XM Shares Rise Despite 2nd Cut in Subscriber Forecast in 2 Months

“Sporadic inventory shortages” hampered XM’s Q2 aftermarket performance when it stopped shipments of plug & play receivers with wireless FM modulators found by the FCC to exceed power limits, CEO Hugh Panero told analysts in a quarterly earnings call. Those shortages will continue with no resolution in sight and will mean lower than expect net subscriber additions in the 2nd half, he said. That, coupled with general softness at retail, prompted XM to do the “prudent” thing and downgrade its year-end subscriber forecast to 7.7-8.2 million, Panero said. Previously, it cut the target to 8.5 million from 9 million (CD May 25 p16). XM said it still thinks it can become “cash flow positive” in late 2006 or early 2007 -- but the forecast will be much riskier if subscriptions pan out at the lower end of the range. The company said it plans this quarter to “refine” the forecast.

XM’s engineering team “is working aggressively to complete design or installation modifications if appropriate, conduct additional testing for the XM radios and address uncertainties regarding emissions variability with testing results,” Panero said. To an analyst who asked when the FCC issue might be resolved, Chmn. Gary Parsons responded that XM is at the Commission “almost on a daily basis having discussions about that.” Sirius is as well, Parsons said. But “there’s uncertainties relative to exactly the testing criteria that have to be met for that,” he said: “Both companies are scrambling to ensure that we do in fact completely satisfy the FCC’s requirements on those testing elements.”

In light of the Commission’s queries, some XM models “are in a better inventory situation than others,” Parsons said. “The key for us is making sure that we're able to respond to that and have significant product in the 4th quarter for the holiday selling season, and obviously that issue is the primary one at question relative to the low end of the guidance.” It would take “a bit more than a month” to fill the pipeline with compliant product once the FCC investigation is over,” Parsons said, responding to another question. “You can compress some of these schedules by air- shipping and things like that. That adds some additional costs when you do it. But we would bear those costs if that’s what it took to make sure that we got product into the marketplace” promptly.

XM said it has exceeded 7 million total subscribers -- a milestone Wall Street would have greeted with great fanfare if not for the downgraded year-end subscriber projections. Meeting the low end of the forecast means XM’s adding only 700,000 subscribers in 2006’s 2nd half, including the crucial holiday selling season. That would be less than 1/2 the 1,515,467 net subscriber additions recorded in 2005’s 2nd half, including 617,152 in Q3 and 898,315 in Q4.

Compounding XM’s troubles at the FCC are indications borne out by NPD’s point-of-sale reports that satellite radio aftermarket sales have slowed to a trickle, Panero said. In Jan., NPD reported 120% average sales gains in the category at retail, but in May and June, the increases were in the single digits, he said. Panero conceded that Sirius “captured” market share from XM at retail Q1, but said XM will do anything reasonable to regain it. Pressed by the analysts to say specifically whether XM will battle Sirius on price, Panero wouldn’t be pinned down, saying XM will use “intelligent strategies that just don’t sell radios but also add subscribers.” Average subscriber acquisition cost (SAC) rose slightly in Q3 on $5 million in charges related to an SEC “adjustment” on existing inventory, CFO Joe Euteneuer said. But he said XM’s SAC “remains low and leads the industry by a wide margin. Even so, XM didn’t offer forecasts of average SACs for Q3 and Q4. Panero said those will “vary, depending on how much we spend and how many subscribers we get.” SAC often reflects price-aggressiveness on receivers.

Other Q2 disclosures: (1) Churn increased to 1.83% from 1.42% a year earlier because XM switched to a new customer service vendor and “fell flat” during the transition, Panero said. (2) The rate that XM converts promotional OEM customers to paid subscribers fell to 54.5% from 57.6% a year earlier. Euteneuer said the rate is expected to fall again to 52% in Q3 because of “operational process issues.” Later, he elaborated, saying an unidentified automaker had failed to give factory activations to a “block” of new buyers, but that situation has been fixed.

On the major record labels’ suit against XM, Panero said it’s a “high-profile company offering bold, innovative products that people love. This is unsettling to some traditional businesses in our space.” They have responded by bringing XM to court and seeking federal legislation to thwart recording by XM devices, he said: “Notwithstanding this litigation, XM has been a strong business partner of the music industry throughout our history, paying significant fees and performance rights to record labels, composers, authors and publishers.” He said XM’s recent license-renewal agreement with ASCAP is proof of its strong working relationship with the music industry.