Goldman analyst Mark Wienkes issued the following on Sirius' Q4.
Swimming upstream as best they can
4Q review What's changed
Sirius’ 4Q results were mixed as softer revenue, but good expense controls lead to an improved, and lower than expected EBITDA loss. While 2007 adjusted EBITDA loss of ($327mn) improved by $200mn yoy, trends in subscriber adds, churn, and ARPU confirm our cautious view on the industry. We note that Sirius did not provide 2008 targets, citing the uncertainty caused by the pending merger decision. Specifically, in 4Q07, revenue increased 29% yoy to $250mn, below our $262mn estimate, while total OpEx fell 7% to $400mn. SAC of $90 (vs. $103 a year ago) led to an EBITDA loss of ($122) mn versus our ($157mn) loss estimate. This resulted in LPS of ($0.11) versus our ($0.14) estimate. ARPU of $10.05 (with $0.41/sub in ad revenue) was below our $10.70 estimate owing largely to ($0.59) in per sub rebates, up from ($0.29)/sub a year ago. Churn rose to 2.3% from 2.0% yoy. Sirius again achieved positive FCF in 4Q, benefiting from a $210mn working capital contribution and just $7mn of capex.
Sirius saw 1mn lower retail net adds in 2007 vs. 2006, with 212K net retail adds in 4Q07 out of the 654K 4Q07 total net adds (and vs. 559K net retail adds in 4Q06), confirming the channel deterioration. OEM net adds grew600k yoy to about 1.7mn, but the penetration story looks to largely play out in 2008. As a result the net change was about 400k fewer net adds in 2007 yoy. We think this trend will continue in ‘08, and expect just 1.9mn net adds vs. 2.3mn in 2007 and 2.7mn in 2006. The financial implications are that while Sirius is moving toward EBITDA breakeven, the worrying sub trends, rising churn, and sinking ARPU seem likely to make realization of free cash flow -sufficient to justify today's valuation- challenging at best. Valuation We maintain our 12-month $2.25 price target, using our DCF valuation. Key risks Superior execution and financial outperformance.
We continue to rate SIRI shares Sell. Even with the market incorporating an increasing probability of merger approval, the stock is down about 22% since the merger announcement a year ago as lower expected cash flows and deteriorating channel trends have weighed on the stock. We think the retail satellite radio market remains moribund and the increasing gross OEM subscriber additions are masking the rising underlying churn – note that the company now has about 1 million ‘car lot’ subs (11% of total as of 4Q07). Given this, and little anticipation of new content deals or compelling technology on the horizon that might drive an upside surprise, we still find it challenging to be comfortable with Sirius’s current absolute and relative valuation.
We are waiting on the following items before considering turning positive on the stock: sustained cost constraint; more tangible visibility into the OEM ramp with steady (and publicly disclosed) conversion rates and stable churn; positive and sustained ARPUmomentum; improving vs. declining retail sales; more conservative consensus financial expectations for 2008-2010, and clarity on the proposed merger and synergies. On February 20, 2007 XM and Sirius announced a definitive agreement to combine in a merger of equals. Based on our analysis, we continue to estimate a 30% chance of a clean approval (meaning non-substantive conditions). Excluding the merger proposal, we do not believe the fundamentals, subscriber growth curves, or risk-adjusted estimates support a premium or equal valuation for Sirius versus XM. Therefore, we continue to think the risk to the downside for SIRI shares remains greater relative to XMSR, even though we also rate XMSR shares SELL, owing to the risk/reward profile of the stock assuming the assorted merger outcomes. In our view SIRI's share price does not properly reflect: 1) the lowered base cash flow outlook; 2) the effect of potential FCC conditions; and as a result; 3) realistic near-term executable synergies, again, assuming DOJ approval. With the majority of the upside baked in, we recommend investors sell SIRI, as even with DOJ approval, the FCC response and potential conditions are more likely to hurt than help. More specifically for XMSR, our Sell rating is valuation based and contemplates possible short-term price swings whether the DOJ approves or rejects. Deal or no deal, we think the current valuation incorporates a view too close to optimal, e.g. DOJ and FCC approvals with few conditions and subsequently, near-certain realization of all potential synergies.
