Beyond the Price-to-Dream Ratio

Satellite radio is not only beyond cool, it's turning a decaying, ad-dominated world of commercial radio on its head. But can two U.S. pioneers, XM (Nasdaq: XMSR  ) and Sirius (Nasdaq: SIRI  ) , not only survive, but reward their investors?

New subscriber-based businesses face enormous odds. The landscape is littered with failed cool new things (or services), and for every America Online (now AOL Time Warner (NYSE: AOL  ) ), there are countless At Homes, Globalstars, Iridiums, or Metricoms. Believe me, if you've ever invested in a great concept and hoped that "somehow the money will be there," you're probably not interested in skating on thin ice facing a Zamboni at full throttle.

Recognizing, then, that we're in the arena of speculation, let's apply a cold heart and cool mind to the financials and determine whether this plate of investing risk comes with a scoop of great reward. It's the only logical next step after yesterday's XM and Sirius Get Busy put both companies through our Rule Breaker paces.

That's right, today we move beyond the price-to-dream ratio.

Cash inferno
Neither XM or Sirius is self-financing, so out of the gate, we have to understand the cash situation. To make an informed speculation, as opposed to a Las Vegas gamble, we need to know how long the current stash will last at its present rate of burn. This is critical because raising additional financing by issuing stock or debt can be costly (shareholder dilution, high interest rate) or impossible (Flush more cash? No way.).

(For more on cash burn, take a ride in the telecom equipment world with JDS Uniphase (Nasdaq: JDSU  ) in its Telecosmic Trip, and with biotechnology in Avoid the Biotech Burnout.)

For a quick analysis of quarterly cash burn, I take revenues and subtract cash operating expenses (satellite and terrestrial operations, broadcast system, programming and content, ad sales, customer care and billing, sales and marketing, and general and administrative).

I then add in net interest expense and capital expenditures (new purchases of property and equipment and any additions to systems under construction). This properly ignores management of working capital, non-cash expenses such as depreciation and amortization, and cash raised through financing.

Sirius has more cash...
Earlier this year, Sirius swallowed the bitter but necessary pill of diluting then-current shareholders by 92%. The reward: $560 million in cash and equivalents at the end of June.

Sirius' cash burn was about $90 million in Q1 and $85 million in Q4 (I go back this far because that's when the huge capital expenditures for system construction costs stopped). Though the company dramatically reduced quarterly interest expense, other expenses increased once the marketing push accelerated. I peg Q2 burn at $94 million or so (we don't have Q2's capital expenditures yet), which gives the company roughly six quarters at present usage.

... but XM has less burn
XM has less cash -- $354 million at the end of June -- but appears to have had a lower burn rate of $74 million for the most recent quarter, up from $53 million the quarter before (using two quarters here for the same reason as with Sirius -- that's when capital expenditures ended for the system construction). That leaves XM about 4.5 quarters of cash at current burn rates.

But the burn won't be static. Each company is expanding its subscriber base, and partners in the auto industry are producing more and more satellite radio-equipped vehicles. The trick is to estimate or project the growth in subscribers and revenue and see what happens to the burn.

Fantasy radio!
Though the companies track their acquisition costs and average revenue per subscriber (ARPU), I prefer to divide total revenues by the number of subscribers at the end of the quarter. For XM, this has been a very steady average of $27 a sub for over five quarters. For Sirius, just starting to ramp revenues, this was about $23 for two quarters and then $20 last quarter. To estimate future revenue, I simply multiply their respective subscribers by $27 for XM and $20 for Sirius. If you think this is high, then you should view the results even more skeptically.

To estimate subscribers quarterly to the end of next year, I simply take recent growth rates and assume a steadily declining sequential growth for each. One assumption is that satellite radio doesn't burn out; here are three others:

  • I assume that Sirius has a higher percentage growth rate for the next six quarters because it's starting from a smaller base.

  • Even though companies say their revenues grow faster in Q4 than others, I think they are overly conservative when they project flat revenues in any other quarters, so here I continue the growth, don't bump up Q4 that much, and trust that it all evens out. (Heck, we're estimating for new, unprofitable businesses, so let's not pretend to be Dr. Science.)

