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| XMSR > SEC Filings for XMSR > Form 10-K on 15-Mar-2004 | All Recent SEC Filings |
15-Mar-2004
Annual Report
To explain our performance, we discuss our results of operations using the following revenue and expense categories that reflect the drivers of the business.
Subscription Revenue
Subscription includes fees from basic and premium service net of subscription-related promotions.
Activation Revenue
Activation includes amortization of subscription activation fees over the estimated average life of a subscriber.
Equipment Revenue
Equipment includes revenue from XM's direct sales of radios and other related equipment.
Net Ad Sales Revenue
Net Ad Sales includes revenue from sales of advertisements and programming sponsorships to advertisers on the XM radio network, net of agency commissions.
Cost of Revenue
Costs of Revenue are those expenses directly related to the generation of subscriber and advertising revenue and have variable and fixed components. Cost of Equipment, Revenue Share & Royalties, along with Customer Care & Billing tend to fluctuate along with increases and decreases in revenues and/or subscribers. Ad Sales, which includes internal and external costs directly associated with selling advertisements on the XM network, tends to fluctuate with increases and decreases in advertising revenue. Satellite & Terrestrial, Broadcast & Operations and Programming & Content are not expected to fluctuate directly with changes in revenue and/or subscribers.
Research & Development
Research & Development is a discretionary expense used primarily to drive new product development and radio component and radio unit cost reductions.
General & Administrative
General & Administrative expenses include legal, human resources, accounting and other overhead costs.
Marketing
Marketing includes: Retention & Support, which are those indirect costs, primarily labor, that are not associated with gaining a subscriber and are not expected to fluctuate directly with changes in revenue and/or subscribers; Subsidies & Distribution, which includes commissions to radio manufacturers and distribution partners that are based on the number of radios or vehicles manufactured or the number of new subscribers added in the period; Marketing, which are those discretionary costs including advertising, media and events, as well as marketing materials for retail and automotive dealer points of presence. Amortization of the GM Liability includes the straight-line accounting treatment of the fixed obligation to General Motors. We consider subscriber acquisition costs (SAC) to include radio manufacturer subsidies, certain sales, activation and installation commissions, and hardware-related promotions. These costs are reported in subsidies & distribution on the consolidated statement of operations. Subscriber acquisition costs also include the negative margins on equipment sales. (Subscriber acquisition costs do not include ongoing loyalty payments to retailers and distribution partners, payments under revenue sharing arrangements with radio manufacturers and distributors and the amortization of the GM liability). We consider Cost Per Gross Addition (CPGA) to include the amounts in SAC, as well as advertising, media and marketing expenses except for retention and support and the amortization of the GM liability.
EBITDA
Net loss before interest income, interest expense, income taxes, depreciation and amortization is commonly referred to in our business as "EBITDA." EBITDA is not a measure of financial performance under generally accepted accounting principles. Consistent with regulatory requirements, EBITDA includes Other Income (Expense). We believe EDITDA is often a useful measure of a company's operating performance and is a significant basis used by our management to measure the operating performance of our business. Because we have funded and completed the build-out of our system through the raising and expenditure of large amounts of capital, our results of operations reflect significant charges for depreciation, amortization and interest expense. EBITDA, which excludes this information, provides helpful information about the operating performance of our business, apart from the expenses associated with our physical plant or capital structure. EBITDA is frequently used as one of the bases for comparing businesses in our industry, although our measure of EBITDA may not be comparable to similarly titled measures of other companies. EBITDA does not purport to represent operating activities, as those terms are defined under generally accepted accounting principles, and should not be considered as an alternative to those measurements as an indicator of our performance.
2003 2002 2001
------------- ------------ ------------
(In thousands, except share amounts)
Revenue:
Subscription $ 78,275 $ 16,344 $ 238
Activation 1,868 484 8
Equipment 6,692 757 —
Net ad sales 4,065 2,333 251
Other 881 263 36
- ----------- - - ---------- - - ---------- -
Total revenue 91,781 20,181 533
- ----------- - - ---------- - - ---------- -
Operating expenses
Cost of revenue (excludes depreciation and
amortization, shown below):
Revenue share & royalties 26,440 12,790 1,739
Customer care & billing 25,945 16,069 5,724
Cost of equipment 9,797 1,679 —
Ad sales 3,257 1,870 2,243
Satellite & terrestrial 39,692 44,818 62,641
Broadcast & operations:
Broadcast 7,689 7,745 6,155
Operations 12,023 12,106 15,805
- ----------- - - ---------- - - ---------- -
Total broadcast & operations 19,712 19,851 21,960
Programming & content 23,109 25,379 17,649
- ----------- - - ---------- - - ---------- -
Total cost of revenue 147,952 122,456 111,956
Research & development (excludes depreciation and
amortization, shown below): 12,285 10,843 13,689
General & administrative (excludes depreciation and
amortization, shown below) 27,418 26,448 20,250
Marketing (excludes depreciation and amortization,
shown below):
Retention & support 7,873 9,857 8,445
Subsidies & distribution 92,521 54,086 9,217
Advertising & marketing 64,309 91,624 75,483
- ----------- - - ---------- - - ---------- -
Marketing 164,703 155,567 93,145
Amortization of GM liability 35,564 13,598 439
- ----------- - - ---------- - - ---------- -
Total marketing 200,267 169,165 93,584
Impairment of goodwill — 11,461 —
Depreciation & amortization 158,317 118,588 42,660
- ----------- - - ---------- - - ---------- -
Total operating expenses 546,239 458,961 282,139
- ----------- - - ---------- - - ---------- -
Operating loss (454,458 ) (438,780 ) (281,606 )
Interest income 3,066 5,111 15,198
Interest expense (110,349 ) (63,573 ) (18,131 )
Other income (expense) (22,794 ) 2,230 160
- ----------- - - ---------- - - ---------- -
Net loss (584,535 ) (495,012 ) (284,379 )
8.25% Series B and C preferred stock dividend
requirement (17,569 ) (20,859 ) (23,153 )
Series B preferred stock retirement gain 8,761 — —
Series C preferred stock retirement loss (11,537 ) — —
- ----------- - - ---------- - - ---------- -
Net loss attributable to common stockholders $ (604,880 ) $ (515,871 ) $ (307,532 )
- ----------- - - ---------- - - ---------- -
Basic and diluted net loss per share $ (4.83 ) $ (5.95 ) $ (5.13 )
- ----------- - - ---------- - - ---------- -
Weighted average shares used in computing net loss
per share—basic and diluted 125,176,320 86,735,257 59,920,196
- ----------- - - ---------- - - ---------- -
EBITDA(1) $ (318,935 ) $ (317,962 ) $ (238,786 )
- ----------- - - ---------- - - ---------- -
XM subscriptions (end of period)(2) 1,360,228 347,159 27,733
(1) Net loss before interest income, interest expense, income taxes, depreciation and amortization is commonly referred to
in our business as "EBITDA." EBITDA is not a measure of
financial performance under generally accepted accounting
principles. Consistent with regulatory requirements, EBITDA
includes Other Income (Expense). We believe EBITDA is often a
useful measure of a company's operating performance and is a
significant basis used by our management to measure the
operating performance
of our business. Because we have funded and completed the build-out of our
system through the raising and expenditure of large amounts of capital,
our results of operations reflect significant charges for depreciation,
amortization and interest expense. EBITDA, which excludes this
information, provides helpful information about the operating performance
of our business, apart from the expenses associated with our physical
plant or capital structure. EBITDA is frequently used as one of the bases
for comparing businesses in our industry, although our measure of EBITDA
may not be comparable to similarly titled measures of other companies.
EBITDA does not purport to represent operating loss or cash flow from
operating activities, as those terms are defined under generally accepted
accounting principles, and should not be considered as an alternative to
those measurements as an indicator of our performance.
2003 2002 2001
---------- ---------- ----------
(In thousands)
Reconciliation of net loss to EBITDA:
Net loss as reported $ (584,535 ) $ (495,012 ) $ (284,379 )Add back non-EBITDA items included in net loss:
Interest income $ (3,066 ) $ (5,111 ) (15,198 )
Interest expense 110,349 63,573 18,131
Depreciation and amortization 158,317 118,588 42,660
- -------- - - -------- - - -------- -
EBITDA $ (318,935 ) $ (317,962 ) $ (238,786 )
- -------- - - -------- - - -------- -
(2) We consider subscribers to be those who are receiving and have
agreed to pay for our service, either by credit card or by
invoice, including those that are currently in promotional
periods paid for by vehicle manufacturers, as well as XM
activated radios in vehicles for which we have a contractual
right to receive payment for the use of our service. Radios
that are revenue generating are counted individually as
subscribers.
Year Ended December 31, 2003 Compared With Year Ended December 31, 2002
XM Satellite Radio Holdings Inc. and Subsidiaries
Revenue
Revenue. Our revenue consists of subscription fees, activation charges, limited direct sales of radios, advertising sales, and revenue earned from royalties and invoice fees. In 2003, we recognized $91.8 million in total revenue, compared to $20.2 million in 2002, an increase of $71.6 million. During 2003, subscription revenue comprised over 85% of our total revenues.
Subscribers. As of December 31, 2003, we had 1,360,228 subscribers, compared to 347,159 at December 31, 2002, an increase of 1,013,069 subscribers. Our subscribers include 1,018,963 self-paying subscribers, 320,473 subscribers in OEM promotional periods (typically ranging from three months to one-year in duration) paid for by the vehicle manufacturers and 20,792 XM activated vehicles with rental car companies. At the time of sale, vehicle owners generally receive a 3-month trial subscription and are included in OEM promotional subscribers. XM generally receives two months of the 3-month trial subscription from the vehicle manufacturer. The number of subscribers electing to continue with the XM service beyond the initial OEM promotional period, the conversion rate, has ranged from 65%—80% through the end of 2003 and averaged approximately 74% for 2003. Beginning in late September 2003, we began an interim auto activation program whereby XM-enabled radios in new vehicles manufactured by General Motors and Honda are automatically activated to receive the XM service as a subscriber at the time of the sale to the vehicle purchaser. In March 2004, we began a fully automated factory activation program whereby XM-enabled radios in new vehicles manufactured by General Motors are activated to receive the XM service at the time of manufacture. These vehicles are not included in our subscriber count until the vehicle is sold to a customer who becomes an OEM promotional subscriber. The fully automated factory activation program was initiated to streamline the process for activating the XM service in vehicles that previously required the auto manufacturers' dealers to contact our listener care center. The fully automated factory activation program also provides activated radios on the dealer lots for test drives. In addition, GM will now provide standard on the window sticker 3 months free of XM service with every XM-enabled vehicle. We cannot predict how the change to this auto activation program will impact our overall conversion rate. However, we expect that the implementation of the fully automated factory activation program will increase the number of subscribers provided by our OEM distribution channel, but will result in a decline in our overall conversion rate due to a larger number of cars activated for trial service. Our subscribers also include 20,792 XM activated vehicles with rental car companies. For the initial model year 2003 XM-enabled rental vehicles, XM receives payments based on the use of XM service. Customers are charged $2.99 per day per vehicle for use of the XM service, on which XM receives
a revenue share. For subsequent model year 2004 and later vehicles, XM receives $10 per subscription per month. Additionally, 100,872 family plan subscriptions at a multi-unit rate of $6.99 per radio per month are included in our total subscriber count. We consider subscribers to be those who are receiving and have agreed to pay for our service, either by credit card or by invoice, including those who are currently in promotional periods paid for by vehicle manufacturers, as well as XM activated vehicles for which we have a contractual right to receive payment for the use of our service. Radios that are revenue generating are counted individually as subscribers.
