The Dog Star suddenly looks like a balloon in search of a pin.
Two years ago I predicted XM and Sirius would have a tough time surviving in the midst of a hard recession while using business models based on tons of red ink far into the future. Surely shareholders would run out of patience and hold them accountable for more rational balance sheets and business practices before rewarding them with higher stock prices.
I think I ignored the lessons of the dot-com bubble and investors' willingness to ride a hot pony with irrational exuberance. Or perhaps I just didn't give them enough time before reality would set in.
The market has leveled off and pulled back into a choppy trading range and appears to be taking a more sober look at what the prospects for these companies really are. Numerous investment advisors are dropping their calls to neutral or outright sell. Of course, satellite stock prices have jumped around a lot, and probably will continue to be volatile in the near future.
Back in 2002 it seemed likely the much smaller Sirius would falter and merge or morph into something else. That hasn't happened. Yet. After leaving Viacom and losing interest in traditional media, Mel Karmazin has ridden in on a white horse with sidekick Howard Stern to keep the Dog Star burning for now. But even Mel may have lost his magic touch with Wall Street. After his recent press conference touting the latest Sirius video add-on feature, for example, the stock immediately sold off 5 percent.
The dot-com boom and bust cycle lasted about eight years. Could satellite radio be following in the same footsteps? There are many parallels and similarities. I only regret that I didn't buy them two years ago and then sell a few months ago to reap profits approaching 1,000 percent.
Instead of shoring up their business plans by restructuring and scaling back risk like any typical young company struggling to become profitable, they're going in the opposite direction. Both have tried to enhance their content offerings and appeal by increasing programming commitments and debt while diluting their share values by issuing more stock. The only thing saving them for now is a steadily growing subscription base. That's the key difference between these companies and many dot-coms that had nifty ideas and a few products but not enough buyers. Wall Street eventually lost its patience with the dot-com bubble businesses and many bit the dust.
The obvious challenge for satellite radio is to keep growing fast enough to convince investors they will turn the corner and become profitable over the long haul. As happened after cable and satellite TV were launched and grew rapidly, subscription growth eventually leveled off and churn rates increased. XM and Sirius hope to cross the threshold of profitability before that happens. As of January, XM counted more than 3 million and Sirius had 1 million subscribers. Both have a very long way to go.
MAKING THE CASE
Radio isn't television. Even in large markets, the selection of over-the-air TV programming was very limited compared to what could be delivered over cable and satellite. Those services have succeeded because most American households have been willing to pay to get a dramatic increase in viewing choices, all with near-perfect pictures and reception.
According to Leichtman Research, the total number of cable and satellite TV subscribers is about 90 million in the United States. First we heard the sat radio boys thought they could eventually count half that many who will buy their service. Now, Karmazin is saying they might even equal that many. Nobody ever accused these guys of not being supremely optimistic.
The case for pay radio is nowhere near as compelling as pay TV's. The most important and valuable radio listening is mobile during drive times. Coverage of local news, weather, traffic, sports and civic events is still the most powerful reason folks turn on the radio. Even in average-sized cities, the number of viable radio-station choices is 20 or more, with many major formats available. CD players, Walkmans, i-PODS and portable MP3 players augment the majority of listening needs and choices for music aficionados. The universe of those who are willing to pay for more radio programming and music choices beyond these traditional methods will most certainly prove to be a small fraction of that enjoyed by pay TV and video.
Sirius is basing much of its future growth on Howard Stern and NFL football, while XM has high hopes for its Major League Baseball deal. Practically all industry observers have noted the prices paid for such marquee content were ridiculously high. The Wall Street Journal has said Sirius is "crushing its own windpipe" with such deals. XM has also added the infamous Opie and Anthony (O&A), plus popular talkers Dr. Laura and Gordon Liddy. The price of good talent honed in traditional radio is being bid way up and a few are crossing over.
Both companies, but especially Sirius, are betting that new subscribers will pay the extra freight and sometime in the future a profit will be made. They keep upping the ante in spite of the odds their bet may not pay off. They're also hoping subscription sales will just keep on rolling after consumers who really want the service buy it separately by including the cost of new subscriptions in the purchase of new cars. Dealers can easily bury the sat radio charges in the monthly car payments in hopes buyers won't really notice or remember they agreed to pay for the service.
GOING OVER THE LINE
In its zeal to enforce indecency standards, the FCC effectively has forced several bad-boy jocks off regulated free radio onto satellite. Opie and Anthony are on XM doing their shtick in unexpurgated fashion. Citadel has chosen to replace Stern in some of their markets with O&A as fill-ins. The dump buttons and post editors must be getting a real workout. Presumably, they're doing this as punishment for Howard spending too much time promoting Sirius and his new show that starts there unfettered by FCC regulations next year.
I'm surprised neither Mel nor Howard have thought about why his show was so popular with indecency restrictions, but why it might not be so attractive without them. Those very limits force such talent to create suggestive and titillating radio bits that "come very close to the line" without going over it.
