Case Overview • Comprehensive analysis of a growth company that requires economies of scale to attain profitability • Company spends aggressively to increase subscriber growth in an attempt to achieve scale economies • Subscriber growth falls short of target in mid 2006, causing stock price to fall • Is this a buying opportunity or a signal that scale economies are unlikely to be reached?
Overview of Business • Underdog in the nascent satellite radio industry duopoly • Business model centers on providing satellite radio services in the US for a subscription fee. • Offers over 100 channels incorporating unique programming • http://www.sirius.com • Misses growth targets in mid 2006 due to slowdown in US auto production
Business Strategy Analysis (1) • Source(s) of competitive advantage in the radio business relative to traditional AM/FM broadcast radio stations • Wide range of programming – 133 channels • Key proprietary content (Stern, Stewart etc.) • Commercial-free music • Programming available through multiple receiver options
Business Strategy Analysis (2) • Identify two key risks associated with Sirius’ business model relative to traditional broadcast radio stations • Unwillingness of listeners to pay ongoing subscription fees • Lack of local content on Sirius • Failure of satellites • Competition from emerging technologies, such as iPod® and Internet radio
Business Strategy Analysis (3) • Sirius uses automakers as a major distribution channel. Briefly evaluate Sirius’ ability to generate and sustain competitive advantage through this distribution channel • Unlikely to generate and sustain a competitive advantage through this channel because the auto companies are few and large, and so have the power to extract rents in the bargaining process. They are unlikely to distribute Sirius radios on terms that leave a lot of abnormal profit on the table for Sirius
Accounting Analysis (4) • Accounting for subscriber acquisition costs : • Sirius basically expenses these costs as they are incurred (shipment/installation for subsidies paid to radio manufacturers and automakers, activation/sale for commissions to automakers, production for chip sets at radio manufacturers).
Accounting Analysis (5) • Assume that instead of using its current accounting practices for its subscriber acquisition costs, Sirius instead capitalizes all of its subscriber acquisition costs in the fiscal year that these costs are incurred and then amortizes them using the straight-line method over the subsequent two fiscal years. Estimate the Loss from operations that Sirius would have reported for the fiscal year ended December 31, 2005. : Restated loss from operations = Reported loss from operations + Subscriber acquisition costs incurred in 2005 – 1/2 of subscriber acquisition costs for 2004 – 1/2 of subscriber acquisition costs for 2003 = (829,140) + 349,641 + 49,709 -1/2*(173,702+33,149)-1/2*(74,860) = (570,646)
Accounting Analysis (6) • Which of the above two methods of accounting for subscriber acquisition costs do you think better reflects the underlying economics of the business? • Page 27 of Sirius Form 10-K indicates that the average monthly churn rate is 1.5%. This means that the typical customer deactivates after 1/0.015 = 66 months or 5 1/2 years. Thus capitalizing the subscriber acquisition costs and amortizing them over the next 2 years better matches these costs to the future generates that they are expected to generate. Amortizing over 5 years would seem to be an even better reflection of the underlying economics – assuming that current churn rates are indicative of future churn rates.
Accounting Analysis (7) • Briefly explain how Sirius accounts for its subscriber revenue. • Subscription fees are recognized in revenue as service is provided to a subscriber. Most subscription fees are prepaid, recorded to deferred revenue and then amortized to revenue ratably over the subscription period.
Accounting Analysis (8) • Assume that instead of using its current accounting practices for subscriber revenue, Sirius instead recognized subscriber revenue upon the receipt of subscriber payments. Estimate the Loss from operations that Sirius would have reported for the year ended December 31, 2005: • Restated loss from operations = Reported loss from operations + Net increase in deferred revenue = (829,140) + 210,947 = (618,193) • [note that net increase in deferred revenue can be taken directly from statement of cash flows or computed from the net change in the deferred revenue liabilities on the balance sheet]
Accounting Analysis (9) • Briefly describe how Sirius accounts for its FCC license. Do you think that Sirius’ current application of this accounting method is appropriate? Explain your answer. • Based on acquisition cost, with periodic evaluation for impairment. To date, no impairment has been recorded. Given that Sirius has experienced a long history of negative cash flows and earnings and this is not expected to change in the near future, it is aggressive of Sirius to argue that no impairment is warranted. They must be assuming that profitability and cash flows will improve dramatically in the future.
