business into Sirius XM, and its financial results are embedded in our guidance today.
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, but with high variable margins, a relatively low capex profile, and substantial scaling in the business as penetration expands, we see many similarities in the financial profile of connected vehicle services and satellite radio.
Just keep in mind the connected vehicle business is still in its very early days. Building this business is a key step in realizing our vision of a merged satellite and IP connected environment that will truly deliver amazing features to our subscribers and benefits to our business. The race we are running is a marathon, not a sprint. It will take several years, just like satellite radio did, to fully deploy our connected vehicle services, but successful leadership now will create a significant source of growth in the years to come.
[Frear] In the fourth quarter, we added an important new accelerator of future growth through the acquisition of the connected vehicle business from Agero, connecting cars at a very early stage of development. In the next five years, we expect connected vehicle production penetration rates to expand to more than 50% from less than 10% last year.
Today, we have relationships with more auto makers than any other connected vehicle service provider, and believe we are in an excellent position to add more OEMs to our roster of connected vehicle partners.
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. For those of you who have been following satellite radio, you know that integration of a product into a car takes time, but once in, it has a visible, long term growth path.
[Meyer]Our vision and what we've demoed to them and shown working hardware of, is a platform that combines satellite and LTE in the North American markets and then it allows the satellite portion to be easily uncoupled everywhere else in the world, at virtually no cost premium to do that.
And so we're providing them a very flexible platform that they could incorporate on a worldwide basis. What specific service strategies will evolve in those evolving regions is still work to be done.
We have been told that the revenue will approach $100 million in 2014 and that it will be at or near EBITDA breakeven. What was casually overlooked is that it will be EPS negative. The 10K shows intangible assets related to the acquisition of $220 million for OEM relationships and another $10.7 million for proprietary software. The former amount is being amortized over a 15 year life (apparently on a straight-line basis) and the latter over a 10 year life (apparently on an accelerated basis). In the last two months of 2013 the total of these two amortization charges (that's the "A" in EBITDA) was $2.7 million. That should result in approximately $16 million of amortization in 2013. It's also debatable as to whether or not the acquisition increased the debt of Sirius.
The debt rose in Q4 when the purchase took place, so it could also be reasonable to consider this a debt financed acquisition. In that case, one could consider the "I" in EBITDA to equate to another $25 million in 2014. Those two items total more than $40 million, and it doesn't take into account some other small amounts for depreciation on the acquired assets of more than $25 million of property and equipment.
The company also notes that:
Pro forma financial information related to this acquisition has not been provided as it is not material to our consolidated results of operations.
Since the acquisition was part of Sirius for less than two months of 2013, the impact would clearly not have been "material." In the context of the company's 2014 guidance of revenue of over $4.0 billion, adjusted EBITDA of approximately $1.38 billion, and free cash flow approaching $1.1 billion, impacts of the acquisition of less than 3% for the 2014 will be small. The real question for investors is: Will the impact of telematics ever be material?
Certainly not in the next three years. Consider this - the acquisition is EBITDA breakeven in 2014. It will generate close to $100 million in revenue this year. Those two statements indicate that the direct cost of sales and operating expenses are also approximately $100 million. Refer back to the comment by Meyer:
...with high variable margins, a relatively low capex profile, and substantial scaling in the business as penetration expands, we see many similarities in the financial profile of connected vehicle services and satellite radio.
I would rather not see many similarities to the "financial profile" of satellite radio. It took a long, long time before satellite radio became profitable, and only after the merger of the only two players in the field. In the connected car space the players are far more diverse and the competition more formidable. From the 10K, we see the services cover:
Our connected vehicle services are designed to enhance the safety, security and driving experience for vehicle owners...
...We offer a portfolio of location-based services through two-way wireless connectivity, including safety, security, convenience, maintenance and data services, remote vehicles diagnostics, stolen or parked vehicle locator services, and monitoring of vehicle emission systems.
The 10K discusses competition as follows:
Our connected vehicle services business operates in a highly competitive environment. Our major competitors include Verizon Telematics and Sprint. OnStar, a division of General Motors, also offers connected vehicle services in GM vehicles. We also compete with wireless devices such as mobile phones, carriers of mobile communications and, to a lesser extent, with systems developed internally by automakers. We compete against other connected vehicle service providers for automaker arrangements on the basis of service quality and reliability, technical capabilities and systems customization, scope of service, industry experience, past performance and price.
Let's face it. Stolen vehicle recovery systems have been around for a quarter of a century. Remember Lojack (LOJN), a pioneer in this area? Location services are available using GPS systems and smartphones. And, before any of the Sirius fanatics start discussing the extra costs of using a smartphone, note that the connected services product that Sirius offers is based on "two-way wireless connectivity."
Verizon (VZ) Telematics has its own website and claims that it is "the service provider of the next level of connectivity" for Mercedes and VW (as well as State Farm). Sirius is partnering with AT&T (T) on its solution for Nissan (OTCPK:NSANY), but AT&T is not about to cede this market. And neither are Apple (AAPL), Microsoft (MSFT), Google (GOOG), or Qualcomm (QCOM).
And if competitors with deep pockets aren't enough of a threat, where is the profit? Meyer has previously talked about acquiring 125-150 software engineers. Is it possible that the total number of employees picked up is close to 500? The 2013 year-end number of employees at Sirius was 2,195, up sharply from the 1,596 at year end 2012 and the 1,526 at year end 2011.
Summary
Meyer discussed the telematics efforts by Sirius as a marathon, not a sprint. It may turn out to be an approach that will work, although in a high tech arena, it could prove to be a recipe for failure. Good marathon runners move along at a steady speed, conserving energy. Sprinters go all out from start to finish.
To the extent that the future of telematics will include rapid adoption and integration of safety features like automatic braking, self steering vehicles and parking assist, companies that can sprint ahead and rapidly adapt and deploy new technologies would seem to be more attractive partners.
Those companies that have expertise in two-way communications or experience in communicating with the embedded computer chip already in the vehicle would also seem to be more desirable partners. Sirius has not demonstrated these strengths. Instead, it has made a large bet by making an acquisition, a bet which may have difficulty living up to the expectations of some analysts and investors.
Disclosure: I am long SIRI, VZ, T. 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. I actively trade SIRI. In addition to my long positions in SIRI, I have January 2015 $4 covered calls written against some of these positions. I may initiate new covered call positions or close out or open new positions in SIRI at any time.