Subscription Revenue. Subscription revenue was $78.3 million during 2003 compared to $16.3 million in 2002, an increase of $62.0 million. Subscription revenue consists primarily of our monthly subscription fees charged to consumers, commercial establishments and fleets, which are recognized as the service is provided. Revenues received from vehicle manufacturers for promotional service programs are included in subscription revenue. At the time of sale, vehicle owners generally receive a three-month trial subscription and are included in OEM promotional subscribers. Beginning in 2004, a standard promotion of 3 months free will be placed on the window sticker of all XM-enabled GM vehicles. We generally receive payment for two months of the three-month trial subscription period from the vehicle manufacturer. For 2003, subscription revenue included $8.5 million from related parties for subscription fees paid under certain promotional agreements, compared with $184,000 in 2002. Subscription revenue also includes revenues from a premium service. Our subscriber arrangements are cancelable without penalty. Promotions and discounts are treated as a reduction to revenue during the period of the promotion. Sales incentives, consisting of rebates to subscribers, offset revenue. Discounts on equipment sold with service are allocated to equipment and service based on relative fair value.
Average Monthly Subscription Revenue Per Subscriber. Average monthly subscription revenue per subscriber (ARPU) was approximately $8.97 during 2003 and $9.43 during 2002. ARPU from our aftermarket, OEM and other subscribers was $9.59 during 2003, compared to $9.54 during 2002. The difference from our retail rate of $9.99 is due primarily to multi-year prepayment plan and family plan discounts. ARPU from our OEM promotional subscribers was $6.48 during 2003, compared to $2.81 during 2002. The OEM promotional programs began in November 2002. ARPU from our rental car fleet subscribers was $5.54 during 2003. ARPU from our family plan subscribers was $6.91 during 2003. Average monthly subscription revenue per subscriber is derived from the total of earned subscription revenue (net of promotions and rebates) divided by the monthly weighted average number of subscribers for the period reported. Average monthly revenue per subscriber is a measure of operational performance and not a measure of financial performance under generally accepted accounting principles. Average monthly revenue per subscriber will fluctuate based on promotions implemented in 2004, as well as the adoption rate of multiyear prepayment plans, multitradio discount plans (such as the family plan), premium and data services.
Activation Revenue. Activation revenue is comprised of one-time activation charges billed to customers. Activation fees are non-refundable, and are recognized on a pro-rata basis over the estimated 40-month life of the subscriber relationship. We expect this estimate to be further refined in the future as additional historical data becomes available. During 2003, we recognized $1.9 million in activation revenue compared to $0.5 million in 2002, an increase of $1.4 million due to an increase in subscribers. The growth in activation revenue will be impacted by the amount of discounts given as a result of the competitive environment.
Equipment Revenue. Equipment revenue is comprised of revenues from any direct sales of radios. Through December 31, 2003, the direct sales of radios have generally been for promotional purposes. During 2003, we recognized $6.7 million in equipment revenue compared to $0.8 million during 2002. For 2003, equipment revenue included $3.0 million from direct sales of radios to related parties compared with $72,000 in 2002. We expect revenue from the sale of equipment to increase proportionately with the increase in direct sales of equipment by XM.
Net Ad Sales Revenue. Advertising revenue consists of sales of advertisements and program sponsorships on the XM network to advertisers that are recognized in the period in which they are broadcast. Advertising revenue includes advertising aired in exchange for goods and services (barter), which is recorded at fair value. Advertising revenue is presented net of agency commissions in the results of operations, which is consistent with industry practice. In 2003, we recognized $4.1 million in net advertising revenue compared to $2.3 million during 2002. These amounts are net of agency commissions, which were $486,000 during 2003, compared to $350,000 during 2002. The increase in net advertising revenue is due primarily to increased demand for advertising on the XM network that results from our subscriber growth, listenership and audience reach. During 2003, we recognized $1.1 million in
advertising barter revenue compared to $0.3 million during 2002. For 2003, advertising revenue included $512,000 from sales of advertisements to related parties compared with $0 in 2002. We expect advertising revenue to increase during 2004 due to increased demand for advertising on the XM network resulting from our subscriber growth, listenership, and audience reach. In March 2004, we will launch our Instant Traffic & Weather channels. Advertising sales on these channels is expected to offset the forgone revenue from the implementation of our 100% commercial-free music format that began February 1, 2004.
Other Revenue. Other revenue earned during 2003 consists of processing fees charged to invoiced subscribers, royalty revenue from certain tuners manufactured, and other revenue. We recognized $0.9 million of other revenue during 2003 compared with $0.3 million during 2002. We expect other revenue to increase during 2004.
Operating Expenses
Total Operating Expenses. Total operating expenses were $546.2 million for 2003 compared to $459.0 million in 2002, an increase of $87.2 million or 19%. The increase was due primarily to an increase in cost of revenue of $25.5 million attributable to increased sales, an increase in marketing expenses of $31.1 million due to increased distribution expenses as a result of the growth in subscribers and an increase in depreciation and amortization of $39.7 million resulting from a reduction in the useful life of our satellites in third quarter of 2002, offset in part by an impairment charge of $11.5 million relating to goodwill recognized in 2002.
Cost of Revenue. Cost of revenue includes revenue share & royalties, customer care & billing costs, costs of radios associated with direct sales of radios, costs directly associated with sales of advertising, satellite & terrestrial operating costs, as well as costs related to broadcast & operations and programming & content. These combined costs were $148.0 million for 2003, up from $122.5 million in 2002, an increase of $25.5 million or 21%.
Revenue Share & Royalties. Revenue share & royalties includes performance rights obligations to composers, artists, and copyright owners for public performances of their creative works broadcast on XM, and royalties paid to radio technology providers and revenue share payments to manufacturing and distribution partners and content providers. These costs were $26.4 million in 2003 compared to $12.8 million in 2002. This increase of $13.6 million was a result of our growth in subscriber base and revenues along with completion of negotiations for performance rights royalties. We expect these total costs to increase during 2004 as subscriber growth continues but to decrease slightly as a percentage of total revenue.
Customer Care & Billing. Customer care & billing operations expense includes expenses from outsourced customer care functions as well as internal IT costs associated with front office applications. These expenses were $25.9 million during 2003, compared with $16.1 million during 2002, an increase of $9.8 million. This increase resulted from the increase in subscribers. We expect customer care & billing operations expense in total to increase during 2004 as we continue to add subscribers, but we expect the average cost per subscriber to decrease.
Cost of Equipment. During 2003, we incurred $9.8 million relating to promotional radios and radio kits that we sold directly to subscribers, compared to $1.7 million in 2002. We expect the cost of equipment to increase during 2004 as we increase direct sales of equipment.
Ad Sales. Ad sales expense was $3.3 million in 2003 compared to $1.9 million in 2002, an increase of $1.4 million or 74%. The increase in ad sales expense is due primarily to an increase in staffing and marketing costs to support ad sales growth. We expect ad sales costs to increase in 2004 in support of advertising revenue growth.
Satellite & Terrestrial. Satellite & terrestrial includes: telemetry, tracking and control of our two satellites, in-orbit satellite insurance and incentive payments, satellite uplink, and all costs associated with operating our terrestrial repeater network such as power, maintenance and lease payments. These expenses were $39.7 million in 2003, compared with $44.8 million in 2002, a decrease of $5.1 million or 11%. The decrease primarily resulted from previously accrued performance incentives payable to Boeing relating to XM Rock and XM Roll that were reversed in 2003 as a result of the December 2003 amendment of our contract with Boeing, which removed this obligation. We expect system operating costs in 2004 to be in line with the costs incurred in 2003.
Broadcast & Operations
Broadcast. Broadcast expenses include costs associated with the management and maintenance of the systems, software, hardware, production and performance studios used in the creation and distribution of XM-original and third party content. The advertising trafficking (scheduling and insertion) functions are also included. Broadcast costs were $7.7 million for 2003, compared to $7.7 million in 2002. Broadcast costs are expected to increase with enhancements to and maintenance of the broadcast systems infrastructure.
Operations. Operations, which includes facilities and back office information technology expense, was $12.0 million in 2003, compared with $12.1 million in 2002, a decrease of $0.1 million. These costs are expected to remain stable in 2004.
Programming & Content. Programming & content includes the creative and production costs associated with our 101 channels of XM-original and third party content. This includes costs of programming staff and fixed payments for third party content. Programming & content expense was $23.1 million during 2003, compared with $25.4 million during 2002, a decrease of $2.3 million or 9%. The decrease is due primarily to decreases in payroll and payroll related costs from a reduction in headcount which occurred in November 2002 and lower fixed payments to certain content providers as a result of contract renegotiations. These costs are expected to increase in 2004 as we make changes to our channel line-up and enhance our programming. In 2004, we expect to launch 20 instant traffic and weather channels, each dedicated to the traffic and weather of a specific market.
Research & Development. Research & development includes the costs of new product development, chipset design, and engineering. These combined expenses were $12.3 million in 2003, compared with $10.8 million in 2002, an increase of $1.5 million or 14%. The increase in research and development expense resulted from the development of four new products, XM PCR, Delphi XM Roady, XM Commander and XM Direct, brought to market in 2003, as well as the commencement of activities under the joint development agreement with Sirius Radio. Research and development expenses will continue to increase in 2004 as we accelerate the development of future telematics applications and new products, including interoperable radios.
General & Administrative. General & administrative expense was $27.4 million during 2003, compared with $26.4 million during 2002, an increase of $1.0 million or 4%. The increase in general & administrative expense primarily resulted from an increase in director and officer insurance premiums, and an increase in non-cash stock-based compensation charges, offset in part by a decrease in costs incurred for professional services. We expect general and administrative expense to increase slightly during 2004.
Marketing. Marketing includes the costs of retention & support, subsidies & distribution, advertising & marketing, and amortization of our liability to GM. These combined costs were $200.3 million for 2003, compared to $169.2 million in 2002, an increase of $31.1 million, or 18%. Marketing expense increased primarily due to increases in subsidies & distribution of $38.4 million and amortization of GM liability of $22.0 million, offset in part by decreases in retention and support of $2.0 million and advertising and marketing of $27.3 million.
Retention & Support. Personnel-related expenses comprise the majority of retention and support. In 2003, these costs were $7.9 million compared to $9.9 million in 2002, a decrease of $2.0 million or 20%, primarily due to a reduction in staffing levels, and a decrease in non-cash stock compensation expense resulting from the reversal of an accrual relating to the Sony warrants. In September 2003, it was evident that Sony did not achieve the minimum performance target required for the vesting of its warrants. Therefore, the non-cash compensation charges of $0.4 million recorded in prior years in relation to these warrants were reversed in 2003.
Subsidies & Distribution. We currently provide incentives and subsidies for the manufacture, purchase, installation and activation of XM radios to attract and retain our manufacturing and distribution partners. Our subsidy and distribution costs are significant and totaled approximately $92.5 million during 2003, compared with $54.1 million during 2002, an increase of $38.4 million or 71%. This increase is due primarily to the increase in subscribers, new activations, and GM vehicles equipped with XM radios, offset in part by a decrease in manufacturing subsidies resulting from changes in the subsidy timing and lower subsidy rates. Subsidy and distribution expense will increase as the number of XM radios that are manufactured, installed and activated increase; however, we expect the cost per new subscriber to decrease.
Subscriber Acquisition Costs. We consider subscriber acquisition costs to include radio manufacturer subsidies, certain sales, activation and installation commissions, and hardware-related promotions. These costs are reported in Subsidies & Distribution. The negative margins from equipment sales are also included in subscriber acquisition costs. Subscriber acquisition costs do not include ongoing loyalty payments to retailers and distribution partners, payments under revenue sharing arrangements with radio manufacturers and distributors and certain guaranteed payments to General Motors. During the years ended December 31, 2003, and 2002, we incurred expenses of $88.8 million, and $54.1 million, respectively, related to subscriber acquisition costs. Our average subscriber acquisition cost was $75 and $116 during 2003 and 2002, respectively. The decline in SAC for 2003 as compared to 2002 is due primarily to the decline in manufacturer subsidies. We expect SAC to decline in 2004.
Advertising & Marketing. Activities comprising these expenses include media, advertising, events and direct marketing programs. Advertising & marketing costs were $64.3 million during 2003, compared with $91.6 million during 2002, a decrease of $27.3 million or 30%. The decrease is due primarily to our decreased purchase of consumer advertising media. We expect these expenses to increase during 2004.
