Imagine, for a second, that you're Sirius Satellite Radio (NASDAQ:SIRI). You've spent the last three quarters swiping market share from your only rival. You landed the top dog in terrestrial radio and now Howard Stern is exclusively on your coast-to-coast airwaves. Your product is an easy sell as you lap the 5 million subscriber mark. Your automaker partners keep ramping up the number of cars rolling off the assembly line and, according to NPD, you are commanding 58% of all new satellite radio purchases at the retail level.
Yes, life is good. Unfortunately, your shareholders are feeling the pain. After Sirius shares peaked in December of 2004, investors have suffered through a 59% drop. XM Satellite Radio (NASDAQ:XMSR) has had an even grimmer slide -- off by 68% -- but it's got momentum working on its side these days. Since bottoming out two months ago, shares of XM have risen 39% higher, while Sirius has only risen 8% off its springtime lows.
Lackluster trading aside, Sirius has a pretty compelling story to tell, and it was the job of CFO David Frear to do just that at the Merrill Lynch Media & Entertainment Conference earlier this month.
To infinity and be long
"There have been a lot of concerns about satellite radio recently," Frear said. "People have talked about growth -- and is the growth slowing down -- so what we thought we'd do is change a little bit in how we talk about the company and talk a little about the growth itself."
Frear went on to compare satellite radio as a category to two other recent subscriber-based success stories; satellite television and cellular phones. Sirius and XM combined to acquire 9.2 million subscribers by the end of last year. If both companies hit their marks, satellite radio will be servicing just over 14 million accounts by the end of the year (with Sirius accounting for the lion's share of that growth). Frear points to how the nascent satellite radio industry is just five years old and how the heady consumer adoption rate would trump that of satellite television providers like DirecTV (NYSE:DTV) and EchoStar (NASDAQ:DISH), as well as the plethora of wireless communication specialists.
He also points out that Sirius is looking to become cash flow positive much quicker than recent subscriber-based offerings. Sirius is looking to produce positive cash flow before the December quarter, but should have no problem achieving that milestone for all of 2007.
Because so much of the overhead in this sector is fixed, things are expected to ramp up in a hurry once Sirius clears the bar. For 2010, Sirius is targeting $1 billion in cash flow before capital expenditures. If so, retail investors who have been accused of overpaying for Sirius will likely have the last laugh in picking up a growth stock for less than six times cash flow before capital expenditures. Yes, 2010 is a little more than three years away, but the moment of truth is now just quarters away.
Stiletto heals
Frear also had with him the Sirius Stiletto, a next-generation portable receiver that's waiting for the FCC to issue it an identification number before hitting the market. The Stiletto offers a few gigs of song storage capacity, and music fans will be getting a satellite radio receiver and a media player in one handheld device. Yes, XM and Sirius have already addressed that convergence with their latest batch of next-generation receivers, but the Stiletto also has Wi-Fi accessibility. If you find yourself in a thick building that has WiFi access but lacks satellite radio reception, Stiletto starts streaming the online version of Sirius' channels.
Innovation is at the heart of satellite radio. For example, XM receivers can order digital downloads from Napster (NASDAQ:NAPS) once the receiver is connected to an online connection. In theory, the Stiletto should be able to do that without the cumbersome docking process. That would place the Stiletto at the cutting edge of high-end portable media players -- the Apple (NASDAQ:AAPL) family of iPods can't do that, and Wi-Fi functionality is what Microsoft (NASDAQ:MSFT) is hoping will win fans over to its upcoming Zune line.
Back to reality
Sirius is hoping to wrap up the year generating $615 million in revenue with 6.3 million subscribers. That is expected to grow to $1 billion in revenue next year and $3 billion come 2010. Can Sirius really pull it off and grow the top line nearly fivefold over the next four years? It seems ambitious, but keep in mind that Sirius has been conservative in the past and has had to raise its targets along the way.
Frear discussed gross subscriber acquisition costs. Critics have taken both XM and Sirius to task for the high price of landing new listeners. Frear explained how that cost has been coming down. It has gone from $179 to $139 to its current level of $110. Frear expects that metric to drop even lower next year. Like XM explained last week, it's a figure often overblown because both companies make most of that back immediately with the upfront subscriber payments. That difference "will likely be zero or positive as we move into 2007." In other words, the company will be managing its new account acquisitions with the money that those new subscribers are paying right away for their initial subscription terms.
Toward the end of his presentation, Frear was asked about the practice at Sirius of accounting for new gross subscribers the moment the cars roll off the assembly line instead of when they're eventually sold off the lot. It's a knock on Sirius that I hear way too often. It seems that I can't write about big subscriber gains at Sirius without folks writing in about how the number is bogus because of the revenue recognition practices at Sirius. I was glad to see Frear address the issue.
"The reason why we record the subscriptions when we do is to keep all the accounting straight," Frear explained. "On the day that the car is shipped from Ford or Chrysler to a dealer, Ford and Chrysler incur an obligation to pay us for the subscription and we incur an obligation to pay them for the subsidy associated with the radio. So the accounting entries go at that time and that's when we record the subscriber."
He also fleshed out the scenario by explaining that the typical car stays on the lot for about three months and that of all of the subscriber adds at Sirius, those on cars that are still on the lot is "now down to something in the 8% range."
Naturally, Frear was also asked about the rumor mill scuttlebutt that keeps wanting Sirius and XM to pair up in a merger of satellite radio giants. He sees the economic benefits of a combination but feels that two issues need to be addressed for a merger to take place.
"One is that the people in the regulatory side of the equation need to say that they think it's an OK thing as well, and honestly, I don't know what they would say. The question hasn't been asked."
"And the second thing is that I think that it's always a matter of price, and so if XM were interested in doing that, presumably, that their board and shareholders have the ability to make that known."
Color me skeptical. The companies seem to be warming up to one another in public statements these days, but it still seems like an unlikely regulatory hurdle. Also, as long as XM is the larger company with the smaller market cap, it won't let itself go cheaply.
Besides, as both companies march toward generating free cash flow, the point of a combination will be moot. The growth prospects of satellite radio are substantial and the market will embrace that and bid the shares up accordingly once it becomes evident to everyone.
Patience pays, even when we're talking about an exotic, high-octane growth stock like Sirius.
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Microsoft is an Inside Value selection.
Longtime Fool contributor Rick Munarriz has been a Sirius satellite subscriber since 2004 and an XM subscriber since this spring. He does not own shares in any of the companies in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.