Both Howard's and O&A's fans are largely folks who enjoy hearing how far the creative genius will go and what they will say next without dropping over the edge. Without limits, this "art form" quickly degenerates. Most everyone values some level of decency and the power of imagination. That's why well-produced soft porn attracts much larger audiences than no-holes-barred XXX. It won't take too long to find out if these guys justify their huge salaries as bona-fide stars or just morph into dirty old men being disgusting all too often.
When XM and Sirius first launched, both CEOs said they could compete and coexist like Coke and Pepsi. If that's the case, traditional radio must be water. XM maintained if they could only attract 10 percent of traditional radio's daily audience of 225 million, they would be successful. But their thresholds of profitability have steadily increased along with the mountains of debt. And now they truly believe they can stretch that number to 45 or even 90 million? Such extravagant projections are going to be reined in by the counter-competitive impact of traditional free radio's fledgling transition to digital with multiple channels and many of the same add-on features like text data and 5.1 surround sound.
DOING THE MATH
Jesse Eisinger broke down the market valuation numbers for Sirius in his Wall Street Journal article in December.
At $9.02 a share (the stock price at that time), its market value based on 1.74 billion owned shares was $15.7 billion. If each subscriber generates about $12 a month in revenue, that totals $144 per year. But investors look at "contribution margin," which measures cash flow after most variable costs except marketing and SAC or subscriber acquisition costs. Sirius expects a 70 percent contribution margin so the $144 "net" value of each subscriber is reduced to $100 per year.
The Sirius "churn rate" is always being debated, but a reasonable estimate is 2 percent per month or 24 percent a year for this exercise, he noted. That means after four years, the equivalent of all subscribers roll over or churn off. Consequently the contribution margin becomes $100 times four years or $400. But we also have to subtract the SAC. That number was $200 for 2004, but Sirius is hoping and analysts are projecting that this number could be reduced to $50 in the future. Allowing for a very generous $50 SAC, we now have a value of $350 for each Sirius subscriber. Divide the market cap of $15.7 billion by 350 and you can then project that the market is valuing Sirius as if it has 45 million subscribers, instead of the real-world 1 million.
The Dog Star suddenly looks like a balloon in search of a pin.
BALANCING THE BALANCE SHEET
Despite highly inflated expectations and stock prices, satellite radio does bring a valuable alternate service to the marketplace that extends and augments what traditional radio has done for 85 years. But at what price to consumers that will sustain the providers as viable businesses?
The economics of both Sirius and XM still seem way out of balance at present subscription rates and income levels. Something will have to change. Higher monthly fees, along with tiered surcharges for "premium" features like Stern and NFL games, are only months away.
When both services first launched, much of the hype and attraction was over their "commercial-free" programming. Few clear-thinking observers thought that would last very long. Over the past year, commercials have started to appear. Most of the Sirius talk channels now include commercials. Karmazin, who started his career as a CBS radio spot salesman, never lost his lust for ad dollars. He recently divulged his fervent desire that 5 percent of all radio ad revenue, about $1 billion, would flow into Sirius. Stop sets of multiple commercials on the music channels could be just around the corner Nobody ever mentions the issue of satellite vulnerability involving these services. "Rock" and "Roll" and the Sirius birds are insured, but a technical flaw with Rock and Roll projects their life span to only seven or eight years instead of the planned 15-year target. XM now will have to launch two more replacement satellites over the next two years to cover the shortfall.
With all the things that can go wrong, having multi-million dollar standbys ready to blast into orbit on short notice seems mandatory. All it takes is for one lucky asteroid or some errant piece of space junk to crash into any of these and instant catastrophic damage could result. This technology has proven to be reliable and durable so far, but loss of service for any extended period of time could wreak havoc and huge financial losses for either.
In spite of an insatiable appetite for spending and debt, almost everyone seems to agree that satellite radio is here to stay. But very soon, real and significant cost-cutting measures are going to have to be a part of their operations. This may already be happening at Sirius under the frugal hand of Mr. Karmazin. While an XM/Sirius merger is a future possibility, the most likely scenario that will ensure the survival of these services will be increased ownership and control by major investors like the automobile companies and large group traditional broadcasters.
When subscriber growth flattens out and these companies still find themselves bathed in red ink, Wall Street undoubtedly will exact its punishment. At that point, the underlying owners will become more actively involved in restructuring the business models that could then subdivide and transition either XM or Sirius into consolidated sub-units of traditional radio. Failing AMs were bought up by profitable groups and FMs over the past 20 years. The new owners had to subsidize the AM operations until they could be transformed into profitability.
As unthinkable as it may sound, Mel could be the tip of that iceberg in reverse, as many of the present employees of XM and Sirius could once again be working for their old bosses in radio companies they left behind.
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The Dog Star suddenly looks like a balloon in search of a pin.