Valuation Our 12-month, $2.25 price target for shares of Sirius Satellite Radio is based on our probability-weighted approach of our DCF-based valuation versus the expected value upon potential merger. In arriving at our price target, we handicap the announcement of a merger proposal, receipt of various approvals, and the estimated success in executing potential synergies.
Fundamental valuation yields $2.00 for SIRI For our fundamental valuation framework, we employ a discounted cash flow analysis. Based on this methodology, we arrive at a value of $2.00 per share for Sirius. In our view, EV/subscriber metrics are viable in mature subscriber businesses with known ARPU, per sub profitability, churn, and associated metrics, but not in early stage, rapid-growth businesses.
Subscriber trends: OEM channel accounting for most of growth We are raising our 2008 year-end subscriber estimate to 10.2 million from 10.1 million on higher OEM penetration rates. Our 2008 estimates now imply net adds of about 1.878 million, with only about 164,000 in retail and about 1.7 million in OEM. For 1Q2008, we estimate 400,000 net new subscribers with about 123,000 coming from retail and about 277,000 OEM. Our estimate places the retail vs. OEM split in 2008 net adds at an approximate 9% / 91% ratio for Sirius, vs. 32% / 68% in 4Q2007 and 26% / 74% in 2007. The increasing proportion of OEM net adds has been expected, but the displacement of what might have otherwise been a retail net add is something to watch carefully. Our assumption is that the OEM channel will drive nearly all of the net longer-term subscriber growth. This assumption is based on the fact that satellite radio is primarily an in-car product, with almost 90% of retail satellite radios sold with a car kit (or two). We believe that the greater OEM model penetration (now approaching 50% for Sirius’ partners in aggregate), the further retail demand will fade. Already we forecast negative net adds (a.k.a. net losses) in the retail channel yoy for certain quarters in 2009.
Our view on why retail weakness is not unexpected We find it challenging to call it a competitive market between satellite radio and .mp3 players (e.g., iPods) for several reasons. The intuitive reasons are the ability to receive live broadcasts on a national basis vs. listening to stored music, the difference in content (live sports and talk, niche channels), and the programmed nature of satellite radio. The numerical reasons are perhaps more convincing. A quick view of the retail net adds from XM and Sirius as compared to the unit sales of just Apple’s iPod device highlights the consumer’s view on the relative value proposition of the different devices.
4Q07 review and company outlook Sirius’s 4Q results were essentially in line with our and consensus estimates and are unlikely to result in any significant changes to the consensus financial outlook.Specifically, 4Q07 revenue of $250mn was 4.5% shy of our $262mn estimate, though adjusted EBITDA of ($107mn) (ex-ESO) beat our ($135mn) estimate owing primarily to lower-than-expected Sales & Marketing and SAC. SAC of $90 beat our $100 estimate, while ARPU of $10.05 (with $0.41/sub in ad revenue) was below our $10.70 estimate owing largely to ($0.59)/sub in rebates, up from ($0.29)/sub a year ago as the company switched to more on-site rebates versus mail-in rebates which have higher breakage. LPS of ($0.11) came in 3 cents better than our ($0.14) estimate. Churn was 2.3% versus 2.0% a year ago. The transition into an OEM driven model continues, as 4Q07 retail net adds were only +212K vs. 559K a year ago. The softer retail channel remains concerning, and we continue to believe that XM is better positioned vs. Sirius given XM’s larger, and increasing, share of OEM production. We also believe that any further deceleration in retail trends would likely have a greater impact on Sirius vs. XM. Additionally, we note that OEM “car lot” subs were11% of the sub base as of 4Q07 flat versus 3Q2007, implying about 72K of the 444K new OEM subs (16%) came from higher auto production penetration.
For 1Q2008, we expect net additions of 400,000 vs. 556,000 a year ago. With the retail market continuing to weaken, we expect retail and OEM gross additions of 363,000 and 650,000, respectively. On a net basis, we estimate only 123,000 retail net adds vs. 277,000 OEM. Our estimates imply an approximate 31% / 69% retail / OEM split in 1Q2008. We expect 1Q revenue and an EBITDA loss of $275 mn and ($49) mn (ex-ESO), respectively, resulting in EPS of ($0.08). Additionally, our SAC and CPGA estimates are $98 and $137. In addition, we introduce 2008 quarterly estimates and 2010 estimates.
