Wedbush analyst William Kidd issued a report on Sirius satellite Radio.
• Sirius reports strong 3Q results on considerably better than expected subscriber growth.
Sirius reported 3Q net adds of 525k, well above our 445k estimate and the consensus estimate, which we believe was near 420k. In terms of financial metrics, Sirius’ 3Q results were essentially in line, with the EPS loss of $0.08, spot on with the consensus and a penny better than we were expecting. Interestingly, some competitor and press reports have suggested there was a revenue miss, which we think is misleading considering revenue was in line and the subscriber differential was significantly positive. Bear in mind, Sirius reported $242 million in revenue, essentially spot on with our $244 million and the like consensus estimate. Sirius did not adjust its 2008 guidance.
• Cost effective subscriber acquisition. Incremental margins improving.
While it is easy to look at metrics like gross additions and SAC (which was down to $103 from $114 last year) to gauge the company’s efficiency in adding subscribers, we think it’s worthwhile to highlight Sirius’ dramatic operating leverage and improvements in profitability. Case in point, over the past year (3Q07 through 3Q06), Sirius had added $75 million in revenue, while its EBITDA margin has improved to negative 33% from negative 76%. We believe the more telling figure is that the incremental EBITDA margin has been positive 63%. Similarly, if we look at our definition of pre-marketing cash flow margins, which are not distorted by subscriber growth like EBITDA margins, we see that PMCF in 3Q07 was 46%, up from 25% last year. However, the incremental PMCF margin was 91%. Both figures show that most of the subscriber growth benefits should continue to fall to Sirius’ bottom line, quickly ratcheting up profitability. We continue to believe that relative to comparable models, like pay television, Sirius has considerably more operating leverage, as its programming costs are considerably less per subscriber, while its fixed cost structure is very stable, since satellite network/transmission costs are not materially impacted by the size of the subscriber base. Programming costs and customer service are really the two big variable cost elements in the company’s model.
• The 3Q subscriber gains are quite impressive.
Although Sirius reported 80k more subs than we were expecting, some of the difference came from churn, as the gross adds differential vs. our expectations was 64k. We estimate (since Sirius only discloses retail/OEM net additions) that OEM gross additions were 665k vs. our 595k, and retail was 336k vs. our 341k, leading Sirius to report 461k vs. our 424k. The growth in OEM additions is considerable, assuming our estimates are close, given that we estimate that the 664k in 3Q07 is comparable to 606k in 2Q07, 519k in 1Q07, 462k in 4Q06, and 331K in 3Q06. We have long held that Sirius and satellite radio in general will be an OEM driven story and that an overly myopic focus on recent retail weakness would be an oversight. While some might discount Sirius’ OEM strength by saying that Sirius books OEM subscribers when cars are shipped to dealers as compared to XM which books OEM subscribers when a consumer activates, this too would be an oversight. The reason for the difference in accounting treatment is really a key aspect of what makes Sirius a better story than XM. Sirius’ OEM agreements require most of its major OEMs to pay for subscription services regardless of whether the consumer activates for a period of six or twelve months, whereas with XM, most of its OEM agreements have XM being paid by subscribers directly. Thus, for Sirius, a shipment equates to revenue, and for XM, only subscriber-elected activations equate to revenue.
• Sirius’ FCF story continues to outshine XM’s:
Funded until FCF break-even and positive FCF again in 4Q. On today’s earnings call, Sirius management indicated that with cash on hand of approximately $362 million, they are fully funded until they reach cash flow break-even. Given that we consider funding and dilution a risk at XM, we believe this point is another key differentiating aspect at Sirius. While we believe the difference with XM largely stems from the embedded profitability of OEM contracts and to a lesser extent programming agreements, we believe the differences are clearly evident in FCF figures. For instance, in 3Q07 Sirius reported a FCF loss of $68 million, a significant improvement from the year ago period loss of $232 million, and guided to being FCF positive in 4Q07. It would not be surprising to see Sirius management guide to being FCF positive in 2008 when it publishes 2008 guidance, though we are not expecting Sirius to be FCF positive until 2009. We do show the company as fully funded.
• Royalty overhand is likely coming to a December conclusion.
Per company filings, the satellite radio operators have proposed a rate of 0.88% of each of their adjusted gross revenues for this statutory license. However, SoundExchange, has filed a direct case proposing a rate increasing from 10% of adjusted gross revenues for the first year of the license increasing each year to over 23% during the final year of the license term. Given the established market value of song rights, reflected in agreements such as radio station royalties, we think it is far more probable than not that the satellite radio providers largely prevail in this arbitration. In total, we are expecting music royalties to all organizations to amount to about 7% of revenues in totality from about 4-5% now, with major entities getting somewhere between 1%-1.5% each. That said, if SoundExchange were to largely prevail in this matter, it would likely lead to a material revision in our near and long-term margins as well as valuation.
• We don't think GM will opt out of exclusivity obligations with XM in the case XM were to fail to achieveminimum market share levels. If Sirius is ever to have a chance at a GM deal, we don’t that until near November 2013 when XM’s deal expires.
XM indicated in its October 30, 2007 10-Q filing that GM's exclusivity obligations would discontinue if by November 2007 and at two-year intervals thereafter, XM fails to achieve and maintain specified minimum share levels in the satellite digital radio service industry. However, XM’s disclosure indicates that it believes it is in compliance with the clause. It’s also important to note that this disclosure is not new and that the minimum share level was not disclosed even in the company’s 1999 S-1 filings. Consequently, we think that it is unlikely for GM to opt of its agreement with XM, if it has the ability to do so, considering that we perceive GM as having favorable economic terms with XM. And although we have heard some outside speculation that XM could try to renegotiate the deal with GM before contract expiration, seeking better economic terms of its own, we are doubtful that XM will be able to do so before expiration. Consequently, we think the disclosure is a non-event, despite the November 2007 citation.
• Sirius did not say much on the merger. However, we still believe a decision could come anytime in November or early December.
• Sirius continues to gain retail market share on XM, a sign that consumers see the strength of Howard and the NFL.
Sirius indicated that its retail market, according to NPD, was 64% this quarter, up from about 60% in recent quarters, and roughly 30% before Howard Stern's arrival in 4Q05/1Q06. Given that the receiver technology differences are fairly small between the two companies, we believe Sirius' market share edge continues to be a function of programming more than anything else. While some thought the Howard Stern effect would quickly subside, giving XM an ability to regain lost share. It clearly has been difficult for XM to do so, based on these latest market share figures. Another interesting aspect is the SAC story, which shows that in 3Q07 XM's SAC (aka CPGA) was $116, up from $94 in 3Q06. Our point is that Sirius' SAC is falling, even with dramatically higher OEM additions, while XM's is climbing. It's hard not to wonder if XM is spending some of its SAC dollars battling a difficult consumer perception of its service.
• Reiterate BUY and $4 price target. Our $4 price target is based on a DCF analysis (see figure 6) and does not incorporate any merger premium/benefit, consistent with our view that the transaction has less than a 50% likelihood of approval and thus, will likely be denied within 12 months.
• Risks to attainment of our share price target include shortfalls in subscriber growth; increased competition whether from XM; AM/FM radio, HD Radio, or streaming-media services; satellite anomalies; new/increased government regulation; a prolonged and/or failed merger attempt; an inability to renew key content and OEM contracts; and an unfavorable outcome in the ongoing arbitration process with record labels over royalty rates