Cost Per Gross Addition. We consider CPGA to include the amounts in SAC, as well as advertising, media and other discretionary marketing expenses. In our financial statements, SAC costs are captured in Subsidies & Distribution and the negative margins from equipment sales, while CPGA costs are primarily captured by the combination of Subsidies & Distribution, Advertising & Marketing, plus the negative margins from equipment sales. CPGA does not include marketing staff (included in Retention & Support) or the amortization of the GM guaranteed payments (included in Amortization of GM Liability). During the years ended December 31, 2003, and 2002, we incurred CPGA expenses of $159.9 million, and $145.5 million, respectively. CPGA for 2003 and 2002 was $137 and $425, respectively. The decline in CPGA for 2003 as compared to 2002 is due to the combined impacts of the declines in manufacturer subsidies, discretionary advertising and marketing expenses and an increase in the number of activations. We expect CPGA to decline in 2004.
Amortization of GM Liability. These costs include the amortization of annual fixed guaranteed payment commitments to General Motors, aggregating to $439 million, under our long-term distribution agreement with the OnStar division of GM providing for the installation of XM radios in GM vehicles. Amortization of the GM liability was $35.6 million for 2003, compared with $13.6 million for 2002. The distribution agreement was amended in June 2002 and then again in January 2003, as described under the captions "Liquidity and Capital Resources—Capital Resources and Financing." As a result of the January 2003 amendment and GM's current roll out plans, commencing in February 2003 we began recognizing the fixed payments, which approximate $397.3 million, on a straight-line basis through September 2013. In January 2003, we expensed the pro rata portion of the fixed payment that was based on the June 2002 amendment to the agreement. We expect these expenses to increase to $37.3 million in 2004 and to remain at $37.3 million per annum through September 2013.
Impairment of Goodwill. We recognized an impairment charge of $11.5 million during the fourth quarter of 2002.
Depreciation & Amortization. Depreciation & amortization expense was $158.3 million during 2003, compared with $118.6 million during 2002, an increase of $39.7 million or 33%. The increase in depreciation and amortization expense primarily resulted from the reduction in the useful lives of our in-orbit satellites from 17.5 years to 6.75 years during the third quarter of 2002 due to a solar array output power anomaly.
Interest Income. Interest income was $3.1 million during 2003, compared with $5.1 million during 2002, a decrease of $2.0 million or 39%. The decrease was the result of lower yields on our investments due to market conditions as well as lower average balances of cash and cash equivalents in 2003.
Interest Expense. We recorded interest expense of $110.3 million and $63.6 million during 2003 and 2002, respectively. The increase in interest expense is due to an increase in debt outstanding from the January 2003 and June 2003 financing transactions, as well as a charge of $7.2 million to interest expense attributable to the beneficial conversion feature on the exchange of $24.0 million carrying value of our 10% senior secured discount convertible notes due 2009 into 8,072,081 shares of Class A common stock.
Other Income (Expense), net. Other income (expense), net was $(22.8) million during 2003, compared with $2.2 million during 2002, a decrease of $25.0 million. The expense during 2003 resulted primarily from losses of $24.7 million from the retirement of debt with a carrying value including accrued interest of $125.2 million, offset in part by income from rental of office space in our corporate headquarters to third parties. Other income (expense), net for 2002 consists primarily of income from rental of office space in our corporate headquarters to third parties.
Net Loss. Net loss for 2003 was $584.5 million, compared with $495.0 million for 2002, an increase of $89.5 million or 18%. The increase primarily reflects the losses recorded in other expense from our deleveraging transactions, increases in interest expense and increases in operating expenses, primarily depreciation and amortization expense, offset in part by the growth in our revenue.
EBITDA. Net loss before interest income, interest expense, income taxes, depreciation and amortization is commonly referred to in our business as "EBITDA." EBITDA is not a measure of financial performance under generally accepted accounting principles. EBITDA during 2003 was $(318.9) million, compared with $(318.0) million during 2002. Included in the 2003 EBITDA are losses of $24.7 million recorded from the deleveraging transactions. Consistent with regulatory requirements, EBITDA includes Other Income (Expense). We believe EDITDA is often a useful measure of a company's operating performance and is a significant basis used by our management to measure the operating performance of our business. Because we have funded and completed the build-out of our system through the raising and expenditure of large amounts of capital, our results of operations reflect significant charges for depreciation, amortization and interest expense. EBITDA, which excludes this information, provides helpful information about the operating performance of our business, apart from the expenses associated with our physical plant or capital structure. EBITDA is frequently used as one of the bases for comparing businesses in our industry, although our measure of EBITDA may not be comparable to similarly titled measures of other companies. EBITDA does not purport to represent operating activities, as those terms are defined under generally accepted accounting principles, and should not be considered as an alternative to those measurements as an indicator of our performance. The reconciliation of net loss to EBITDA is as follows (in thousands):
Year Ended December 31,
----------------------------
2003 2002
------------- ----------
Net loss as reported $ (584,535 ) $ (495,012 )
Add back non-EBITDA items included in net loss:
Interest income (3,066 ) (5,111 )
Interest expense 110,349 63,573
Depreciation & amortization 158,317 118,588
-- ---------- - - -------- -
EBITDA $ (318,935 ) $ (317,962 )
-- ---------- - - -------- -
Year Ended December 31, 2002 Compared With Year Ended December 31, 2001
XM Satellite Radio Holdings Inc. and Subsidiaries
Revenue
Revenue. Our revenue consists of subscription fees, activation charges, limited direct sales of radios, advertising sales, and revenue earned from royalties. In 2002, we recognized $20.2 million in total revenue, compared to $0.5 million in 2001, an increase of $19.7 million. During 2002, subscription revenue comprised approximately 81% of our total revenues.
Subscribers. As of December 31, 2002, we had 347,159 subscribers, compared to 27,733 at December 31, 2001, an increase of 319,426 subscribers. Our subscribers at December 31, 2002 included 31,317 subscribers in OEM promotional periods. We began offering OEM promotional programs in November 2002. We consider subscribers to be those who are receiving and have agreed to pay for our service, either by credit
card or by invoice, including those who are currently in promotional periods, as well as XM activated vehicles for which we have a contractual right to receive payment for the use of our service. Radios that are revenue generating are counted individually as subscribers.
Subscription Revenue. Subscription revenue was $16.3 million during 2002 compared to $0.2 million during 2001, an increase of $16.1 million. Subscription revenue consists primarily of our monthly subscription fees charged to consumers, commercial establishments and fleets, which are recognized as the service is provided. Revenues received from vehicle manufacturers for promotional service programs are included in subscription revenue. For 2002, subscription revenue included $184,000 from related parties for subscription fees paid under certain promotional agreements. Subscription revenue also includes revenues from a premium service. Our subscriber arrangements are cancelable, without penalty. Promotions and discounts are treated as a reduction to revenue during the period of the promotion. Sales incentives, consisting of rebates to subscribers, offset revenue.
Average Monthly Subscription Revenue Per Subscriber. Average monthly subscription revenue per subscriber (ARPU) was approximately $9.43 during 2002, and $8.57 during 2001. In 2002, ARPU from our aftermarket, OEM and other subscribers was $9.54. In 2001, we had just launched commercial operations and essentially all of our subscribers were aftermarket, OEM and other subscribers. Average monthly subscription revenue per subscriber is derived from the total of earned subscription revenue (net of promotions and rebates) divided by the monthly weighted average number of ending subscribers for the period reported. We made two changes to our calculation of ARPU at the end of 2002 in an effort to provide a metric that we feel is more reflective of our earned recurring monthly subscription revenue. First, we no longer include earned activation revenue as part of the ARPU calculation. We also refined our methodology to calculate ARPU using a denominator of monthly weighted average customers rather than our previous approach of daily weighted average customers to be consistent with how we manage our business. Average monthly revenue per subscriber is a measure of operational performance and not a measure of financial performance under generally accepted accounting principles.
Activation Revenue. Activation revenue is comprised of one-time activation charges billed to customers. Activation fees are non-refundable, and are recognized on a pro-rata basis over the estimated 40-month life of the subscriber relationship. During 2002, we recognized $484,000 in activation revenue compared to $8,000 during 2001, an increase of $476,000 due to an increase in subscribers.
Equipment Revenue. Equipment revenue is comprised of revenues from any direct sales of radios. Through December 31, 2002, the direct sales of radios have generally been for promotional purposes. During 2002, we recognized $757,000 in equipment revenue compared to $0 million during 2001. For 2002, equipment revenue included $72,000 from direct sales of radios to related parties.
Net Ad Sales Revenue. Advertising revenue consists of sales of advertisements and program sponsorships on the XM network to advertisers that are recognized in the period in which they are broadcast. Advertising revenue includes advertising aired in exchange for goods and services (barter), which is recorded at fair value. Advertising revenue is presented net of agency commissions in the consolidated statements of operations, which is consistent with industry practice. During 2002, we recognized $2.3 million in net advertising revenue compared to $251,000 during 2001. These amounts are net of agency commissions, which were $350,000 during 2002, compared to $43,000 during 2001. The increase in net advertising revenue is due primarily to increased demand for advertising on the XM network that results from our subscriber growth, listenership and audience reach. During 2002, we recognized $330,000 in advertising barter revenue compared to $0 during 2001.
Other Revenue. Other revenue earned during 2002 consisted of royalty revenue from certain tuners manufactured during 2002, and other broadcast revenue. We recognized $263,000 of other revenue during 2002 compared with $36,000 during 2001.
Operating Expenses
Total Operating Expenses. Total operating expenses were $459.0 million for 2002 compared to $282.1 million in 2001, an increase of $176.9 million or 63%. The increase was primarily a result of a full year of operations in 2002.
Cost of Revenue. Cost of revenue includes revenue share & royalties, customer care & billing costs, costs of radios associated with radio sales, costs directly associated with sales of advertising, satellite & terrestrial operating costs, as well as costs related to broadcast & operations and programming & content. These combined costs were $122.5 million for 2002, up from $112.0 million in 2001, an increase of $10.5 million or 9%.
Revenue Share & Royalties. Revenue share & royalties includes performance rights obligations to composers, artists, and copyright owners for public performances of their creative works broadcast on XM and royalties paid to radio technology providers and revenue share payments to manufacturing and distribution partners and content providers. These costs were $12.8 million in 2002 compared to $1.7 million in 2001. This increase of $11.1 million was a result of our growth in subscriber base and revenues along with completion of negotiations for performance rights royalties.
Customer Care & Billing. Customer care & billing operations expense includes expenses from outsourced customer care functions as well as internal IT costs associated with front office applications. These expenses were $16.1 million during 2002, compared with $5.7 million during 2001, an increase of $10.4 million. This increase resulted from a full year of commercial operations and increase in subscribers.
Cost of Equipment. During 2002 we incurred $1.7 million relating to promotional radios and radio kits that we sold directly to subscribers, compared to $0 in 2001.
Ad Sales. Ad sales expense was $1.9 million in 2002 compared to $2.2 million in 2001, a decrease of $0.3 million or 14%.
Satellite & Terrestrial. Satellite & terrestrial includes: telemetry, tracking and control of our two satellites, in-orbit satellite insurance and incentive payments, satellite uplink, and all costs associated with operating our terrestrial repeater network such as power, maintenance and lease payments. These expenses were $44.8 million in 2002, compared with $62.6 million in 2001, a decrease of $17.8 million or 28%. This decrease primarily resulted from a charge of $4.0 million in 2002 compared to a charge of $26.3 million in 2001 related to terrestrial repeater sites no longer required. Exclusive of this charge, we incurred increased operating expenses in 2002 compared to 2001 as our satellites and terrestrial repeater network performed over a first full year of operations.
Broadcast & Operations
Broadcast. Broadcast expenses include costs associated with the management and maintenance of the systems, software, hardware, production and performance studios used in the creation and distribution of XM-original and third party content. The advertising trafficking (scheduling and insertion) functions are also included. Broadcast costs were $7.7 million for 2002, compared to $6.2 million in 2001, an increase of $1.5 million or 24%. The increase reflects a full year of operations for 2002.
