Citi analyst Eileen Furukawa issued a report on Sirius' Q4.
Sirius Satellite Radio Inc (SIRI) OEM Side Means More Subs Spread Over Fixed Costs=Less Losses
Fate of SIRI Still Depends on Merger — We still believe SIRI price reflects a rough 25% probability of merger approval, where we believe its more likely than not. Maint. Buy (1S) rating w/probability weighted target of $4.25. SIRI has a favorable risk/reward with 39% ETR to target, vs (15%) downside pot.
Solid Sub Growth Fueled by OEMS — As pre-announced, SIRI ends ’07 with8.3M subs (up 38% Y/Y and 200K above orig. est). OEM fuels growth w/ 27%Y/Y Net add growth, offsetting sluggish Retail Net Adds down (62%) Y/Y tho better than expected and better than 3Q. We expect ’08 YE subs at over 10M.
Expenses Down Despite Rising Revenue — Despite 29% boost in revs SIRI cuts expenses by (7%) w/ notable cuts in mktg and SAC, with 4Q SAC at $90 (down12.5%) and 4Q CPGA at $137 (down 16% Y/Y). SAC improvement in face of shift to higher SAC OEMs is positive. Strong cost controls + more subs spread over fairly fixed costs lead to lower 4Q loss/sh. at ($0.11) vs ($0.17) last yr.
Churn Rate Continues to Impress — Inline 4Q Churn of 2.3%, and self paying churn of 1.7% is impressive in light of mix shift toward OEM promo subs and given Retail confusion with merger. We est. OEM conversion rate is in mid-50’s, which looks good in light of rapidly rising factory install penetration rate over the last year. SIRI’s continued focus on churn remains a positive.
4Q07 Recap — Despite higher-than-expected subs at 8.3M, softer ARPU due to more “instant” rebates left revs a bit light at $250M still up 29% Y/Y. Lowerexps means slightly better adj EBITDA at ($150) and inline loss/sh at ($0.11).
We Believe SIRI Stock Remains Highly Dependant on Merger Outcome Similar to every other quarter in 2007, Sirius once again narrows its losses on a Y/Y basis driven primarily by an increase in OEM subs, which enabled them to spread their relatively fixed cost over a larger base of subscribers. That aside, the main driver of the stock continues to be the seemingly never ending roller coaster of sentiment regarding the pending merger, and whether or not governmental approval will be achieved. At the current price, we believe SIRI’s stock price continues to under appreciate the probability of getting regulatory approval and/or the absolute value of cost synergies a combined Sirius and XM could drive. Specifically, at the current stock price and assuming $7 billion in PV synergies, and assuming (15%) downside if the deal is not approved, we estimate that the current stock price reflects only a 25% probability of successfully completing the merge. In contrast, we continue to believe a merger is more likely than not, leading to our probability-weighted price target of $4.25 and thus our Buy rating. At the same time, we maintain our Speculative risk rating to account for the high level of risk involved in investing in SIRI given its wholly binary outcome which is almost exclusively based on whether or not the merger is approved, and if the synergies can indeed be realized. While we believe it is more likely than not that the deal is done, it is not without risk. Further, we continue to expect merger related news flow to Bethe primary stock driver for now, with fundamentals taking a back seat until the merger approval process is completed.
OEM Growth Strong and Retail Better than Original Forecast; OEM Likely to Drive Bus Going Forward In 4Q07, Sirius saw 654K in total net additions, a (28%) decline Y/Y, but well above our original estimate (before preannouncement) of 432K, with year ending subscribers of 8.3 million versus our original 8.1 million forecast. At the same time gross subscriber additions were 1.19M, down just slightly on a Y/Y basis. Breaking this down, SIRI had 4.64 million Retail subs, above our original 4.47 million forecast, and 3.67 million OEM subscribers, slightly above our 3.61 million forecast. OEM net additions grew a solid 27% Y/Y. Retail net adds declined (62%) which while tough, was better than expected and an improvement over 3Q07 which saw a (69%) decline in net adds. Looking into 2008 we expect the trends of 2007 to play out, with sub growth driven by the OEM channel and Y/Y growth in OEM net adds and continued Y/Y declines in Retail net adds. On the OEM side, Sirius should benefit from higher penetration levels at OEMs like Chrysler and Ford, ramping up to 70% penetration for their 2008 and 2009 model cards respectively. This is a large ump for both, with Chrysler at closer to 50% and Ford closer to 30% penetration by our estimation. We would also note, that these cars are considered subscribers when delivered to the lot, with Sirius installed cars on the lot at 11% which the company reports is steady with historical rates. On the Retail side, we look for ongoing Y/Y gross and net add declines as subscriber growth continues to shift to the OEM channel. Specifically, we forecast 1.15 million retail gross adds in 2008, down (20%) Y/Y, translating into 256K retail net adds, a (48%) Y/Y decline. Overall, despite a lack of guidance from the company pending the outcome of the merger, we look for Sirius’ subscriber base to grow from 8.3 million at 2007 year-end to 10.4 million by 2008 year-end.