Ratio Analysis (10) • Property & Equipment turnover ratios for Sirius and Citadel for fiscal year 2005. • Property & Equipment turnover ratio for Sirius = 242,245/((828,357+881,280)/2) = 0.28 • Property & Equipment turnover ratio for Citadel = 419,907/((86,076+93,816)/2) = 4.67
Ratio Analysis (11) • Major reason(s) for the difference between turnover ratios. • Sirius has made a considerable investment in its satellite system to support its satellite-based radio network. Citadel is a traditional broadcast radio station, requiring less capital investment to support this transmission method.
Ratio Analysis (12) • Operating margin ratios for Sirius and Citadel for fiscal year 2005 • Operating margin for Sirius = -829,140/242,245 = -342.3% • Operating margin for Citadel = 143,390/419,907 = 34.2%
Ratio Analysis (13) • Major reason(s) for the difference between the margins that you computed above. • Two basic reasons. First, Sirius’ business model needs much greater scale economies to operate profitably in order to cover the fixed costs of the satellite system and programming (see depreciation and programming and content expenses). Sirius is still growing rapidly and has not yet achieved sufficient economies of scale. Second, Sirius is spending much more than Citadel on marketing (see sales and marketing, subscriber acquisition costs) as it tries to grow its subscriber base.
Ratio Analysis (14) • Major reason(s) why ‘Net loss’ has been more negative than free cash flow during these years. • From the statement of cash flows, we see that there are four major reasons: • Large non-cash depreciation expense related to depreciation of satellite system (cash for purchase of satellite system was paid out several years earlier). • Aggressive use of equity grants to pay third parties and employees • Aggressive use of accounts payable and accrued expenses to defer payment of expenses • Deferral of subscription revenue receipts until service has been provided
Forecasting Analysis (15) • The sell-side analyst model provided with this case presents a ‘Base Case’ model in which Sirius’ total subscribers are forecast to grow to 17.3 million by the end of 2010. Briefly evaluate the plausibility of this forecasting assumption. • Subscribers are at 3.3 million at the end of 2005, so this forecast represents an average annual growth rate of approximately 40% over the next 5 years. It is very unusual for such a high growth rate to be sustained over such a long period, so this assumption is very aggressive. • Assuming similar growth in XM, these assumptions imply that about 15% of US population will individually sign up for Satellite radio by 2010
Forecasting Analysis (16) • The sell-side analyst model provides a ‘Revised Model’ in which Sirius’ depreciation and amortization expense is forecast to grow at a much lower rate than its total revenues through 2010. Do you think that this lower growth rate for depreciation and amortization expense is justified? Explain your answer. • Yes, this assumption is reasonable because most of Sirius capital costs are fixed over the next few years and have already been incurred (e.g., satellite system). So revenues can grow without growing the PP&E base generating those revenues.
Forecasting Analysis (17) • Load Sirius into eVal and provide a set of forecasting assumptions that yield similar sales growth and EPS assumptions to those in the ‘Revised Model’ (see Exhibit 2 of the model). (note that Sirius data can be loaded from the eVal ‘Data Center’ sheet by typing SIRI in the white box at the top of this sheet and clicking the adjacent ‘Go’ button) • Set sales growth and gross margin assumptions to match analyst • Trend non-operating income to zero • Trend cash to 10% • Invoke economies of scale argument to trend Other Current Assets, Other Current Liabilities, PP&E, Intangibles and Other Assets assumptions in proportion to sales growth • Trend Long-Term Debt to zero • Set R&D to zero (lump into SG&A) • Use Goal Seek tool to set SGA assumption so as to hit analyst Net Income forecasts • Set valuation date to 06/01/2006
Forecasting Analysis (18) • Evaluate the plausibility of the forecasting scenario you provided in answer to the preceding question. • We will defer the answer to this question until question 22 • Note that one particular challenge we face in this forecasting exercise is making sure we come up with a positive value for total equity. Economies of scale imply that assets will remain fairly constant as Sirius grows, but liabilities such as accounts payable, accrued expenses and deferred revenues should grow in proportion to sales. This means that Sirius will generate a substantial ‘cash float’ from its operations, reducing the need for debt and equity financing. In reality, we would expect Sirius to have a positive equity balance and to ‘plug’ the balance sheet by holding excess financial assets such as cash (insurance companies have similar financial structures, as they generate a cash float from their prepaid policy premiums).