Operations. Operations, which includes facilities and information technology expense, was $12.1 million in 2002, compared with $15.8 million in 2001, a decrease of $3.7 million or 23%. The decrease in operations expense in 2002 is attributed to a decrease in rent expense which was a direct result of the purchase of our corporate headquarters in the third quarter of 2001 and a decrease in costs incurred for professional services related to information technology as a result of a decreased need for post-implementation support.
Programming & Content. Programming & content includes the creative and production costs associated with our 101 channels of XM-original and third party content. This includes costs of programming staff and fixed payments for third party content. Programming & content expense was $25.4 million during 2002, compared with $17.6 million during 2001, an increase of $7.8 million or 44%. The increase reflects a full year of operations for 2002.
Research & Development. Research & development includes the costs of new product development, chipset design, and engineering. These combined expenses were $10.8 million in 2002, compared with $13.7 million in 2001, a decrease of $2.9 million or 21%. The decrease in research and development expense primarily resulted from the higher cost of designing the initial chipset in 2001 compared with subsequent chipset designs in 2002 when the manufacturers absorbed a portion of the engineering charges.
General & Administrative. General & administrative expense was $26.4 million during 2002, compared with $20.3 million during 2001, an increase of $6.1 million or 30%. The increase in general & administrative expense primarily resulted from increased director and officer insurance premiums in the fourth quarter, and costs incurred in 2002 for the 2003 bond exchange transaction.
Marketing. Marketing includes the costs of retention & support, subsidies & distribution, advertising & marketing, and amortization of our liability to GM. These combined costs were $169.2 million for 2002, compared to $93.6 million in 2001, an increase of $75.6 million, or 81%. Marketing expense increased due to increases in subsidies & distribution of $44.9 million, advertising & marketing of $16.1 million, amortization of GM liability of $13.2 million, and retention and support of $1.4 million.
Retention & Support. Personnel related expenses comprise the majority of retention and support. In 2002, these costs were $9.9 million compared to $8.4 million in 2001, an increase of $1.5 million or 18%.
Subsidies & Distribution. We currently provide incentives and subsidies for the manufacture, purchase, installation and activation of XM radios to attract and retain our manufacturing and distribution partners. Our subsidy and distribution costs are significant and totaled approximately $54.1 million during 2002, compared with $9.2 million during 2001, an increase of $44.9 million due to 2002 being a full year of operations.
Subscriber Acquisition Costs. We consider subscriber acquisition costs to include radio manufacturer subsidies, sales, activation and installation commissions, and hardware-related promotions. These costs are reported in Subsidies & Distribution. The negative margins from equipment are also included in subscriber acquisition costs. Subscriber acquisition costs do not include ongoing loyalty payments to retailers and distribution partners, payments under revenue sharing arrangements with radio manufacturers and distributors and guaranteed payments to General Motors. During the years ended December 31, 2002, and 2001, we incurred expenses of $54.1 million, and $9.2 million, respectively, related to subscriber acquisition costs. Our average subscriber acquisition cost was $116 during 2002.
Advertising & Marketing. Activities comprising these expenses include media, advertising, events and direct marketing programs. Advertising & marketing costs were $91.6 million in 2002 compared with $75.5 million in 2001, an increase of $16.1 million or 21% as a result of a full year of operations in 2002.
Cost Per Gross Addition. We consider CPGA to include the amounts in SAC, as well as advertising, media and other discretionary marketing expenses. In our financial statements, SAC costs are captured in Subsidies & Distribution and the negative margins from equipment sales, while CPGA costs are captured by the combination of Subsidies & Distribution, Advertising & Marketing, plus the negative margins from equipment sales. CPGA does not include marketing staff (included in Retention & Support) or the amortization of the GM guaranteed payments (included in Amortization of GM Liability). During the years ended December 31, 2002, and 2001, we incurred expenses of $145.5 million, and $84.0 million, respectively. CPGA for the full year 2002 was $425. Due to our launch late in 2001 and significant pre-operations costs recorded, CPGA figures for 2001 and prior are not meaningful.
Amortization of GM Liability. These costs include the amortization of annual fixed guaranteed payment commitments to General Motors, aggregating to $439 million, under our long-term distribution agreement with the OnStar division of GM providing for the installation of XM radios in GM vehicles. In 2001 we expensed $439,000, the annual fixed payment for that year. We amended the agreement in June 2002, and following the amendment began amortizing the annual fixed payments due through November 2005, which approximated $63.6 million, on a straight-line basis. We expensed $13.6 million for 2002, reflecting a pro rata portion of the 2002 fixed annual payment for the period from January 2002 through June 2002 and the straight-line portion of the $63.6 million for the remainder of 2002. The distribution agreement
was amended again in January 2003. As a result of the January 2003 amendment and GM's current roll out plans, commencing in February 2003 we are recognizing the guaranteed payments due under the long-term distribution agreement, which approximate $397.3 million, on a straight-line basis through September 2013, the remaining term of the agreement.
Impairment of Goodwill. We recognized an impairment charge of $11.5 million during the fourth quarter of 2002 in accordance with the provisions of SFAS No. 142 Goodwill and Other Intangible Assets. SFAS No. 142 required that we perform an assessment of the fair value of our reporting unit and compare it to the carrying value of the reporting unit. As a result of the value of our stock and other securities being impacted by negative trends in the capital markets during 2002, our market capitalization had fallen below our book value, indicating that our reporting unit's goodwill may be impaired. In accordance with SFAS No. 142, we performed the second step of the annual impairment test during the fourth quarter of 2002 and recognized an impairment charge of $11.5 million as required by SFAS No. 142.
Depreciation & Amortization. Depreciation & amortization expense was $118.6 million during 2002, compared with $42.7 million during 2001, an increase of $75.9 million. The increase in depreciation and amortization expense primarily resulted from our commencing depreciation of major components of our system, including our satellites and terrestrial systems, upon commencement of commercial operations in September 2001. During 2002, we ceased amortizing goodwill and our DARS license in accordance with our adoption of SFAS No. 142. As a result of a solar array output power anomaly, during 2002, we reduced the useful lives of our in-orbit satellites from 17.5 years to 6.75 years.
Interest Income. Interest income was $5.1 million during 2002, compared with $15.2 million during 2001, a decrease of $10.1 million or 66%. The decrease was the result of lower average balances of cash and cash equivalents during 2002 coupled with lower yields on our investments due to market conditions.
Interest Expense. We recorded interest expense of $63.6 million and $18.1 million during 2002 and 2001, respectively. In addition, we capitalized interest costs of $0.0 million and $45.2 million associated with our DARS license and our XM Radio system during 2002 and 2001.
Other Income (Expense), net. Other income (expense), net consists primarily of income from rental of office space in our corporate headquarters to third parties. Other income (expense), net was $2.2 million in 2002, compared with $0.2 million in 2001, an increase of $2.0 million. The increase reflects a full year's rental income in 2002 compared with four month's rental income in 2001, as we purchased our corporate headquarters in August 2001.
Net Loss. Net loss for 2002 was $495.0 million, compared with $284.4 million for 2001, an increase of $210.6 million or 74%. The increase primarily reflects increases in operating expense, depreciation and amortization expense and interest expense in connection with our ramp-up of commercial operations, offset in part by the growth in our revenue.
EBITDA. Net loss before interest income, interest expense, income taxes, depreciation and amortization is commonly referred to in our business as "EBITDA." EBITDA is not a measure of financial performance under generally accepted accounting principles. EBITDA for 2002 was ($318.0 million), compared with ($238.8 million) for 2001. The increased loss is due primarily to an increase in operating expense in connection with our ramp-up of commercial operations, offset in part by the growth in our revenue. Consistent with regulatory requirements, EBITDA includes Other Income (Expense). We believe EDITDA is often a useful measure of a company's operating performance and is a significant basis used by our management to measure the operating performance of our business. Because we have funded and completed the build-out of our system through the raising and expenditure of large amounts of capital, our results of operations reflect significant charges for depreciation, amortization and interest expense. EBITDA, which excludes this information, provides helpful information about the operating performance of our business, apart from the expenses associated with our physical plant or capital structure. EBITDA is frequently used as one of the bases for comparing businesses in our industry, although our measure of EBITDA may not be comparable to similarly titled measures of other companies. EBITDA does not purport to represent operating activities, as those terms are defined under generally accepted accounting principles, and should not be considered as an alternative to those measurements as an indicator of our performance. The reconciliation of net loss to EBITDA is as follows (in thousands):
Year Ended December 31,
----------------------------
2002 2001
------------- ----------
Net loss as reported $ (495,012 ) $ (284,379 )
Add back non-EBITDA items included in net loss:
Interest income (5,111 ) (15,198 )
Interest expense 63,573 18,131
Depreciation & amortization 118,588 42,660
-- ---------- - - -------- -
EBITDA $ (317,962 ) $ (238,786 )
-- ---------- - - -------- -
Liquidity and Capital Resources
At December 31, 2003, we had total cash and cash equivalents of $418.3 million, which excludes $0.1 million of restricted investments, and working capital of $295.3 million. Cash and cash equivalents increased $385.5 million during 2003. The increase resulted from $616.0 million provided by financing activities and $14.6 million provided by investing activities, offset by $245.1 million used in operating activities. The proceeds from financing activities resulted primarily from a private placement in January 2003 that resulted in the issuance of our 10% Senior Secured Discount Convertible Notes that yielded gross proceeds of $210 million, the issuance of 5.5 million shares of Class A common stock that yielded gross proceeds of $15 million, the issuance of our 12% Senior Secured Notes that yielded gross proceeds of $185 million, and the issuance of 11.3 million shares of Class A common Stock that yielded gross proceeds of $150 million. The financing activities completed during the year are more fully discussed below. Investing activities consisted primarily of proceeds provided from the maturity of restricted investments. Cash flows used in operating activities includes the net loss of $584.5 million and the net cash used by our operating assets and liabilities, offset in part by non-cash expenses included in the net loss.
By comparison, at December 31, 2002, we had total cash, cash equivalents and short-term investments of $42.8 million, which excludes $29.7 million of restricted investments, and working capital of $(49.5) million. This amount reflects the use of cash, cash equivalents and short-term investments of $210.9 million at December 31, 2001, plus the proceeds of $151.6 million from financing activities, to fund $294.3 million of cash used in operations and $7.0 million in investing activities. The proceeds from financing activities resulted primarily from an equity offering during 2002. Cash flow used in operations reflected the net loss from the Company's first full year of commercial operations of $495.0 million, and the accumulation of current liabilities as part of the Company's efforts to conserve cash. Investing activities consisted primarily of capital expenditures for infrastructure and terrestrial system completion.
We expect that our future working capital, capital expenditures, and debt service requirements will be satisfied from existing cash, cash equivalents, and short-term investments augmented by the results of our January 2004 financing activities described below and by cash received from revenue-generating activities. Our business plan contemplates the use of cash on hand to fund the completion and launch of XM-3 and the construction of XM-4. We may need to raise additional funding for the launch of XM-4 depending on the amount and timing of the receipt of the insurance proceeds and other factors.
Capital Resources and Financing
We raised $2.6 billion of equity and debt gross proceeds from inception through December 31, 2003 from investors and strategic partners to fund our operations. In 2003, we raised $626 million of gross funds. This includes $225 million of gross funds raised in the January 2003 financing transactions, $185 million of gross funds raised in the June 2003 transaction, including $10 million raised in July 2003 from the exercise of an over-allotment
option, and $150 million of gross funds raised in the September 2003 transactions, as well as $66 million of funds raised through the Direct Stock Purchase Program. The January 2003 financing transactions also included $250 million of payment deferrals and a line of credit. The proceeds received have been used to acquire our DARS license, make required payments for our system, including the satellites, terrestrial repeater system, and ground networks, and for working capital and operating expenses. Provided that we meet the revenue, expense and cash flow projections of our business plan, we expect to be fully funded and will not need to raise additional financing to continue operations or to fund the completion and launch of XM-3 and the construction of XM-4. We may need to raise additional funding for the launch of XM-4 depending on the amount and timing of the receipt of the insurance proceeds and other factors.
