Sirius XM Radio Q3 Earnings Preview – Part 2 of 2

By Relmor Demitrius

Welcome back today for part 2 of the King of all Trades earnings preview in advance of Sirius XM Radio’s (NASDAQ: SIRI) third quarter conference call, which is taking place on the 5^th of November.  In case you missed Part 1, you can find that article here – Sirius XM Radio Q3 Earnings Preview #1.

As Sirius XM entered into the last half of the year, Mel Karmazin, CEO of Sirius XM radio, had given us a $400 million EBITDA guidance, and Sirius XM has only realized about half of this amount in the first two quarters.  Q3 being a traditionally cost heavy quarter (costs increases in Q3 results from charging a large amount of chip related costs, and inventory creation), there are few expecting any EBITDA additions to Mel’s yearly guidance (I think we get some anyway).  Q4, a revenue intensive quarter that should allow Sirius XM to post its first ever fully adjusted profits in its history (Free cash flow has already been achieved).  Mr. Karmazin has alluded that the company will be FCF (free cash flow) positive for the entire year for 2009.  In between this potentially historic earnings report and now is a Q3 that should still show significant improvements in becoming a profitable entity, and allowing Sirius XM to enter 2010 as a potential cash machine for the first time in its long and troubled history.  Sirius XM appears to be finally turning the corner after always being underwater with huge start up costs (infrastructure, satellites, licenses, talent acquisitions, paying forward for future subscribers off the backs of current subscribers, etc..).  Let’s take a look now at the numbers.

Here is a look at the Q2 Revenue line items.  You will see that most of their revenue is generated from subscriber monthly fees.  There is also some advertising revenue as well.

So we see last quarter’s revenue came in at 561 million.  This is a huge jump from Q2 of 2008, of 266 million, as you can see.  Some deferred revenue comes from Promo subs, but realized on the revenue side only when a person is actually paying for that sub, and off the free trial.  Self pay numbers, a new metric Sirius XM has broken down for us this year separates Promo subs (we estimated total subs in Q3 to be around 18,662,424) from “self pay” sub numbers.  Here is a look at this line item in the Q2 report.  You will see this breakdown.

Revenue is generated from this category, the self pay subscriber total numbers.  Since we know around 44% or more of every new sub turned on in the OEM market (new autos) will stay, so growing this base with large promo sub numbers is important.  If you sell 12 million cars, after 3 months to as long as one year from that time (average length of trial subs, as each makers deal is different), you will add 2.8 million subscribers to the self pay numbers (minus churn rate).

I am expecting self pay sub totals to go up slightly this quarter.  These are your hardcore core, the loyal base Liberty fell in love with.   A lot of angry subs have already cancelled due to internet charges, lineup changes, royalty charges, bankruptcy concerns (which is completely off the table for years due to debt restructuring, and a strong cash on hand position), and bitter investor/subscribers.  The remaining self pay numbers have held steady for 2 quarters now during the worst economic conditions in memory.  This bodes well for a return to positive growth in this area.  It will be modest, but I expect an improvement here.  I’m going to give some credit to Sirius XM’s excellent job of customer retention by offering Best Of Packages, new improved internet line up, iPhone/iTouch accessibility, new radios, and new talent (Rosie O’Donnell began airing for the first time this week).  15,500,000 self pay subscribers is the number I am going to use. The trend on self pay numbers right now is that it is holding steady.

Once we know churn and self pay subscriber totals we now can begin to calculate Sirius XM earnings for the third quarter.

Now that we know the proper number of subs to generate our revenue line item from, we will need to get the other side of the equation; how much does each sub generate in revenue per month.  This is called ARPU (average revenue per unit).  Last quarter this metric was at 10.66.   Here is what Sirius XM had to say about this metric’s performance in Q2, and let’s see if we can use some of that information to make an educated guess on what we might be looking at in Q3.

[ARPU. ARPU is derived from total earned subscriber revenue and net advertising revenue, divided by the number of months in the period, divided by the daily weighted average number of subscribers for the period. See accompanying footnotes for more details.