Some Moving Parts, but Overall Expense Control Better than Expected As it works towards gaining merger approval, SIRI continues to focus on expense management in order to lessen its losses. In 4Q07, total operating expenses actually declined on a year/year basis by (7%) (500bps better than expectations) despite a 29% increase in revenue. With respect to SAC/CPGA, Sirius delivered SAC of $90 slightly above our $85 estimate, and down 12.5% Y/Y. Still, with sales and marketing well below expectations, SIRI delivered estimated CPGA of $137, much better than our prior $160 estimate. That said, there was a higher level of rebate redemption than we had previously expected due to a movement toward “instant” versus “mail-in” rebates. Further, royalty and revenue share came in higher than our forecast as Sirius began to pay higher royalties as part of the company’s recent settlement with SoundExchange regarding performance royalties. Also, the revenue share side of this line item also increased as we saw a mix shift toward OEMs. Aside from royalties, revenue share & subscriber acquisition costs, all other expense line items including R&D, G&A, Satellite & Transmission, Programming, Stock Compensation, Cost of Equipment, and Sales & Marketing came in lower than forecast. Looking ahead, we expect SIRI to continue to narrow its adjusted EBITDA loss with our forecast for adjusted EBITDA of ($145) million in 2008 versus ($315 million) in 2007.
We Believe Churn Remains Well Under Control in 4Q07 Sirius saw effective churn (for both OEM and Retail) of 2.3% for 4Q07, inline with our forecast. Further, Sirius indicated that its overall self-paying churn was a low 1.6%, also consistent with our forecast and a clear testament to the stickiness of Sirius' content offerings. For full year 2007, overall effective churn was 2.2%, the low end of the company’s original target range for 2007 of 2.2%-2.4%. With self paying churn steady (and in line), we believe the company's OEM conversion rate continues to hold up well despite increasing factory install penetration rates with Sirius’ auto OEM partners. While our current long term forecast assumes that the OEM conversion rate will slowly drop into the 40%s and below we estimate that Sirius' OEM conversion rate is in the mid 50%s or higher currently. Further, we see overall effective churn ticking up only slightly in 2008 to 2.3%.
4Q Recap: Higher Subscriber Growth, In line EPS SIRI reported ending subscribers of 8.3 million, which was inline with SIRI’s preannouncement and 200K above our original estimate with most of the upside to our original estimate stemming from the retail side of the business. SIRI delivered lower than expected revenue on lower ARPU (higher rebates) and lower equipment revenue with revenue of $250 million, up 29%, versus our $271 million estimate. Still, with lower Sales & Marketing and stock compensation expense, operating income loss was roughly in line with our forecast at ($149.8M). Similarly, SIRI's bottom line was also in line with our estimate at ($0.11) per share.
Investment strategy We rate the shares of Sirius Satellite a Buy/ Speculative (1S). In our view, satellite radio still remains one of the few areas within the media sector that offers attractive secular growth. Further, after a difficult 1H07 in terms of net add growth, we saw a return to net add growth in 3Q07, with improvement in this metric in 2008 vs 2007 as OEM growth continues to pick up the slack left by Retail. Specifically, we expect OEM sub growth to continue to be strong (stemming from already committed, factory installations at key auto manufacturers). Still, with a proposed merger with XM Satellite in the works and a high level of uncertainty as to the outcome, merger-related news flow will likely be the key stock driver for now. We continue to feel there is greater than currently expected potential upside if the merger goes through, and that there is a greater probability that the deal is consummated than currently reflected in the stock. Understanding the strictly binary potential paths for SIRI stock on whether the deal is approved or not, for investors with a greater risk tolerance, we think the risk-reward in SIRI favors investment in SIRI stock.
Valuation Our $4.25 price target is based on a probability weighted analysis on whether or not the proposed SIRI/XM merger will gain governmental approval and be closed. Specifically, assuming (16%) downside risk to the price if the deal does not close, and a 50%+ potential upside if it does (assuming a PV of $7.2 billion in synergies), and assuming a 69% probability that the deal goes through, we arrive at our $4.25 price target. Further, our analysis assumes a Cost of Equity in deriving the present value of synergies of 8.9%, a risk free rate of 4.1%, an equity risk premium of 4.2%, and beta of 1.2 which translates into a terminal year multiple of 13.5x (based on a long-term free cash flow growth rate estimate of 1.5%).
Risks We assign a Speculative Risk rating to Sirius Satellite due primarily to the strong stock impact (up or down) from the binary decision on whether or not SIRI and XM's pending merger is approved. Other risks include SIRI's early stage business cycle position, current free cash flow and net income quarterly losses and volatile stock price. Further, we see several risks that could preclude Sirius Satellite from achieving our forecast and/or price target, including a failure to complete the pending merger with XM Satellite, heightened competition leading to a price war at retail (which would likely delay profitability), a smaller than expected market for satellite radio long term, the loss of auto OEM partnerships, a higher than expected increase in music royalties, and the loss of key exclusive content such as The Howard Stern Show.
Position - Long Sirius, XM