Partnerships

In the wake of the GM bankruptcy, investors in satellite radio suddenly have become concerned about what impact will befall Sirius XM. Analysts such as Scott Moritz of TheStreet.com say that this “can’t be good”. In a video Moritz spoke briefly about the situation, but seems to have only highlighted one side of the story. I submit that the news is a mixed bag, and that both short and long term impacts need to be considered.

Moritz looked at the impact from a “subscriber numbers” standpoint, saying, “They are already going to lose 1.6 million subscribers this year, and that was before the GM bankruptcy announcement.”

The problem with looking at only part of the picture is that there is a whole dynamic that gets missed. Yes, GM is Sirius biggest supplier of subscribers, but they are also a huge expense to the company. Each subscriber requires an investment by Sirius XM radio. This investment, referred to as Subscriber Acquisition Cost, is an expense to the company in the short term, in hopes that that investment will pay for itself in the long term. In the best situation, with higher end cars, it takes about a year for the company to recoup their SAC cost. Lower end cars can approach the three year mark to reach break even.

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As Sirius XM gets ready for their annual meeting of shareholders, their biggest OEM partner, GM, could well be getting ready to file for bankruptcy. For the overall sentiment of the economy, the GM news is hardly good. Consumer confidence has been on a virtual see-saw, and a GM bankruptcy has wide reaching implications. The question for Sirius XM shareholders is what impact a GM bankruptcy will have.

Sirius XM has already absorbed the news that Chrysler’s woes will carry a dramatic impact on the Q2 numbers. With their bankruptcy, Chrysler halted production of vehicles, and by extension, satellite radio installations.

General Motors bondholders have rejected a debt for equity swap that would have staved off bankruptcy and facilitate an additional cash infusion into the company. The automaker has until Monday to complete government-ordered restructuring of debt, labor costs, and production plant closures. The UAW had agreed to take a 20% stake in the company, but it is the $27 billion in debt held by bondholders that is the stumbling block. Those bondholders were offered a 10% stake.

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The headlines came out toady, but the news was not unexpected. The troubles at Chrysler and GM have been known for quite some time, and dealership closings were inevitable. The impact of these closings will be wide reaching both economically, as well in the psychology of the consumer.

Consumers sometimes become as loyal to a dealership as they do to a car brand. A good dealer gets repeat sale after repeat sale. If that dealership offers good service, they get continued business. In the near future it is possible that 789 Chrysler dealerships will close if the court approves. From the GM standpoint, it has already been announced that 1,100 dealerships. If these dealerships close, consumers will find themselves shopping, and perhaps will shift to other brands.

According to Chrysler, half of their dealerships accounted for 90% of their sales. If true, these metrics virtually demand that closings happen. The American car companies have had many challenges in trying to compete with imports. Huge costs and and a perceived lower quality have riddled the big three for years. With a slumping economy, the issue has simply come to a where substantial change needed to happen.

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With Chrysler filing for bankruptcy protection, and the news that they will be halting production for a period of up to two months, people may immediately assume that the news will be bad for Sirius XM Radio. Frankly, the Chrysler situation presents a mixed bag of news for satellite radio investors. There are a few stories out there that note the Chrysler news, but look at it as a pure negative. If you look deeper into how the mechanisms of these deals work, you may arrive at a differing conclusion. To better understand the discussion of this article, we request that you refer to our piece titled “Understanding The Metrics Of Sirius XM”

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It did not get a lot of fanfare in analyst reports, nor did it seem to be a huge topic of discussion, but the new GM deal means a lot to Sirius XM Radio. To fully grasp this, we need to go back in time to when the GM deal was first struck.

When XM Satellite Radio reached a deal with General Motors, it was a big win for satellite radio in terms of “getting onto the map”. It was the GM deal that paved the way for other OEM’s to follow suit. In many ways, the success of satellite radio happened because of that deal. That being said, it turned out to be a quite expensive deal for XM satellite radio, and now the merged Sirius XM.