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Three Months : For the three months ended June 30, 2009 and 2008, total ARPU was $10.66 and $10.55, respectively. The increase was driven mainly by the sale of “Best of” programming, increased rates on our multi-subscription packages and revenues earned on our internet packages, partially offset by lower ad revenue] – Q2 Quarterly Report

Advertising revenue probably bottomed.  As credit improves, and companies grow again, advertising will pick back up again.  From Q2 Year-to-year, it actually went from 8 million to 12 million.  I think this trend will continue, but it will be a slow recovery for this metric.  As far as Best of Packages, I don’t see this trend stopping  either, as consumers demand the best of both worlds.  It is much cheaper to add Best of package, than to order another full subscription.  Internet charge for Iphone and internet lineup  will also add to ARPU.  It is called “premium internet” service by Sirius XM, and it is a 2.99 charge if you want internet access and use of your Iphone application.  Here is where the app’s true value comes into play.  Of the 15 million core users of Sirius XM, and the millions of people who downloaded the free trial, I believe at least 300,000 of these people have added the 2.99 charge, at least.  I am going low here.  With new internet channels, making internet charge mandatory, and Iphone application requiring the charge, I feel this number may even be low.  So there will definitely be an increase in ARPU this quarter.  Royalty fees will not add to ARPU.  They will hit the bottom line, but not in this line item.

Using trends from Q3’s in the past, and strong current ARPU metrics, analyzing Sirius XM’s own statement on what they attributed their increase to, we can assume a modest jump this quarter in ARPU.  I am estimating Q3 APRU to come in around 10.78.

Subscriber revenue includes subscription fees, activation fees and the effects of rebates.   So using last quarter’s information assuming it’s consistent , and a clear revenue trend is in play, we see how the last few quarter’s revenue has gone for Sirius XM.

Total Revenue in:
Q2 of 08: 283,017,000
Q3 of 08: 488,443,000
Q4 of 08: 644,108,000
Q1 of 09: 586,579,000
Q2 of 09: 590,829,000

The revenue base hit its high in Q4 (as expected) and retraced, but to nowhere near Q2 levels of last year.  Q1 revenue came back strong in 09 with 586 million.  Sirius XM then rose in Q2 again, to 590 million.

Q3 estimate:  Self Pay subs (15.5 million) * 10.78 * 3 = 510 million dollars.

Q2 numbers using the same equation (15.4 million) * 10.66 *3 =  492 million.

Difference of 18 million dollars.

Going to give a 5 million dollar increase as well in advertising revenue, to illustrate the improved economic conditions we are experiencing.  That gives us an additional 23 million dollars in revenue this quarter, from last quarter.

My revenue estimate for Q3 is 613 million dollars in revenue.

Now that we know how much they will take in, we can determine costs, and see what their earnings are going to look like.

Here is a look at their cost line items for Q2 of 2009.

Here is a quick look at how costs have come in the last few quarters.

Total Costs In:
Q2 of 08: 351,066,000
Q3 of 08: 564,561,000
Q4 of 08: 689,752,000
Q1 of 09: 545,918,000
Q2 of 09: 553,594,000

Costs to acquire subs is reflected to a degree in rising costs for this quarter, so SAC (subscriber acquisition costs) will go up from Q2.  A lot of the costs associated with acquiring a years worth of new customers, occurs in Q3.  But maybe not as much as you think.  Let’s break it down.  SAC line above states costs at 67 million dollars.  However in Q4 of 2008, this was more than Q3 of 2008.

SAC:  Q2 of 08: 78     Q3 of 2008:  74    Q 4 of 2008:  71       Q1: 53      Q2 :  57

You can see costs are going down.  SAC for Q3 was 74, but for Q4 it was 71!!

Huge jump?  I didn’t see it.  In fact, if you notice costs from last Q3 and Q4, it actually is higher in Q4!!  Is this a change in philosophy from Sirius XM on how they distribute costs throughout the year?  We shall find out soon enough.

Look at these line items that will occur noteworthy increases in chip and other related OEM costs for new radios and inventory.

The 3 line items of interest here that may see a huge jump in operation costs would be: Cost of Equipment, Subscriber Acquisition Costs, and Eng./Development.  Inventory cost differences Q to Q have been inconsequential.

Here is Q2 2008.

Here is Q3 of 2008.

