Static at XM Satellite Radio

A board member resigns to protest soaring marketing costs in the wake of Howard Stern's debut at rival Sirius Satellite

Add this to the list of things you never want to hear a board member say: I'm departing because there's a "significant chance of a crisis on the horizon." That's precisely what happened at XM Satellite Radio on Feb. 13, when director Pierce Roberts told the company he was resigning. XM disclosed Roberts' resignation letter on Feb. 16, along with financial results for last year.

Roberts, an XM board member of five years and former head of telecom investment banking at Bear, Stearns & Co. (BSC) hinted in his letter that he was troubled by the XM (XMSR) management's decision to chase growth instead of profitability. He predicted that, "even absent a crisis, I believe that XM will inevitably serve its shareholders poorly without major changes now."

His beef: XM's decision to ratchet up spending to lure subscribers and combat rival Sirius Satellite Radio (SIRI). Watching subscribers flock to Sirius, where shock jock Howard Stern arrived in January, XM spent lavishly on advertising and hardware subsidies. While analysts expected XM to promote its brand aggressively before the Stern debut, the magnitude of the increase surprised many. XM's marketing spending surged 82%, to $196.5 million. Laura Martin, an analyst with Soleil Media Metrics, was expecting a 14% increase.


  Worse, the spending didn't help XM much. Loyal Stern listeners were going to flock to Sirius in any case, analysts say. Indeed, Sirius had its best quarter ever, adding 1.14 million subscribers, to end the year with a total of more than 3.3 million.

XM, which is almost twice as large, added only 900,000 customers in the same period. It ended the year with about 6 million subscribers and missed its own targets, if only slightly. XM blamed fourth-quarter weakness on slumping sales at General Motors (GM), which installs XM satellite radios in cars.

XM's financial results suffered too. The fourth-quarter loss widened to $268.3 million from $188.2 million a year earlier, even as sales jumped to $177.1 million from $83.1 million. XM stock took a beating, falling 5%, to $23.98, on Feb. 16. That extended the drop for the year to 15% (see BW Online, 12/28/05, "Satellite Radio: Now It's a Race").

Roger Nissbaum, portfolio manager with Your Source Financial, says the drop was an "overreaction." SG Cowen analysts reckon that now is a good time to get into XM stock. "With 50%-plus relative upside expected in the next 12 months, we see recent weakness as a buying opportunity," analysts Tom Watts and Shaun Parvez wrote in a Feb. 16 report.


  And the news from XM wasn't all bad. Management expects the company to report its first positive cash flow in the fourth quarter. And Roberts' concerns weren't universally shared by the board.

"The company and other directors concur in Mr. Roberts' assessment that lower programming and marketing expenditures, and a potentially lower growth rate, would likely result in earlier positive cash generation," XM said in a statement. "The other directors, however, believe that the company's high growth rate, market leadership, and large base of subscribers are strategically important assets to ensure the company's long-term value and can be sustained."

XM may have a point. The splurge won't be repeated, company officials hinted on a conference call. XM expects its costs per subscribers, which ballooned to $89 last quarter from $64 a year earlier, "to return to normal levels," Hugh Panero, XM's CEO, said during the call. Costs per gross subscriber addition should fall this year, as well, the company said.

In 2005, these costs reached $109, from $100 in 2004. "In reaction to Howard Stern, XM did something out of character by overspending," says Stuart Kagel, an analyst with Janco Partners. "Now, they will be going back" to more conservative spending, he says.

If costs still do fluctuate during the year, rival Sirius is likely to see the same increases as the two battle for retail customers and build up defenses against competing technologies (see BW Online, 01/13/06, "Everyone's Aiming at Satellite Radio"). Sirius also had to increase marketing spending last quarter, Martin says. The company reports fourth-quarter results on Feb. 17.


  That said, XM will likely remain the more conservative spender of the two. Consider: Back in 2004, Sirius offered Stern a five-year, $500 million deal (plus stock thrown in) to air his show on Sirius. But on Feb. 9, XM announced it will spend $55 million to get talk show host Oprah Winfrey on board for three years. By many estimates, the latter is a pretty fair deal. Winfrey's channel, expected to include programming from herself as well as her friends, will debut on XM in September. Winfrey has already promoted XM on her popular TV show.

While the channel may not fuel the same level of subscriber growth as Stern's appearance on Sirius, Winfrey is nevertheless likely to bolster XM's longer-term growth prospects. Research shows that 89% of women view Winfrey favorably. Meanwhile, women buy 59% of cars, and hold influence in 80% of all car-buying decisions, according to XM research. As a result, as XM sees a major jump in the number of car models with its radios preinstalled in 2007 and 2008, "Oprah may play a major role with women buyers," believes Kagel.

Also, XM might enjoy faster growth when, in March, the much-anticipated Samsung Helix and Pioneer Inno devices are released. Smaller than a deck of cards, these gadgets are the smallest-ever portable live satellite radio players. They will be able to receive live feed from XM's satellites on the go, as well as play MP3 music files. Chances are, Sirius is still months away from introducing comparable devices. "We see this as blowing the whole market away," says Frank Viquez, an analyst with tech consultancy ABI Research.

That said, the fact that XM is well-positioned to pursue growth doesn't mean that it's in the clear financially. "The issue with a company like XM is you have to manage expenses in the short term and grow the business for the long term, and it's a fine line," says Kagel. It's one that XM's management still has to prove it can walk.

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