January 2004 Financing Transaction
On January 28, 2004, we completed a public offering of 20,000,000 shares of our Class A Common Stock at $26.50 per share, 13,000,000 shares of which were offered for sale by certain selling stockholders. This 7,000,000 share offering resulted in gross proceeds to us of $185.5 million. The proceeds from this offering were used in part to repay the unvested portion of the 10% Senior Secured Convertible Note held by OnStar, a subsidiary of General Motors. We expect to use the proceeds for the prepayment of a portion of our outstanding debt as well as for working capital and general corporate purposes.
September 2003 Financing Transaction
On September 11, 2003, we completed a public offering of 11,320,755 shares of our Class A Common Stock at $13.25 per share to Legg Mason Funds Management, Inc., Legg Mason Capital Management, Inc. and another large institutional investor, each on behalf of its investment advisory clients. This offering resulted in gross proceeds of $150 million. We expect that all or a significant portion of the net proceeds may be used for funding for the construction of XM-4, our new ground spare satellite, if insurance proceeds are not received in a timely manner. We expect to otherwise use the proceeds for working capital and general corporate purposes, which may include the repurchase or pre-payment of outstanding debt.
June 2003 Financing Transaction
On June 17, 2003, we completed an offering of $185 million, including $10 million related to the over-allotment option in July 2003, of Inc.'s 12% Senior Secured Notes due June 15, 2010. Interest on the notes is payable every six months in cash in arrears on December 15 and June 15, commencing on December 15, 2003. The notes, which are Inc.'s senior secured obligations, are secured by substantially all of Inc.'s assets, are guaranteed by the Company and will rank equally in right of payment with all of Inc.'s other existing and future senior indebtedness and senior in right of payment to all of Inc.'s existing and future subordinated indebtedness. Inc. may, at its option, redeem the notes at declining redemption prices at any time on or after June 15, 2007. At any time on or prior to June 15, 2006, Inc. may redeem a portion of the outstanding notes with the proceeds of certain equity offerings as long as the redemption occurs within 90 days of the date of the closing of such equity offering and at least $100 million aggregate principal amount of notes remains outstanding after the redemption We expect to use the proceeds from the June 2003 financing transaction to fund the construction and launch of XM-3, if insurance proceeds are not received in a timely manner. We expect to otherwise use the proceeds for working capital and general corporate purposes, which may include the repurchase or pre-payment of outstanding debt.
January 2003 Financing Transactions
In January 2003, we completed a private placement of $279.3 million aggregate principal amount at maturity of our 10% Senior Secured Discount Convertible Notes due December 31, 2009, which yielded gross proceeds of $210.0 million, and a private placement of 5,555,556 shares of our Class A common stock, which yielded gross proceeds of $15.0 million. Concurrently with these transactions, we completed an exchange offer in which we exchanged $300.2 million aggregate principal amount of Inc.'s previously outstanding 14% Senior Secured Notes due 2010 for $438.0 million aggregate principal amount at maturity ($300.2 million accreted value as of March 15, 2003) of 14% Senior Secured Discount Notes due 2009, cash and warrants to purchase Class A common stock.
In January 2003, General Motors provided us with a $100.0 million Senior Secured Credit Facility, maturing as late as December 2009, that enables us to make monthly draws to finance payments that become due under our distribution agreement with OnStar Corporation and other GM payments. In January 2004, this facility was amended and became a revolver. XM and Inc. are co-borrowers under this credit facility. The outstanding principal amount of all draws will be due December 31, 2009 and bear interest at the applicable 90-day LIBOR rate plus 10% through December 31, 2003, and presently bear interest at a per annum rate of LIBOR plus 8%. We will be able to make interest payments semi-annually in shares of Class A common stock having an aggregate fair market value at the time of payment equal to the amount of interest due. The fair market value will be based on the average daily trading prices of the Class A common stock over the ten business days prior to the day the interest payment is due. We have the option to prepay all draws in whole or in part at any time, and, with effect from the January 2004 amendment, may re-borrow prepaid amounts. Beginning in 2005, we will be required to prepay the amount of any outstanding advances in an amount equal to the lesser of (i) 50% of our excess cash and (ii) the amount necessary to prepay the draws in full. In order to make draws under the credit facility, we are required to have a certain minimum number of subscribers that are not originated by GM and a minimum pre-marketing cash flow.
In January 2003, we issued a 10% Senior Secured Convertible Note due December 31, 2009 in the amount of $89.0 million to General Motors' subsidiary, OnStar Corporation. The note was provided in lieu of our obligation to make $115 million in guaranteed payments to OnStar under the distribution agreement from 2003 to 2006. The note becomes convertible at the holder's option on a quarterly basis through 2006, at 90% of the then fair market value of our Class A common stock but subject to a $5.00 per share minimum and escalation maximum (up to $20 per share) for each fiscal year. Interest is payable semi-annually in cash or shares of our Class A common stock, at our option, at fair market value at the time of payment. In February 2004, we completed the redemption of the note. As part of the redemption, General Motors converted $7.8 million in principal amount of the note, representing the entire principal amount of the note that had vested conversion rights at the time of the redemption, into 980,670 shares of our Class A Common Stock in accordance with the terms of the note. The remaining $81.2 million in principal amount plus accrued interest was repaid with cash
In January 2003, General Motors provided us with the ability to satisfy up to $35.0 million in future subscriber acquisition payments that we may owe to OnStar under the distribution agreement in shares of our Class A common stock, valued at fair market value at the time of each semi-annual payment.
Other Equity Issuances and De-leveraging Transactions
During the year ended December 31, 2003, we issued 10,814,500 shares of Class A
common stock for proceeds of $66 million under our Direct Stock Purchase Program
(DSPP).
Concurrent with the funds raised through the DSPP, we entered into agreements with certain holders of our notes to exchange $125.2 million carrying value, or $160.1 million fully accreted face value at maturity, of their notes, for $6.8 million in cash consideration and 19,232,230 shares of Class A common stock. Also concurrent with the funds raised through the DSPP, we entered into agreements with certain holders of our 8.25% Series B convertible redeemable preferred stock to exchange $19.7 million in shares of Series B preferred stock for $10.2 million in cash consideration. We also entered into agreements with certain holders of our 8.25% Series C convertible redeemable preferred stock to exchange $101.0 million carrying value, in shares of Series C preferred stock, for 11,951,381 shares of Class A common stock. Additionally, we entered into agreements with certain holders of Class A common stock warrants to exchange 55,846 warrants convertible into 4,746,910 shares of Class A common stock for 3,579,818 shares of common stock and received $13.0 million in cash proceeds from the exercise of 47,962 warrants converted into 4,076,770 shares of Class A common stock.
As a result of these de-leveraging transactions, we have eliminated approximately $245.9 million of carrying value including accrued interest of debt and preferred securities or approximately $280.7 million of face amount at maturity. We have eliminated $2.1 million carrying value including accrued interest ($2.0 million face amount at maturity) of our 14% Senior Secured Notes due 2010, $65.5 million carrying value including accrued interest ($94.2 million face amount at maturity) of our 14% Senior Secured Discount Notes due 2009 issued in January 2003, $33.6 million carrying value including accrued interest ($33.4 million of face amount at maturity) of our 7.75% Convertible Subordinated Notes due 2006, $24.0 million carrying value including accrued interest ($30.5 million
face amount at maturity) of our 10% Senior Secured Discount Convertible Notes due 2009, $19.7 million of our Series B preferred stock and $101.0 million carrying value of our Series C preferred stock. In total, these de-leveraging transactions have eliminated approximately $429 million in future interest, dividends, accretion and principal payments as well as 32 million shares of incremental dilution.
As a result of our financings and other issuances of securities, the conversion price of the Series C preferred stock issued in August 2000 has been adjusted from $9.39 at December 31, 2002 to $8.90 at December 31, 2003, the exercise price of the warrants sold in March 2000 has been adjusted to $45.24 and the number of warrant shares has been adjusted to 8.780294. The exercise price of the warrants sold in January 2003 remained at $3.18 and the number of warrant shares remained at 85.00000. There was no impact on the consolidated results of operations as a result of the adjustments to these prices.
We expect that our future working capital, capital expenditures, and debt service requirements will be satisfied from existing cash, cash equivalents, and short-term investments and by cash received from revenue-generating activities. Our business plan contemplates the use of cash on hand to fund the construction and launch of XM-3 and the construction of XM-4. We may need to raise additional funding for the launch of XM-4 depending on the amount and timing of the receipt of the insurance proceeds with respect to XM "Rock" and XM "Roll," and other factors.
Future Operating and Capital Resource Requirements
Our funding requirements are based on our current business plan, which in turn is based on our operating experience to date and our available resources. We are pursuing a business plan designed to increase subscribers and revenues while reducing or maintaining subscriber acquisition costs and avoiding large expenditures to the extent practicable. Our plan contemplates our focusing on the new automobile market where we have relationships with automobile manufacturers, the continuing introduction of lower-priced and more user-friendly radio technology in the retail aftermarket and the use of our most productive distribution channels. We have also maintained a lower level of spending on advertising and kept our workforce streamlined.
Provided that we meet the revenue, expense and cash flow projections of our business plan, we expect to be fully funded and will not need to raise additional financing to continue operations. Our business plan is based on estimates regarding expected future costs and expected revenue. Our costs may exceed or our revenues may fall short of our estimates, our estimates may change, and future developments may affect our estimates. Any of these factors may increase our need for funds, which would require us to seek additional financing to continue implementing our current business plan.
Our business plan contemplates the use of cash on hand to fund the completion and launch of XM-3 and the construction of XM-4. We may need to raise additional funding for the launch of XM-4 depending on the amount and timing of the receipt of the insurance proceeds with respect to XM Rock and XM Roll, and other factors.
In the first quarter of 2003, we filed the proofs of loss for constructive total loss claims on both our satellites with our insurance carriers for the aggregate sum insured (less applicable salvage), relating to a progressive degradation problem with the solar array output power of Boeing 702 class satellites, including XM Rock and XM Roll, identified to our insurers in September 2001. We have launch and in-orbit insurance policies that provide coverage to us for a total, constructive total or partial loss of each of our satellites where such loss arises from an occurrence within the first five years after launch (both satellites were launched during the first half of 2001). The aggregate sum insured in the event of the total or constructive total loss of both satellites is $400 million ($200 million per satellite). During the third quarter of 2003, we received letters from our insurers rejecting our proofs of loss and denying our claims. We anticipate continuing correspondence and meetings with individual and groups of insurers to resolve this matter and will proceed with negotiations, arbitration or litigation as necessary to recover the losses. We continue to believe that we will ultimately receive insurance payments adequate to launch our spare satellite and fund a portion of XM-4, although there can be no assurance as to the amount of any insurance proceeds, or that any insurance proceeds will be received in a timely manner.
In light of the progressive degradation noted above, we plan to launch our ground spare satellite (XM-3) into one orbital slot by year-end 2004, and operate XM Rock and XM Roll collocated in the other orbital slot. In 2007, we plan to launch XM-4 to replace the collocated XM Rock and XM Roll. In this way, we will have replacement satellites
in orbit and operating prior to the times XM Rock and XM Roll can no longer provide full service, or half service in collocated mode. Our commitments regarding XM-3 and XM-4 are described under "Capital Expenditures" below.
Since the solar array power degradation issue is common to the first six Boeing 702 class satellites now in orbit, the manufacturer and we are closely watching the progression of the problem, including data from a satellite that has been in orbit longer than either of our two satellites by approximately 15 and 17 months, respectively. With this advance visibility of performance levels, a firm launch commitment for our spare satellite in the fourth quarter of 2004, the ability to provide full service for an extended period of time with XM Rock and XM Roll collocated in one orbital slot and the spare located in the other slot (which would allow partial use of the existing satellites through the first quarter of 2008), firm commitments to build a fourth satellite and provide launch services therefore, and various mitigation actions to extend the full or partial use of the existing satellites, we believe that we will be able to launch additional satellites prior to the time the solar array power problem might cause the broadcast signal strength to fall below minimum acceptable levels.