Here is Q4 of 2008.

Here is Q1 of 2009.

Here is Q2 of 2009.

As you can see, the increases in costs from Q3 to Q4 in these line items is noticeable.

Here is Sirius XM definition of what these 3 line items mean, along with Q2 explanations on why this line item performed as it did.

Cost of Equipment. Cost of equipment includes costs from the sale of SIRIUS and XM radios, components and accessories.

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Three Months : For the three months ended June 30, 2009 and 2008, cost of equipment was $8,051 and $6,647, respectively, which represents an increase of 21%, or $1,404. The Merger-related increase of $3,442 was offset mainly by lower sales volume through our direct to consumer channel and lower inventory related charges.This metric will go up in Q3 from Q2.

 

Subscriber Acquisition Costs. Subscriber acquisition costs include hardware subsidies paid to radio manufacturers, distributors and automakers, including subsidies paid to automakers who include a SIRIUS or XM radio and a prepaid subscription to our service in the sale or lease price of a new vehicle; subsidies paid for chip sets and certain other components used in manufacturing radios; commissions paid to retailers and automakers as incentives to purchase, install and activate SIRIUS and XM radios; product warranty obligations; provisions for inventory allowance; and personnel costs associated with stock-based awards granted in connection with certain distribution agreements. The majority of subscriber acquisition costs are incurred and expensed in advance of, or concurrent with, acquiring a subscriber. Subscriber acquisition costs do not include advertising, loyalty payments to distributors and dealers of SIRIUS and XM radios, and revenue share payments to automakers and retailers of SIRIUS and XM radios.

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Three Months : For the three months ended June 30, 2009 and 2008, subscriber acquisition costs were $67,651 and $81,392, respectively, which represents a decrease of 17%, or $13,741. This decrease was primarily due to lower OEM subsidies, decreased production of certain radios, and lower aftermarket inventory reserves in the three months ended June 30, 2009 compared to the three months ended June 30, 2008, partially offset by the impact of the Merger. XM’s subscriber acquisition costs accounted for $22,226 during the three months ended June 30, 2009.

The sentence I have highlighted is going to begin to reverse, as OEM sales are picking up, but still not representing anywhere near the costs to Sirius XM as a 15 million run rate on autos would give.  I would think Mel is smart enough to not need to make inventory for 15 million cars, when the current estimate is around 12 million, bringing us even under the 2008 levels of 13.2 million.  Hence, all these huge increase in costs, I do see some, I just don’t see the “huge” increases investors are warning about.

This metric will go up from Q2.

Engineering, Design and Development. Engineering, design and development expenses include costs to develop chip sets and new products, research and development for broadcast information, and costs associated with the incorporation of our radios into vehicles manufactured by automakers.

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Three Months : For the three months ended June 30, 2009 and 2008, engineering, design and development expenses were $11,944 and $9,028, respectively, which represents an increase of 32%, or $2,916. This increase was primarily due to the impact of the Merger, partially offset by lower costs associated with manufacturing of radios, OEM tooling and manufacturing, and personnel.

This metric will go up from Q2.

Seems like Mel is going to distribute costs more evenly now that the companies have merged.  Due to inventory slow downs from Chrysler, Ford, and GM and the low estimated run rate of 12 million autos in 2010, I am going with lower costs in Q3 of 2009, than in 2008.  Deflation has also hit our country hard, sending Sirius XM supply costs down.  All companies are spending less in 2009, than in 2007, etc….

Cost estimates for Q3 will be 570 million dollars.

Revenue of 613 million dollars minus 570 million in operating costs.  This leaves us with a net gain of 43 million dollars.  Remove a 100 million dollars in accounting charges due to Liberty Loan restructuring and you get an overall net negative 57 million dollar loss, much smaller than Q3 of 2008, YTY.

They will announce .01 cent earnings per share, based on 43 million in earnings, and adjust it to a .01 cent loss (due to accounting charges only).

Summary:
Self Pay Estimate: 15.5
ARPU : 10.78
SAC : Higher than Q2(Under 65)
Revenue: 613 million
Operating Costs : 570 million
Preadjusted earnings :  .01 cent a share.
43 million in earnings.