GMP throws in towel on XM Canada
It was only a few months ago when XM (XMSR:NASDAQ) and Sirius (SIRI:NASDAQ) announced their desire to merge their U.S. operations. Although anti-trust issues will potentially get in the way of that deal, I’d find it ironic if the FCC tried to tell these two players that, having already lost billions to build the satellite radio industry, they need to continue to do so as the two firms joining forces will be anti-competitive. How many ways can one get music or sports broacasts these days? Is the FCC really going to tell shareholders that the best thing for the industry is that one of the two players goes bankrupt? Perhaps. But there’ll still be but one player when all is said and done, either way.
I remember quite vividly that XM Canada, formally known as Canadian Satellite Radio (XSR:TSX), was around $8 a share at that time. It traded up a snick on the U.S. merger news, even though the ability of the two Canadian players to do a merger of equals was immediately called into question by the team behind Sirius Canada. Fast forward a few weeks, and you can see that the game of poker continues to play out.
John I. Bitove is a great entrepreneur, and he knows how to win. But when things take longer than planned, and the forecast burn to breakeven exceeds CSR’s cash resources and parent line of credit, it sure can’t be fun to work this stuff out in the limelight.
Here is GMP’s research summary on the most recent quarter released by Canadian Satellite Radio. Although CSR missed the low end of the revised subscriber forecast by a mere 15,000 folks, GMP cut the share price target by more than 50%. Playing a bit of catch-up by the looks of it:
“Today (June 11), XSR reported Q3/F07 subscriber results below our expectations. The company reported 270,000 total subscribers at quarter-end including self-paying, OEM trial subscribers and “other paying” subscribers, compared to our 285,000 estimate. Recall that after the Q2 results, we lowered our subscriber forecast significantly, hence, this result is lower than our revised forecast. As is common practice for XSR, the company did not provide a breakdown of the composition of the subscriber base choosing to wait until the Q3 financial release before providing additional detail. As such, it is difficult to draw definitive conclusions on the impact to our forecast until financial and full subscriber results are released (expected in mid-July).
What is clear is that XSR’s subscriber growth is lagging our initial and revised forecasts despite the fact that industry subscriber growth is in line with our expectations. XSR has fallen behind in market share versus Sirius Canada, largely due to Sirius’ focus on the retail market while XSR had focused on the OEM market (which has been slower than expected to develop). With XSR’s recent emphasis on the retail market (announced on the Q2 call) and the fact that they become the exclusive broadcasters of the NHL in the upcoming season, we expect XSR to reduce the market share gap going forward. We also expect the OEM market to be a greater contributor going forward further improving the market share profile.
However, we believe it will take a couple of quarters with convincing evidence that XSR’s subscriber growth is accelerating before we can recommend investors to buy XSR shares. We believe Q1/F08 will be a critical quarter to that end as it is the most important quarter from a seasonality perspective (the holiday selling season). Hence, we maintain our cautious tone to XSR shares in the interim.
We are lowering our retail subscriber forecast as we believe it will take time for XSR to win market share from Sirius. We also lowered our OEM subscriber forecast slightly. While we believe XSR’s OEM partnerships will ultimately bear fruit, subscriber growth has been slower than expected. We also revised our financial forecast as we believe XSR will incur additional subscriber acquisition costs (SAC) and lower ARPU as the company offers customer incentives to improve its retail market share. Our financial forecast revisions result in a cash deficit, beyond the $45 mm credit facility provided by XMSR, beginning in 2009 and, as such, we believe XSR will have to raise additional capital.
As a result of our forecast changes and the increased risk profile, we are lowering our target price to $3.50 from $8.00 and we are lowering our recommendation to HOLD from Buy. XSR ended Q2 with unrestricted cash and short-term investments of $24.3 mm ($0.50 per fully diluted share). On the Q2 call, management announced it had begun to explore cost containment initiatives in an effort to reduce cash burn through to cash flow breakeven and it announced it would begin to draw down on its $45 mm credit facility provided by XMSR. The facility can only be used to pay licence fees due to XMSR, which represents 15% of subscriber fee revenue. Recognizing the likelihood of a cash deficit in F08 management has chosen to begin drawing on the facility beginning in Q3.
While management believes the company is fully funded through to EBITDA breakeven, our forecast calls for bank indebtedness of $61.9 mm in F09, of which, a maximum of $45 mm will be covered by the XMSR line of credit. Hence, we believe the company faces financing risk in the event that financial metrics do not improve relative to our forecast.
We are lowering our target to $3.50 from $8.00 as a result of our forecast changes. We are
lowering our recommendation to HOLD from Buy. We continue to believe in the viability of the
satellite radio industry. Satellite radio service has proven appeal as evidenced by the subscriber growth in the United States and the early results in Canada. That said, XSR has materially lagged its only satellite radio competitor. While we believe there are positive developments that could narrow the gap (NHL exclusivity, expansion of the distribution network and development of the OEM channel), we believe our previous market share forecast for XSR was too aggressive. We have lowered our subscriber forecast and reduced our ARPU assumption and raised our SAC estimate as we believe XSR will have to pursue more aggressive measures to improve its market share profile. Our revised forecast points to a financing deficit in F09 adding an additional element of risk.
While XSR shares have declined materially in recent months and may have, in fact, overcorrected, we recommend investors exercise caution until evidence surfaces that subscriber metrics are improving and until there are clear indications that additional financing has been secured or is not needed (due to an improvement in the financial metrics above our forecast).
We continue to value XSR utilizing a DCF model. However, due to our perceived increased risk, we have raised our discount rate to 18% (from 16%) and we have lowered our terminal multiple to 7.5x (from 10.0x) to arrive at a valuation of $3.30 per share.”