Based on the consistency of the degradation trends (with no substantial improvement to date) and continuing analyses by BSS and us, our management adjusted the estimated useful lives of our in-orbit satellites, with effect from September 2002, to the period running through first quarter 2008 (approximately 6.75 years from launch). Our management will continue to monitor this situation carefully and may re-adjust the estimated useful lives of our in-orbit satellites based on future information. We have not recorded any impairment due to our forecasted cash flows (which are sufficient to recover the system assets); however, should we reduce or not meet our forecasted cash flows or reduce further the estimated useful lives of the satellites, we may be required to record an impairment (which may be substantial) at that time. We have not adjusted the estimated useful lives of our spacecraft control facilities, as we believe that these facilities will continue to be of use in our system as XM-3 and if necessary XM-4 are launched.
We plan to seek additional financing for the launch of XM-4 to the extent needed. In addition, we may seek additional financing to undertake initiatives not contemplated by our current business plan or obtain additional cushion against possible shortfalls. We may pursue a range of different sizes or types of financing as opportunities arise, particularly the sale of additional equity securities. We have and may continue to take advantage of opportunities to reduce our level of indebtedness and preferred stock in exchange for issuing common or other equity securities, if these transactions can be completed on favorable terms.
In the event of unfavorable future developments, such as adverse developments in the debt and equity market of the type experienced during much of 2001 and 2002, we may not be able to raise additional funds on favorable terms or at all. Our ability to obtain additional financing depends on several factors, including future market conditions; our success or lack of success in developing, implementing and marketing our satellite radio service; our future creditworthiness; and restrictions contained in agreements with our investors or lenders. Additional financings could increase our level of indebtedness or result in further dilution to our equity holders. If we fail to obtain necessary financing on a timely basis, a number of adverse effects could occur, or we may have to revise our business plan.
Contractual Obligations and Commercial Commitments
We are obligated to make significant payments under a variety of contracts and other commercial arrangements, including the following:
Service Providers. We have entered into an agreement with a service provider for customer care functions to subscribers of our service. Employees of this service provider have access to our customer care systems to establish customer accounts, activate radios, update program and account information and respond to general inquiries from subscribers. We pay an hourly rate for each customer care representative supporting our subscribers. During the years ended December 31, 2003, 2002, and 2001, we incurred $14.2 million, $8.7 million, and $2.0 million, respectively, in relation to services provided for customer care functions. We changed service providers during 2003 and received reduced hourly rates.
Programming Agreements. We have also entered into various long-term programming agreements. Under the terms of these agreements, we are obligated to provide payments to other entities that may include fixed payments, advertising commitments and revenue sharing arrangements. During the years ended December 31, 2003, 2002, and 2001, we incurred expenses of $19.6 million, $20.3 million and $7.2 million, respectively, in relation to
these agreements. The amount of these costs will vary in future years, but is expected to increase next year as the number of subscribers and advertising revenue increase. The amount of the costs related to these agreements cannot be estimated, but are expected to be substantial future costs. Of these amounts, $391,000, $339,000 and $52,000, respectively, are included in Revenue Share & Royalties, and $10.1 million, $9.0 million, and $4.2 million, respectively, are included in Advertising & Marketing.
Royalty Agreements. We have entered into fixed and variable revenue share payment agreements with performance rights organizations that expire as late as 2006. During the years ended December 31, 2003, 2002 and 2001, we incurred expenses of $9.5 million, $9.5 million and $45,000, respectively, in relation to these agreements.
Marketing & Distribution Agreements. We have entered into various joint sales, marketing and distribution agreements. Under the terms of these agreements, we are obligated to provide incentives, subsidies and commissions to other entities that may include fixed payments, per-unit radio and subscriber amounts and revenue sharing arrangements. As previously described, we subsidize the manufacture of certain component parts of XM radios in order to provide attractive pricing to our customers. The subsidies are generally charged to expense when the radios are activated with XM service. The amount of these operational, promotional, subscriber acquisition, joint development, and manufacturing costs related to these agreements cannot be estimated, but are expected to be substantial future costs. During the years ended December 31, 2003, 2002, and 2001, we incurred expenses of $56.3 million, $55.7 million and $19.1 million, respectively, in relation to these agreements, excluding expenses related to GM.
General Motors Distribution Agreement. We have significant payment obligations under our distribution agreement with General Motors. During the term of the agreement, which expires 12 years from the commencement date of our commercial operations, GM has agreed to distribute the service to the exclusion of other S-band satellite digital radio services. We will also have a non-exclusive right to arrange for the installation of XM radios in vehicles equipped with OnStar systems in non-GM vehicles that are sold for use in the United States. The agreement was amended in June 2002 and January 2003 to clarify certain terms in the agreement, including extending the dates when certain initial payments are due to GM and confirming the date of our commencement of commercial operations, and to provide that we may make certain payments to GM in the form of indebtedness or shares of our Class A common stock, as described above under the caption "Liquidity and Capital Resources—Capital Resources and Financing." XM's total cash payment obligations were not increased. We have significant annual, fixed payment obligations to GM. As a result of the June 2002 amendment, we commenced recognizing these fixed payment obligations for the period ending through November 2005, which approximate $63.6 million, on a straight-line basis. However, due to the January 2003 amendment to the Distribution Agreement and GM's current roll out plans which demonstrate a likelihood that GM will exceed minimum installation targets, in 2003 we are now prospectively recognizing these fixed payments, which approximate $397.3 million, on a straight-line basis over the remaining term of the contract. We have issued a 10% Senior Secured Convertible Note due 2009 with an aggregate principal amount of $89.0 million to OnStar in lieu of making these fixed payments to OnStar for amounts otherwise due in 2003 through 2006. In February 2004, we completed the redemption of the note. As part of the redemption, GM converted $7.8 million in principal amount of the note, representing the entire principal amount of the note that had vested conversion rights at the time of the redemption, into 980,670 shares of our Class A common stock in accordance with the terms of the note. The remaining $81.2 million in principal amount plus accrued interest was repaid with cash. Additional payments totaling $320.3 million are due as follows: $80.7 million in 2007, $106.7 million in 2008 and $132.9 million in 2009.
In order to encourage the broad installation of XM radios in GM vehicles, we have agreed to subsidize a portion of the cost of XM radios, and to make incentive payments to GM when the owners of GM vehicles with installed XM radios become subscribers for our service. We must also share with GM a percentage of the subscription revenue attributable to GM vehicles with installed XM radios, which percentage increases until there are more than 8 million GM vehicles with installed XM radios (at which point the percentage remains constant). We will also make available to GM bandwidth on our system. As part of the agreement, OnStar provides certain call-center related services directly to XM subscribers who are also OnStar customers and XM must reimburse OnStar for these XM-related call center services. The agreement is subject to renegotiation at any time based upon the installation of radios that are compatible with a unified standard or capable of receiving Sirius Satellite Radio's service. The agreement is subject to renegotiation if as of November 2005, and at two-year intervals thereafter, GM does not achieve and maintain specified installation levels of GM vehicles capable of receiving our service, starting with 1,240,000 units by November 2005, and thereafter increasing by the lesser of 600,000 units per year and
amounts proportionate to target market shares in the satellite digital radio service market. There can be no assurances as to the outcome of any such renegotiations. General Motors' exclusivity obligations will discontinue if, by November 2005 and at two-year intervals thereafter, we fail to achieve and maintain specified minimum market share levels in the satellite digital radio service market (we are currently in excess of the minimum market share levels). Prior to 2001, we had not incurred any costs under the distribution agreement. As of December 31, 2003, 2002 and 2001, we had paid $29.4 million, $9.9 million and $0.6 million, respectively, and incurred total costs of $108.3 million, $30.1 million and $1.3 million, respectively, under the distribution agreement.
Satellite Contracts. We have entered into contractual agreements for our satellites that are more fully described under the heading "Capital Expenditures."
Non-Cash Stock-Based Expense
We incurred non-cash compensation charges of approximately $3.0 million, $1.5 million and $4.9 million during 2003, 2002 and 2001, respectively. These charges relate to stock options granted to employees, consultants, talent and vendors and warrants granted to vendors. Additional compensation charges may result depending upon the market value of our Class A common stock at each balance sheet date.
Related Party Transactions
We developed strategic relationships with certain companies that were instrumental in the construction and development of our system. In connection with our granting to them of large supply contracts, some of these strategic companies have become large investors in us and have been granted rights to designate directors or observers to our board of directors. The negotiation of these supply contracts and investments primarily occurred at or prior to the time these companies became related parties.
We are a party to a long-term distribution agreement with OnStar Corporation, a subsidiary of General Motors that provides for the installation of XM radios in General Motors vehicles, as further described above under the heading "Liquidity and Capital Resources—Contractual Obligations and Commercial Commitments." In connection with the development of our terrestrial repeater network, we are a party to a contract with Hughes Electronics Corporation and were under a contract with LCC International ("LCCI"), as further described under the heading "Liquidity and Capital Resources—Capital Expenditures." DIRECTV has provided consulting services in connection with the development of our customer care center and billing operations. We have agreements with OnStar and American Honda to make available use of our bandwidth. Clear Channel Communications provides certain programming services to us. We have a sponsorship agreement with Clear Channel Entertainment to advertise our service at Clear Channel Entertainment concerts and venues. Premiere Radio Networks, a subsidiary of Clear Channel Communications, has in the past served as one of our advertising sales representatives. We also run advertisements on a spot and network basis on radio stations owned by Clear Channel. In addition, we lease 4 sites for our terrestrial repeaters from Clear Channel Communications.
As of December 31, 2003, we are engaged in activities with GM and Honda to jointly promote new car buyers to subscribe to the XM service. At December 31, 2003, there were approximately 320,473 subscribers in promotional periods (ranging from three-months to one year to three years in duration) paid for by the vehicle manufacturers. These subscriptions are included in our year-end subscriber total. Subscriber revenues received from GM and Honda for these programs are recorded as related party revenue.
General Motors is one of our largest shareholders and Chester A. Huber, Jr., the president of OnStar, is a member of our board of directors. Hughes Electronics was one of our largest shareholders until January 2004 and was a subsidiary of General Motors until December 2003. Jack Shaw, a member of our board of directors, was Chief Executive Officer of Hughes Electronics Corporation until December 2003. DIRECTV, a subsidiary of Hughes Electronics, was a holder of our Series C preferred stock until January 2003. Randall Mays, a member of our board of directors, is Executive Vice President and Chief Financial Officer of Clear Channel Communications. Thomas G. Elliott, a member of our board of directors, is Executive Vice President, Automobile Operations of American Honda Motor Company.
We earned the following revenue from transactions with related parties described above (in thousands):
Years ended December 31,
-------------------------------
2003 2002 2001
----------- ------ -----
GM $ 11,630 $ 256 $ —
Honda 368 — —
-- -------- -- --- - ---
$ 11,998 $ 256 $ —
-- -------- -- --- - ---
We have incurred the following costs in transactions with the related parties described above (in thousands):
Year ended December 31, 2003
---------------------------------------------------------------------------------
Clear
GM Hughes DIRECTV Channel LCCI Motient
--------- -------- --------- -------- -------- ---------
Terrestrial repeater network $ — $ 278 $ — $ — $ — $ —
Terrestrial repeater site leases — — — 60 — —
Customer care & billing operations 960 — — — — —
Marketing 107,346 — — 8,646 — —
General & administrative — — — — — —
Year ended December 31, 2002
---------------------------------------------------------------------------------
Clear
GM Hughes DIRECTV Channel LCCI Motient
--------- -------- --------- -------- -------- ---------
Terrestrial repeater network $ — $ 10,386 $ — $ — $ 3,089 $ —
Terrestrial repeater site leases — — — 57 — —
Customer care & and billing operations 178 — — — — —
Marketing 29,915 — 125 10,182 — —
General & administrative — — 3 — — —
Year ended December 31, 2001
---------------------------------------------------------------------------------
Clear
GM Hughes DIRECTV Channel LCCI Motient
--------- -------- --------- -------- -------- ---------
Terrestrial repeater network $ — $ 88,116 $ — $ — $ 59,958 $ —
Terrestrial repeater site leases — — — 36 — —
Customer care & billing operations — — 623 — — —
Marketing 1,264 — — 4,351 — —
General & administrative — — — — — 193
Capital Expenditures
As of December 31, 2003, we had paid approximately $474.8 million, including financing charges and interest under the satellite contract related to XM Rock, or XM-2, XM Roll, or XM-1, XM-3 and XM-4. We originally entered into our satellite contract in March 1998 with Boeing Satellite Systems International, Inc., or BSS, and have subsequently amended the contract, including in July 2003 and December 2003.