At that time, XM Satellite Radio was not 100% commercial free music. The price of a subscription was also less expensive at $10 per month vs. Sirius’ $13 for commercial free music. XM’s business plan called for subscription revenue PLUS ad revenue. The thought was that the ad revenue would bolster the money brought in in a substantial way. What XM promised GM was that they would get a percentage of the SUBSCRIPTION revenue (capped and based on the $10 subscription rate) that would eventually get to 50%. This is not a real problem for XM if they were getting an additional $3 or $4 dollars in ad revenue. It became a huge problem because that type of ad revenue never came to fruition. Eventually XM abandoned the ad supported music business model, raised prices, and went commercial free on music.

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It is no secret that the OEM channel is where Sirius XM Radio garners most of their subscribers. Given that fact, it becomes important to understand how the OEM channel works as well as how the metrics are counted. While most already know it, different companies have different deals, and the determination of whether a radio is considered a subscriber is tied to a payment on a subscription. Thus, some manufacturers, such as GM, are not counted until the end user buys the car. This happens because there is no subscription payment until the car is sold. On the other side of the equation, we have Chrysler. Chrysler pays for a subscription at manufacture, and in doing so, the subscription is counted as soon as the car rolls off of the assembly line. In terms of subscriber numbers, it is not only car sales that matter, but OEM production as well.

One oft discussed metric in the OEM channel is the penetration rate. This metric is measured by the percentage of vehicles that come with SDARS installed. Typically, when the OEM world is running like clockwork, this metric has true meaning. There are enough constants out there that you can measure the penetration rates of various OEM against their sales or production. In times like these, the penetration rate as a measure gets quite skewed.

HERE IS WHY… if we assume that an OEM is going to manufacture 1,000,000 vehicles, and has a 50% penetration rate, then we can expect 500,000 satellite radio subscriptions in the pipe-line. Sirius XM contracts the production of the radios, and supplies them to the OEM partner. Now assume that auto sales are down drastically, and that OEM slows production to 750,000. The 500,000 radios are on the shelf and awaiting installation. In this situation, the penetration rate increased to 66%, but the number of radios remained the same. Is the new 66% penetration rate good news? For someone that does not think deeply enough it would appear to be. The real question that is not quantifiable when looking at the OEM channel is whether or not the supply of radio’s has changed. Investors need to consider this.

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With the clock ticking on Chrysler to solve their debt woes, investors in Sirius XM have something to think about. Chrysler was a major player in the OEM channel for Sirius over the past few years, but slow sales, and slowed production have made Chrysler’s contribution to the subscriber roles diminish.

Different OEM’s have different deals, and the way OEM subscriber counts are tallied also differs. Sirius XM counts vehicles in which they receive payment for as a subscriber. This is the case whether the payment is from the OEM or the end user. Because Sirius XM receives payment from Chrysler at production, the subscription is counted prior to the car being sold to an end user. This would help boost subscriber numbers, but the trade off is a lower ARPU (average revenue per user). The reasoning is simple. The 1 year subscription that the end user receives from a Chrysler brand product does not start until the consumer buys a car. The payment received for the subscription from Sirius XM is booked as deferred revenue. Deferred revenue is a liability, and does not switch to revenue until the service contracted is delivered. Because cars do not roll directly off of the assembly line and sell, there is a period of time when cars will not show any revenue and thus the ARPU is impacted.

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Anyone invested in satellite radio knows how important OEM subscribers are to the subscriber count, and in theory, the bottom line. The OEM channel offers more exposure for SDARS than any other outlet. Now, the two auto manufacturers that have the most lucrative OEM contracts with Sirius XM are about to get yet another bailout as the race to restructure their business.

The initial restructuring plans of both GM and Chrysler were rejected by the government. The companies have tried to maintain a status quo in means and methods of business. For their part, the government at least was able to recognize that the status quo would not work. Now, with a $5 Billion dollar carrot hanging out there, perhaps new restructuring plans will come to fruition.

Whether the sweeping changes in the OEM landscape that some expect will have a dramatic impact on SDARS is yet to be seen, but certainly Sirius XM should be making contingency plans with all OEM partners at this point, as it appears that GM can not remain the biggest and restructure at the same time. This will leave a SDARS void for others to fill. Perhaps Ford, which has not taken government money will step up in a way that will keep the SDARS installs at a level where they make sense.

Position – Long Sirius XM, No Position OEM’s