  • I keep expenses constant. This reflects the fact that while customer care and billing expenses increase with subscribers, the beauty is that the other costs don't vary much by number of subs, so they will decline as a percentage of revenue. In fact, a constant expense number may be too conservative.
                       XM         Subs.% Seq. Total       Cash CashQuarter  '000 Change Revs. Exp.  Burn & Equiv.ESTIMATED12/04    2400  14%  $64.8  $74   $ 9  $177   9/04     2100  17%   56.7   74    17   1876/04     1800  20%   48.6   74    25   2043/04     1500  25%   40.5   74    34   22912/03    1200* 33%   32.4   74    42   2639/03      900  30%   24.3   74    50   304ACTUAL6/03      692  43%   18.3   74.4       354 3/03      483  39%   13.1   53.3    *Company estimate                    SIRIUS         Subs.% Seq. Total      Cash  CashQuarter  '000 Change Revs. Exp. Burn  & Equiv.ESTIMATED12/04    1000  25%  $20    $94  $74   $ 63    9/04      750  33%   16     94   78    1376/04      600  33%   12     94   82    2153/04      450  50%    9     94   85    29712/03     300* 67%    6     94   88    3829/03      180  71%    3.6   94   90    470ACTUAL 6/03      105  55%    2.1   94         5603/03       68 127%    1.6   94*Company estimate

Key:
Subs.=subscribers
% Seq. Change=change from prior quarter
Exp.=business cash expenses
Cash burn=revenues minus expenses

Things definitely look better for XM, but don't forget the wild card: It will have to spend $190 million in Q4 2004 to launch its ground spare Boeing (NYSE: BA  ) 702 satellite. And it expects insurance coverage to provide most or all of the $130 million cost of replacing that spare in 2005. Sirius has no similar expense on the horizon.

At these estimates, XM will likely need cash sometime by the end of 2004, and this will either mean diluting shareholders or borrowing at perhaps unfavorable rates, or both. The day of reckoning may come sooner if XM can't meet my projected subscriber numbers, though any increased ramp might mean less financing will be required.

Sirius, too, will clearly need financing in the first half of 2005 -- unless its subscriber growth significantly exceeds these estimates. And that may not be the last time, either, as it likely won't become self-financing until well after XM.

Pot o' gold?
If these companies do survive to 2005 -- if their dreams come true and everyone and his grandmother signs up for satellite radio -- what's the payoff? Remember, high-risk investments demand huge returns.

Both businesses have large fixed costs, so revenues -- and eventually profits -- depend on rapid subscriber growth. An optimistic scenario gives XM half a billion dollars in revenues for 2008, the fifth year out. Let's assume 5% a year share dilution -- maybe too low for now, too high for later -- and an admittedly healthy free cash flow margin of 25%. If the market assigns a market cap-to-free cash multiple of 25, the stock ends up with a total return of 143% (between a double and a triple) and a compound annual growth rate (CAGR) of 16%.

Not bad, but not enough for the hair-raising risk. Much better if you had bought XM -- or at some point can buy again -- in the single digits. For instance, at a market cap of around $600 million, when this scenario could conceivably grant you a sweet five- or six-bagger by year-end 2008.

Worth it?
Of the two, XM will almost certainly be the first to reach cash breakeven. Its current subscriber numbers and rate of uptake give it an enormous advantage over Sirius. But at rough calculations of subscriber and revenue growth, there is a high probability that both companies will need to raise cash: XM by late 2004 and Sirius by the first half 2005. That could mean dilution, higher interest expense, or both.

XM is the better bet because of its significant subscriber lead, but the potential returns may not justify the risk, unless you can pay a lower price than yesterday's $12.95 close -- or unless the subscriber ramp is on track to zoom past 2.4 million subs by the end of 2004. On the other hand, Sirius has more cash, and if its subscriber growth shows signs of trouncing 1 million by the end of next year, informed speculators may want to hold both stocks.

Wow, that's two days of satellite radio, and I hope you enjoyed it. Can you tell I'm excited? Our esteemed editors can -- there were another 1,000 words but they said "no way." Never fear, because you can get all the satellite radio info and debate you want on our XM or Sirius Satellite Radio discussion boards!

Until next week, stay Foolish, and thanks for reading.

The Motley Fool is celebrating its 10th anniversary with 10 Ways to Make More Money Now!

Writer and senior analyst Tom Jacobs (TMF Tom9 welcomes your comments at TomJ@Fool.com.Find all his Fool.com columns in his archive. Tom owns shares of XM Satellite Radio and others you can find listed in his profile. The Motley Fool is investors writing for investors.


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