Satellite Contract—XM Rock and XM Roll. Under our satellite contract, BSS has delivered two satellites in-orbit, XM Rock and XM Roll, supplied ground equipment and software used in the XM Radio system and provided certain launch and operations support services.
Satellite Contract—Replacement Satellites Deployment Plan. In light of the progressive degradation affecting Rock and Roll noted above, we plan to launch our ground spare satellite, XM-3, into one orbital slot by year-end 2004, and then temporarily operate XM Rock and XM Roll collocated in the other orbital slot. In 2007, we plan to launch XM-4 to replace the collocated XM Rock and XM Roll. In this way, we will have replacement satellites in orbit and operating prior to the times XM Rock and XM Roll can no longer provide full service, or half service in the collocated mode.
Satellite Contract and Other Costs—XM-3. Construction of our ground spare satellite, XM-3, is currently being completed, including certain modifications to correct the solar array degradation issues experienced by Rock and Roll, as well as other changes agreed with BSS discussed below. As of December 31, 2003, with respect to XM-3, we have deferred $15 million at an interest rate of 8% through December 5, 2006 and borrowed $35 million from Boeing Capital in a separate transaction to be repaid prior to launch of XM-3.
In addition to the modifications to address the solar array degradation issues as noted above, BSS is making certain alterations to optimize XM-3 for the specific orbital slot into which it will be launched during a three-month launch period commencing October 15, 2004. The aggregate remaining cost, excluding the above $15 million deferral and $35 million loan, of the launch, optimization for the specific orbital slot, appropriate software and certain pre and post-launch services is approximately $100 million to be paid during the first quarter 2004. Further, BSS has the right to earn performance incentive payments of up to $25.9 million, excluding interest, based on the in-orbit performance of XM-3 over its design life of fifteen years.
Satellite Insurance—XM-3. In addition to the XM-3 related costs noted above, we plan to acquire and pay for launch and in-orbit insurance in connection with the launch of XM-3. The cost of launch and in-orbit insurance for this launch is subject to market prices and conditions at the time during 2004 when such insurance is obtained.
Satellite Contract and Other Costs—XM-4. We have committed in our satellite contract, as amended in July 2003, and by a separate August 2003 contract with Sea Launch Company, LLC, or Sea Launch, to acquire from BSS a fourth satellite, XM-4, which should be available for shipment to the launch services provider no later than October 31, 2005, and from Sea Launch the associated launch services for the satellite. The fixed prices for XM-4 and the associated launch services total $186.5 million, excluding in-orbit performance incentives and financing charges on certain amounts deferred prior to launch. Following our payment of $3 million in total for XM-4 and the associated launch services during the third quarter 2003, satellite construction payments aggregating approximately $104 million are deferred until as late as the first quarter 2006. Interest accrues monthly at a rate of 10.75% per annum through December 2004 and is payable thereafter on a current basis, pursuant to the December 2003 amendment, which extends the deferral from the first quarter 2005 and reduces the applicable interest rate from 12.75% to 10.75%. Of this deferred amount, $22.3 million is in the Other Non-Current Liabilities line on our balance sheet as of December 31, 2003. Most of the remaining portion of the fixed costs for XM-4 and the associated launch services are payable during construction with the last payment due one month following launch.
After launch of XM-4, BSS has the right to earn performance incentive payments of up to $12 million, plus interest, over the first twelve years of in-orbit life, up to $7.5 million for performance above specification during the first fifteen years of in-orbit life, and up to $10 million for continued high performance across the five year period beyond the fifteen year design life. If XM-3 is launched successfully and operates satisfactorily, we may elect, under
the above contracts, to defer launch of XM-4 and, as a result, approximately $50 million in payments related to launch services could be postponed until the 2007 timeframe.
Options to Procure Fifth Satellite and Associated Launch Services. We have also obtained fixed price options to acquire a fifth satellite from BSS, under the July 2003 amendment, on pricing and performance incentive terms similar to those applicable to XM-4 and associated launch services from Sea Launch under the August 2003 contract.
Satellite Contract—Warrant to BSS. Pursuant to our satellite contract, we issued a warrant to BSS in July 2003 to purchase 500,000 shares of our Class A common stock at $13.524 per share. The fair value of these warrants was determined to be $5.8 million using a Black-Scholes based methodology and is included in the System Under Construction balance as of December 31, 2003.
Terrestrial Repeater System. As of December 31, 2003, we incurred aggregate costs of approximately $267.7 million for a terrestrial repeater system. These costs covered the capital cost of the design, development and installation of a system of terrestrial repeaters to cover approximately 60 cities and metropolitan areas. In August 1999, we signed a contract with LCCI for engineering and site preparation. As of December 31, 2003, we had paid $128.4 million under this contract. There are no further payments due under the LCCI contract. We also entered into a contract effective October 22, 1999, with Hughes Electronics Corporation for the design, development and manufacture of the terrestrial repeaters; there are no further payments due under this contract except those related to ongoing out-of-warranty repairs. As of December 31, 2003, we had paid $114.1 million under this contract and recorded an additional liability of $59,000.
Ground Segment. As of December 31, 2003, we incurred aggregate ground segment costs of approximately $138.6 million. These costs were related to the satellite control facilities, programming production studios and various other equipment and facilities.
Joint Development Agreement Funding Requirements. The costs related to our agreement with Sirius Radio for joint development of a unified standard for satellite radios are being expensed as incurred in research & development. During 2003, we incurred $0.6 million compared to no expense during 2002. We expect this expense to increase steadily this year; each party is obligated to fund one half of the development cost for a unified standard for satellite radios.
Long-term debt
We have raised funds from the following issuances of long-term debt.
• In March 2001, we issued $125.0 million aggregate principal
amount of 7.75% Convertible Subordinated Notes due 2006. In July
and August 2001, holders of these 7.75% Convertible Subordinated
Notes exchanged $45.9 million of notes for 4,194,272 shares of
our Class A common stock. In 2003, an additional $33.4 million of
these notes were exchanged for 2,711,649 shares of Class A common
stock. As a result of these transactions, approximately $45.7
million of the notes remained at December 31, 2003. Principal on
the convertible subordinated notes is payable at maturity, while
interest is payable semi-annually. In March 2004, the holders of
the $45.7 million 7.75% Convertible Subordinated Notes due 2006
called for redemption following our January offering elected to
convert into 3.7 million shares of our Class A common stock in
accordance with the terms of the notes. This represented the
retirement of all our remaining outstanding 7.75% Subordinated
Convertible Notes.
• In August 2001, we borrowed $29.0 million to finance the
purchase of our headquarters facility. This loan is for a term
of five years and bears interest at a rate based on the
six-month London Interbank Offer Rate plus an indicated spread.
We make monthly payments of principal and interest on this loan.
• In December 2001, we borrowed $35.0 million from a subsidiary of The Boeing Company. This loan is for a term of five years
and bears interest at a rate based on the six-month London
Interbank Offer Rate plus an indicated spread. Principal is
payable at maturity, while interest is payable quarterly.
This loan must be repaid when we launch XM-3, presently
expected to occur in late 2004.
• On January 28, 2003, we completed a three-part financing.
• We issued $279.3 million aggregate principal amount at maturity
of 10% Senior Secured Discount Convertible Notes in a private
placement. Principal on the 10% Senior Secured Discount
Convertible Notes is payable at maturity, while interest accretes
until January 1, 2006 and is thereafter payable semi-annually in
cash or, at our option, in additional notes. If all of the
interest is paid in additional notes, these notes would aggregate
$412.6 million when they come due in 2009.
• We issued to OnStar, a subsidiary of General Motors, $89.0
million in aggregate principal amount of a 10% Senior Secured
Convertible Note due December 31, 2009 in lieu of our obligation
to make $115 million in guaranteed payments from 2003 to 2006
under the General Motors distribution agreement. Principal on the
OnStar note is payable at maturity, while interest, which is due
semi-annually, is payable at our option in shares of our Class A
common stock. In February 2004, we completed the redemption of
the note. As part of the redemption, General Motors converted
$7.8 million in principal amount of the note, representing the
entire principal amount of the note that had vested conversion
rights at the time of the redemption, into 980,670 shares of our
Class A Common Stock in accordance with the terms of the note.
The remaining $81.2 million in principal amount plus accrued
interest was repaid with cash.
• We completed an exchange of $300.2 million aggregate principal
amount of the 14% Senior Secured Notes due 2010 for $438.0
million aggregate principal amount at maturity ($300.2 million
accreted value as of March 15, 2003) of 14% Senior Secured
Discount Notes due 2009, cash and warrants to purchase Class A
common stock. Principal on the 14% Senior Secured Discount Notes
due 2009 is payable at maturity, while interest accretes until
December 31, 2005 and is thereafter payable semi-annually.
Through December 31, 2003, we have extinguished $65.5 million
carrying value, or $94.2 million face amount at maturity, of
these notes.
• In June 2003, Inc. issued $185.0 million aggregate principal
amount of 12% Senior Secured Notes due 2010, $10 million of which
were issued in July 2003, pursuant to the overallotment option.
Principal on the 12% Senior Secured Notes due 2010 is payable at
maturity, while interest is payable semi-annually.
Based on the various terms of our long-term debt, our ability to redeem any long-term debt is limited. We have and may continue to take advantage of opportunities to reduce our level of indebtedness in exchange for issuing equity securities, if these transactions can be completed on favorable terms.
Lease obligations. We have noncancelable operating leases for office space and terrestrial repeater sites and noncancelable capital leases for equipment that expire over the next ten years. As discussed below, in December 2001, we determined that the planned number of terrestrial repeater sites could be reduced due to the relative signal strength provided by our satellites. We recognized a charge of $26.3 million with respect to terrestrial repeater sites no longer required. This charge includes a lease termination liability of $8.6 million for 646 terrestrial repeater site leases, which would reduce the future minimum lease payments. This liability was increased by $4.0 million during 2002 and by $4.8 million during 2003. As of December 31, 2003, we maintained a liability of $4.1 million for the estimated lease termination costs and costs to deconstruct the sites.
The following table represents our contractual obligations as of December 31, 2003, adjusted for the conversion of our 7.75% Convertible Subordinated Notes into Class A common stock in March of 2004 and the repayment of our $89 million 10% Senior Secured Convertible Note due 2009 held by OnStar Corporation, a subsidiary of General Motors, in February of 2004:
Payments Due by Period
------------------------------------------------------------------------------------------
2009 and
Contractual Obligations 2004 2005 2006 2007 2008 Beyond Total
---------------------------- --------- -------- --------- --------- --------- ----------- -----------
(In thousands)
GM Distribution Agreement(1) $ — $ — $ — $ 80,753 $ 106,688 $ 132,889 $ 320,330
GM Revolver(1) — — — — 100,000 100,000
GM Note(1) 89,042 — — — — — 89,042
Boeing Note 35,000 — — — — — 35,000
Other long-term debt(1) 1,309 2,352 27,136 — — 786,913 817,710
Capital Lease Obligations 2,377 1,226 252 — — — 3,855
Other Operating
Agreements(2) 21,576 30,262 35,241 10,765 5,300 436 103,580
Operating Lease Obligations 18,192 15,375 5,680 3,379 1,416 2,911 46,953
XM-3(3) 100,000 — — — — — 100,000
XM-4(3) 3,000 26,700 105,300 48,500 — — 183,500
- ------- - ------ - ------- - ------- - ------- - --------- - ---------
Total $ 270,496 $ 75,915 $ 173,609 $ 143,397 $ 113,404 $ 1,023,149 $ 1,799,970
- ------- - ------ - ------- - ------- - ------- - --------- - ---------
(1) The above amounts do not include interest, which in
some cases is variable in amount.
(2) Other operating agreements include programming, marketing and royalty agreements. The above amounts include agreements
amended or entered into in January 2004.
