|UBS on XM's Quarter End|
Solid 1Q05 Results Lead Into Upbeat 2Q05 Outlook
XM reported better than expected net adds (4/1/05), cost metrics, and EBITDA for 1Q05. As a result of the customer reaction thus far to XM's price hike and planned promotions during the quarter, XM has guided to flat net adds in 2Q versus UBS and Street expectations for a sequential decline.
* EBITDA Inflection in 1Q05
XM's EBITDA loss of $(71)M during the quarter was a 9% improvement over 1Q04 and represents an inflection for quarterly EBITDA loss. We note this milestone as it indicates what we believe is key inflection in XM's ultimate ability to achieve positive FCF, EBITDA, and EPS.
* Dad and Grad Promotion for Multiple Subscriber Households
During the Father's Day/Graduation time period in the second half of 2Q05, XM will offer a free Roady 2 with each purchase of an XM receiver. The promotion is intended to increase overall subscribership and will likely result in sub acquisition of lower churn and higher return subs, while benefiting XM's 2Q05 sub growth.
* Valuation: Maintain Buy 2; Increase target to $41 from $40.50
Our target is based on a DCF analysis assuming 3% growth in perpetuity and a 10.2% WACC. Our NPV analysis implies an incr sub valuation of $340, or 25M subs at current levels vs our 29M 10-year forecast. We believe the NPV discount and upside from ad revs support our Buy 2 rating.
* Better Than Expected 1Q05 Results Accompany Upbeat 2Q05 Outlook. XM reported better than expected 1Q05 results highlighted by impressive cost controls, lower SAC (subscriber acquisition costs), CPGA (cost per gross addition), CCPU (cash cost per user—operating expenses less CPGA), improved EBITDA loss, and narrowed EPS loss. As a result of the success during 1Q05 and the promotions planned in 2Q05, XM management expects net additions to be flat with 1Q in the 2Q05, versus our expectation for a sequential decline. First quarter results highlight the operating leverage we expect XM to achieve over the long-term. XM has demonstrated its focus on cost cutting and ultimately achieving positive FCF and positive returns for shareholders. We reiterate our Buy 2 rating and increase our price target modestly to $41 from $40.50 following revisions to our model.
Table 1: XM Satellite Radio—UBS 1Q05 Estimates Versus Actuals
* XM Achieves EBITDA Inflection Point in 1Q05. While revenues and ARPU were essentially in-line with our estimates, XM reported SAC of $52 versus UBSe of $65 and CPGA of $90 versus UBSe of $101. Stronger than expected gross additions of 825k (versus UBSe of 808k) helped to drive lower cost per gross addition metrics, however, total acquisition costs (CPGA times gross additions) of $74 million were still below UBSe of $82 million. In addition, operating expenses excluding acquisition costs (CCPU) were $8.47 per average subscriber or $89 million, which is well below UBSe of $10.61 ($111 million). We would note that for the third quarter in a row XM generated positive EBITDA before marketing (EBITDAM) of $13 million (13% margin). As a result of the better than expected cost metrics, EBITDA loss of $(71) million was well ahead of our $(102) million estimate and was a 9% improvement over 1Q04. While XM has had positive EBITDA inflection points in the past (Chart 1), we believe the trend toward positive EBITDA is highlighted by 1Q05 results and will continue, except for 3Q05E, until EBITDA positive in 2007E.
Chart 1: Annual Change in XM Satellite Radio Quarterly EBITDA (1Q03—4Q07E)
* Upbeat Outlook for 2Q05. XM expects net additions during 2Q05 to be in-line with 1Q05 net additions, while churn is anticipated to remain flat with first quarter results. This outlook is better than we had expected given the impact of the recent price increase that was enacted on April 2, 2005. We had expected a mild increase in churn coupled with lower net additions during the quarter. Our revised estimates for 2Q05 reflect the positive outlook for the quarter, as demonstrated in Table 2. As we discuss below, one of the drivers of the upbeat outlook for 2Q05 is XM’s planned Dads and Grads promotion in the second half of the quarter.
Table 2: XM Satellite Radio—Revised Model (1Q05A—2008E)
* Planned Dad and Grad Promotion during 2Q05. XM intends to run a promotion during the graduation and Father’s Day time frame in the second half of 2Q05, which will feature a free Roady 2 receiver with the purchase of any XM receiver. We believe the market’s initial reaction (trading down at the beginning of the day), that the industry leader does not need to give away free receivers, may have been shortsighted (as was recognized by the stock ultimately closing up on the day). XM is the cost leader in the industry and is well positioned to offer a product promotion that will encourage multiple subscriber households, lower churn, and higher return on investment. We believe this promotion will likely help XM achieve its 2Q05 subscriber growth estimate and keep the company on track to potentially exceed current 2005 subscriber guidance of 5.5 million. We would note, our revised subscriber estimates are now 2.4 million net additions in 2005, which results in 5.6 million total subscribers by year-end.
* Slightly lower ARPU Outlook in the Near-term; Normalized Over the Long-term. In addition to the changes in 2Q05 subscriber growth, we have slightly lowered our ARPU estimates modestly for the quarter and the year as we expect the impact to XM’s financials from the recent price hike to have a longer overall adoption curve. In other words, while we expect ARPU to increase as a result of the price hike, we believe the full impact to XM’s financials will take longer than originally expected due to the company’s plan to push higher rates once billing cycles have been completed, which could push the impact out from our prior estimates.
* Valuation: Increase 12-month price target modestly to $41 from $40.50 representing 45% upside potential; Maintain Buy 2 rating. Following the better than expected first quarter results, we have modestly increased our target to $41 from $40.50. Our target is based on a discounted cash flow analysis assuming 3% growth in perpetuity and a 10.2% weighted average cost of capital. Our target equates to a 15 times 2010E EBITDA multiple and an 11.6 times 2010E FCF multiple. Given the early stage nature of the business, we believe multiple valuation approaches are beneficial to the understanding of the business. Accordingly our NPV analysis implies an incremental subscriber valuation of $340 and the market is valuing 25 million subscribers in the current stock price versus our 29 million 10-year forecast. In addition, the NPV analysis does not incorporate the benefits from advertising revenue. As a result, we believe the NPV discount to our model coupled with upside from advertising supports our Buy 2 rating on the stock.