Forecasting Analysis (19) • The ‘Revised Model’ (see Exhibit 2 of the model) assumes that the diluted weighted average number of common stock outstanding will remain constant at 1,628.3 million between 2006 and 2010. Compare these numbers to the number of shares outstanding in your own eVal forecasting model and explain any differences. • This assumption is unreasonable. We know that Sirius has aggressively used common stock grants to pay third parties and employees in the past (see income statement) and that they have continued to do this moving forward (see Note 15 on page F-33 of Sirius 10-K, indicating that 34 million shares of common stock were subsequently granted to Howard Stern and his agent). Thus, the number of common stock outstanding should grow significantly higher than 1,628.3.
Valuation Analysis (20) • The default valuation is less than -$20,000/share! • The negative valuation arises because the default assumptions imply that Sirius will operate perpetually with a negative ROE, while continuing rapid sales growth over the next 10 years. • Note that negative prices are not observed in practice, but we get a negative value in eVal because the default forecasting assumptions imply that Sirius will continue to issue new capital to support its unprofitable growth (look at equity and debt issues in Cash Flow Analysis sheet). • Note that the main causes of the negative valuation are the lack of economies of scale built into the cost and operating asset assumptions.
Valuation Analysis (21) • In mid 2006, Sirius was trading at around $4.50/share. Using eVal, provide a set of forecasting assumptions that approximates this price. Use a cost of equity capital of 10% and a valuation date of June 1, 2006. Do you think that these forecasting assumptions are plausible? • Start with valuation from Q. 17 • Change terminal SG&A assumption to 47% • Valuation = $4.45/share
Valuation Analysis (22) • Based on your analysis above, evaluate the plausibility of the $5.79 price target proposed in the sell-side analyst model (see Exhibit 1 of the model). • Sales assumed to grow to around $3 billion by 2012, implying about 25 million subscribers (assuming no reduction in subscription fees) • Net margins climb to 22% and NOA turns climb to over 6, implying RNOA of 137% • This is just for the $4.45 valuation • Assumptions are very aggressive • At best, they assume lack of competition (iPod, Internet Radio?) and enormous pricing power (FCC?)
Sirius Reports Fourth Quarter and Full Year 2006 Results - Achieves First-Ever Quarter of Positive Cash Flow from Operations and Free Cash Flow - 2006 Revenue Increases 163% to a Record $637 Million - Highest Satellite Radio Subscriber Share in Company's History - 2007 Outlook For More Than 8 Million Subscribers and Revenue Approaching $1 Billion - Executed Definitive Merger Agreement with XM Satellite Radio • NEW YORK, Feb 27, 2007 /PRNewswire-FirstCall via COMTEX News Network/ -- SIRIUS Satellite Radio (Nasdaq: SIRI) today announced record full year and fourth quarter 2006 results driven by an 82% increase in subscribers to more than 6 million, positive free cash flow in the fourth quarter and the highest satellite radio subscriber market share in the company's history. • "In 2006, SIRIUS added 2.7 million new subscribers, an annual record for satellite radio, and captured 62% share of satellite radio subscriber growth. More importantly, SIRIUS achieved positive free cash flow in the fourth quarter 2006 -- four years after adding our first subscriber," said Mel Karmazin, CEO of SIRIUS. "The fourth quarter marked the fifth consecutive quarter of satellite radio subscriber leadership for SIRIUS and a record 67% of satellite radio growth. We look forward to another year of strong growth in 2007, anticipating that we will approach $1 billion in total revenue. The pending merger with XM will offer unprecedented choice for consumers and create tremendous value for our shareholders." • Editor’s note: • 2006 Cost of Equity Grants = $438 million • 2006 Net Loss = $1.1 billion
Key Takeaways • Both earnings and cash flows can be managed • Economies of scale can make default ‘straight line’ forecasting assumptions unreasonable • Forecasting future profitability is more difficult in regulated industries with potential monopoly power • Investors tend to be over-optimistic regarding the prospects of firms with ‘hot’ business models, but sustainability of these business models is often questionable