XM Curdles as Churn Comes to Light

The company's been publicizing a subscriber-defection figure that ignores some customer losses.
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Investors are suddenly picking up some troubling signals from

XM Satellite Radio

(XMSR)

.

The Washington, D.C., pay radio broadcaster and 2003 market favorite posted

seemingly solid first-quarter financial figures Thursday, including a threefold year-over-year sales increase. But Wall Street's enthusiasm was tempered by disclosure of a stealthy and unhealthy subscriber-departure trend.

There's little question that many drivers, particularly new car buyers, are willing to pay $10 a month for 120 channels of radio programming. XM, after all, expects to have nearly 3 million customers by year-end. The nagging issues for investors are how much cash it will take to keep subscribers coming in the door and, more pointedly, how many will stay after XM paid so much to attract them.

"It's a high top-line growth company," says Rodman & Renshaw analyst Dan Ernst. "I just don't know if it's worth $8 billion," he added, referring to the company's enterprise value, or market cap plus debt. Ernst has a sell rating on the stock and neither the analyst nor his firm has any XM investment position.

Shares of the radio broadcaster fell 8% Thursday, while satellite rival

Sirius

(SIRI) - Get Report

dropped 5%.

At first glance, subscriber losses seem like a nonissue at XM. After all, the company reported Thursday that, on average, a mere 1.35% of its subscribers canceled service each month in the first quarter.

But like the pro forma profit calculations of yesteryear, this so-called churn number can be a slippery critter. The number is calculated at the company's discretion and, as critics point out, can include whatever numbers executives choose.

This latest wrinkle was exposed on a conference call with analysts Thursday. XM executives, responding to a question, revealed for the first time in memory a gross subscriber-addition figure. That's a figure the company hasn't routinely disclosed, preferring instead to focus on the ever-rising net figure.

A bit of back-of-the-envelope math shows why XM hasn't been eager to share the gross-adds figure. The company says it added a total of 475,000 customers in the first quarter.

That looks good, but recall that XM added 321,675 new subscribers in the quarter on a net basis. That means 153,325 customers somehow vanished -- putting the monthly churn at something like 3.8%, nearly three times the official count.

That churn figure looks substantially less rosy, though XM representatives were quick to explain why. They say their churn number excludes customers who drop the service after a three-month introduction when they buy an XM-equipped car. "We felt comfortable" disclosing the gross subscriber figure on the call rather than having analysts guess at it, says a company rep.

XM adds that it converts about 70% of these promotional users into monthly subscribers. But as observers note, all the promotional users are counted in the overall subscriber totals.

Counting freeloaders as actual customers helps XM pump up its subscriber growth and helps spread the per-gross-add costs over a much wider base, say critics. That makes it look like acquisition expenses are coming down, an important consideration at a cash-burning company.

Still, keeping customers is just as important as winning them. The company says it expects to spend $110 for every customer it adds. But if the customer doesn't stick around for a year, paying the full $10 per month, XM will have trouble recouping its investment.

For its part, XM says it probably won't offer two different churn numbers in future press releases. But the company rep says XM "may be more open than we have been in the past" in disclosing gross subscriber additions.

"That would be more in keeping with the times," says Rodman's Ernst.