What to watch for
(1)Larger-than-expected slowdown in auto sales: Recent comments from the automotive industry (both OEM and dealer chain) indicate that many of the issues impacting the subprime, CDO and CLO market are projected to trickle down and carry negative implications on new car sales, implying around 15-16 million units sold in 2008. As satellite radio operators progress towards an OEM centric model, watch for primary and derivative effects of a housing and auto slowdown to temper the subscriber ramp.
(2) OEM conversion ratios: Sirius does not yet, and may never, report OEM conversion rates—either in aggregate or by OEM or by vintage—so we must draw from the trends at XM. Rather than expecting a rebound in the OEM conversion ratio we continue to look for an incrementally downward trend. Longer term, XM has historically stated that it expects the conversion rate to fluctuate around the mid-50% range, though we have always estimated a gradually more conservative outlook in our model, estimating rates approaching 40%-45% by 2010 for both XM and Sirius.
(3) OEM production trends: Watch for more clarity on production targets from Sirius’s OEM partners and more measured increase in penetration rates. As the company stated, Ford extended its exclusive relationship until 2016, targeting roughly 70% penetration in all Ford and Mercury model 2009 vehicles. As a reminder, Daimler Chrysler committed to a 70% penetration (up from 40%) in the 2008 model year, and VW/Audi has a goal of 80%. Full integration may take longer, however, as logically, management thinks it would be more beneficial to conversion rates to integrate Sirius into premium models and trim packages rather than a full standard integration across all models. Despite likely production cuts from domestic auto manufacturers, Sirius’ OEM growth could by partially offset by increasing foreign auto sales and model penetration.
(4) OEM contracts and potential margin compression: Watch for the “sales and marketing” line item of Sirius’s income statement to increase over time as it includes subsidies and revenue shares paid to OEM partners. Industry sources suggest 10%-25% typical revenue share, with recent revenue share agreements potentially as high as 35% and including equipment subsidies up to 100% of the cost along with nominal upfront cash payments as well. Although Sirius has revenue share arrangements with most of its OEM partners, the terms are likely better than the speculated 30%-50% split XM has agreed to share with GM.
(5) Material ramp in churn: As evidence from the ramp in churn in 4Q, we believe that OEM churn will continue to meaningfully affect Sirius in 2008 as the early gestational periods for late 2005 and 2006 OEM subs end and conversion is measured. Therefore, we believe that Sirius will sustain higher churn rates in 2008 as XM saw in 2006 and 2007, given the impact of its longer promotional periods and different subscriber accounting.
(6) Ad revenue: High-margin advertising revenues could impact results significantly to the upside. Specifically, in the fourth quarter Sirius saw a 16% yoy increase in ad revenue to $10mn. We estimate that Sirius will increase its advertising revenues to $45 mn in 2008 from $34 mn in 2007. The company has previously indicated that advertising revenues should ultimately rise to 10% of revenues.
(7) Satellite Delay: Sirius plans to delay the launch of its satellite launch, Sirius 5, to the second quarter of 2009 from the fourth quarter of 2008. The company noted that from an operational perspective, Sirius 5 is not necessary until mid-2010, so the delay was based on the lack near-term need and likely satellite launch costs.
- Ultimate satellite radio subscriber universe is larger than our expectations and it takes less time than expected to reach.
- A merger is approved by all regulatory bodies and expected synergies are fully realized.
- Programming and distribution costs remain at current levels or decrease, bringing cash flow breakeven sooner than our estimates indicate.
- Widespread consumer acceptance of both the service and new products.
- A merger is rejected and the stocks trade down to levels consistent with fundamentals.
- Satellite problems, chipset delays, or OEM partner production issues.
- Disruption to key exclusive content, or onerous royalty rates for music.
- Failure to attract and retain new subscribers with exclusive content.
Position - Long Sirius, XM