(3) Exclude financing charges, in-orbit incentives, and launch
insurance, and assumes launch of XM-4 in 2007.
The long-term debt payments due in 2006 include the maturity of our $27.1 million loan to finance the purchase of our headquarters facility. The long-term debt payments due in 2009 and beyond include the maturity of XM's remaining outstanding $22.8 million of 14% Senior Secured Notes, which come due in 2010, the maturity of XM's $343.5 million aggregate principal amount at maturity of 14% Senior Secured Discount Notes, which come due in 2009, the maturity of our $235.6 million aggregate principal amount at maturity of 10% Senior Secured Discount Convertible Notes, which come due in 2009, and the maturity of our $185.0 million aggregate principal amount at maturity of 12% Senior Secured Notes due 2010. In January 2004, the credit facility arrangement with GM was renegotiated to become a revolver providing for borrowings up to a maximum of $100 million through the maturity of the instrument in December 2009. In March 2004, the holders of the $45.7 million 7.75% Convertible Subordinated Notes due 2006 called for redemption following our January offering elected to convert into 3.7 million shares of our Class A common stock in accordance with the terms of the notes. This represented the retirement of all our remaining outstanding 7.75% Subordinated Convertible Notes. Also, in February 2004, we repaid the $89 million 10% Senior Secured Convertible Note through the issuance of cash and shares of Class A common stock. XM's 12% Senior Secured Notes due 2010 provide for a partial redemption up to a maximum of $85 million within 90 days of an equity issuance. XM completed an equity issuance on January 22, 2004, and thus has 90 days to redeem a portion of these notes.
Critical Accounting and Subscriber Policies
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting policies that we believe are most critical to understanding and evaluating our reported financial results include those pertaining to the following policies. Senior management has discussed with the audit committee of the board of directors the development and selection of estimates and assumptions required for the following accounting policies:
• Revenue Recognition—Revenue from subscribers consists of our monthly subscription fee, which is recognized as the service is provided, and
a non-refundable activation fee, which is recognized on a pro-rata
basis over an estimated term of the subscriber relationship
(currently 40 months), which was based upon market studies and
management's judgment. We expect to refine this estimate as more data
becomes available. Promotions and discounts are treated as an offset
to revenue during the period of promotion. Sales incentives,
consisting of discounts and rebates to subscribers, offset earned
revenue. Discounts to equipment which is sold with service are
allocated to equipment and service based on relative fair value. If
the actual term of our subscriber relationships is significantly
greater than our current estimate of 40 months, the period over which
we recognize the non-refundable activation fee will be extended to
reflect the actual term of our subscriber relationships.
• Estimates of payments due to manufacturers and distributors—Payments
owed to manufacturing and distribution partners are expensed during
the month in which the manufacture, sale, and/or activation of the
radio unit occurs. The amounts of these expenses are dependent upon
units provided by our internal systems and processes, (such as
subscriber management system and supply chain management system) and
partner systems and processes. However, due to lags in receiving
manufacturing and sales data from partners, estimates of amounts due
are necessary in order to record monthly expenses. In subsequent
months when lagged data is received from partners, expenses are
reconciled, and adjusted where necessary. Since launching commercial
operations, we continue to refine the estimation process based on an
increased understanding of the timing lags, and close working
relationships with our partners. Generally, estimates recorded on our
books are adjusted to actuals within two months.
• Useful Life of Satellites and Spacecraft Control Facilities—Following receipt of our satellites, we extended their expected lives from 15
years, the initial design life, to 17.5 years based upon updated
technical estimates we received from our satellite provider following
our satellite launches. However, based on the consistency of the
degradation trends (with no substantial improvement to date) and
continuing analyses by Boeing Satellite Systems and us, as described
above under the heading "Liquidity and Capital Resources—Future
Operating and Capital Resource Requirements," we adjusted the
estimated useful life of our in-orbit satellites with effect from
September 2002, to the period running through first quarter of 2008
(approximately 6.75 years from launch). We continue to monitor the
situation and may need to re-adjust the estimated useful lives of our
in-orbit satellites based on future information. We are not recording
an impairment at this time, due to our forecasted cash flows (which
are sufficient to recover the system assets); however, should we
reduce or not meet our forecasted cash flows or reduce further the
estimated useful lives of the satellites, we may be required to
record an impairment (which may be substantial) at that time. An
impairment, if recorded, would be calculated as the amount by which
the carrying value of the assets exceeds the undiscounted future cash
flows. At December 31, 2003, the combined carrying value of XM-1 and
XM-2 is $369 million. The receipt of insurance proceeds would reduce
the carrying values of XM-1 and XM-2 and would mitigate the risk of a
future impairment. Based on the forecasted cash flows in our current
business plan and without receipt of insurance proceeds, a reduction
of 5 months in the estimated useful lives of XM-1 and XM-2 could
result in an impairment charge in the period in which the estimated
useful lives are reduced. We have not adjusted the estimated useful
lives of our spacecraft control facilities, as we believe that these
facilities will continue to be used in our XM system. A significant
decrease in the estimated useful life of our satellites and
spacecraft control facilities could have a material adverse impact on
our operating results in the period in which the estimate is revised
and in subsequent periods.
• Accrued Network Optimization Expenses—As a result of the planned
reduction of the number of terrestrial repeater sites, we
recognized charges of $4.8 million, $4.0 million and $26.3
million in 2003, 2002, and 2001, respectively. The charge of
$26.3 million in 2001 included $17.7 million of site-specific
capitalized costs that were written off and a lease termination
accrual of $8.6 million for 646 terrestrial repeater site leases.
The charges of $4.8 million and $4.0 million in 2003 and 2002,
respectively, represent additional costs associated with
terminating leases on terrestrial repeater sites no longer
required. At December 31, 2003, we had recorded a lease
termination accrual of $4.1 million that represents an estimate
of the costs to terminate the remaining 78 leases based on
management's judgment, advice of lease consultants, and early
negotiations with landlords. The liability also includes the
estimated costs to deconstruct the existing sites, which are
based upon quotes from contractors. This amount could vary
significantly from the actual amount incurred, which will be
primarily based on our ability to negotiate lease termination
settlements.
• Programming Agreements—We have entered into various programming agreements. Under the terms of these agreements, we are obligated
to provide payments and commissions to other entities that may
include fixed
payments, advertising commitments and revenue sharing arrangements. Fixed amounts due under programming agreements are recognized on a straight-line
basis though the termination and/or renegotiation date defined in the
agreements. Revenue share agreements that contain minimum guarantees are
recorded as an expense based upon the greater of the revenue share amount
or a pro-rata portion of the guarantee over the guarantee period.
• Distribution Agreement with General Motors—We have significant
payment obligations under our distribution agreement with General
Motors, which was amended on January 28, 2003 to provide that we
could make certain payments by issuance of indebtedness or shares
of Class A common stock. This agreement is subject to
renegotiation if General Motors does not achieve and maintain
specified installation levels, starting with 1,240,000 by
November 2005 and thereafter increasing by the lesser of 600,000
units per year and amounts proportionate to our share of the
satellite digital radio market. In light of GM's initial roll-out
plans, the June 2002 amendment of the distribution agreement and
management's assessment of the likelihood of renegotiating during
the period ending 2005, we recognized the fixed payment
obligations due to GM for the period through November 2005, which
approximate $63.6 million, on a straight-line basis. In light of
the January 2003 amendment of the distribution agreement and GM's
current roll out plans which demonstrate a likelihood of GM
exceeding minimum installation targets, in 2003 we are
prospectively recognizing fixed payment obligations to GM, which
approximate $397.3 million, on a straight-line basis through the
remaining term of the agreement in September 2013. Additional
fixed payment obligations beyond 2006 range from $80.7 million to
approximately $132.9 million through 2009, aggregating
approximately $320.3 million.
• DARS License. We determined that our DARS license was an
intangible asset having an indefinite useful life. While the DARS
license has a renewable eight-year term, we believe that the
administrative fees necessary to renew the license are expected
to be de minimis compared to the initial fee to obtain the
license, and we have met all of the established milestones
specified in the DARS license agreement. We also anticipate no
difficulties in renewing the license as long as we continue to
adhere to the various regulatory requirements established in the
license grant. Although we face competition from a variety of
sources, we do not believe that the risk of the technology
becoming obsolete or that a decrease in demand for the DARS
service is significant. Further, we believe that our license is
comparable with the licenses granted to other broadcasters, which
are also classified as indefinite lived intangible assets. We
understand that there continues to be deliberations concerning
the application of this standard regarding the effect of the
costs to renew FCC licenses. Our application of this standard
could change depending upon the results of these deliberations.
• Subscriber Count. We consider subscribers to be those who are
receiving and have agreed to pay for our service, either by
credit card or by invoice, including those that are currently in
promotional periods, as well as XM activated radios in vehicles
for which we have a contractual right to receive payment for the
use of our service. Radios that are revenue generating are
counted individually as subscribers. Approximately 24% of our
subscribers at year end were in promotional periods with
sponsored accounts. A change in our methodology of counting
subscribers that excluded subscribers in promotional periods with
sponsored accounts would delay the timing of the recognition of
the subscriber until the end of the promotional period, which is
generally 3 months. Subscribers with delinquent account balances
are included in the subscriber count until such time as the radio
is deactivated for non-payment in accordance with our normal
procedures.
Recent Accounting Pronouncements
We adopted Statement of Financial Accounting Standards ("SFAS") No. 143, Accounting for Asset Retirement Obligations, effective January 1, 2003, and SFAS No. 143 does not have a material impact on the financial statements. Our asset retirement obligations are limited to deconstruction of its terrestrial repeater sites. SFAS No. 143 requires entities to record the fair value of a legal liability for an asset retirement obligation in the period in which it is incurred. When a new liability is recorded, we will capitalize the costs of the liability by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity settles the obligation for its recorded amount or incurs a gain or loss upon settlement.
In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback
accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. We recorded losses of $24.7 million during the year ended December 31, 2003, respectively from the early retirement of debt with a carrying value including accrued interest of $125.2 million. The loss is reported in other income (expense) in the consolidated statement of operations for the year ended December 31, 2003.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when incurred at fair value. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 may have an effect on the timing of future restructuring charges taken, if and when they occur.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123. This Statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. The disclosures required by SFAS No. 148 are included in note 1 (k) to the consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. On December 24, 2003, the FASB issued final modified FASB Interpretation No. 46 ("FIN 46R"), primarily to clarify the required accounting for interests in VIEs. Application of FIN 46R is required in financial statements of public entities that have interests in entities that are commonly referred to as special-purpose entities, or SPEs, for periods ending after December 15, 2003. Application by public entities for all other types of VIEs (i.e., non-SPEs) is required in financial statements for periods ending after March 15, 2004. The adoption of FIN 46R is not expected to have a material impact on the financial position or the financials results of the Company.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 addresses the classification and measurement of mandatorially redeemable freestanding financial instruments, including those that comprise more than one option or forward contract, and requires an issuer to classify certain instruments as liabilities. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period after June 15, 2003. The adoption of SFAS No. 150 has not had a material effect on the classification and measurement of our financing transactions but may have an effect on the classification and measurement of future mandatorially redeemable financing transactions, if and when they occur.
The Emerging Issues Task Force issued EITF No. 00-21, Revenue Arrangements with Multiple Deliverables addressing the allocation of revenue among products and services in bundled sales arrangements. EITF 00-21 is effective for arrangements entered into in fiscal periods after June 15, 2003. Based on the sales and marketing programs in place during 2003, the application of the new pronouncement has not had a material impact on our financial statements. However, our sales and marketing programs may change over time and we will continue to evaluate the applicability of EITF 00-21 as it relates to sales of service and hardware. This new pronouncement has no impact on the economics of our sales and marketing programs, but it does impact the timing and classification of revenue reported within the financial statements and has a corresponding impact on the Average Revenue per Subscriber ("ARPU"). As a result of this new pronouncement, the Company recognized a lower subscriber ARPU for the period.
In July 2003, the Emerging Issues Task Force provided additional guidance on Topic D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock. The additional guidance states that the carrying amount of preferred stock should be reduced by the issuance costs of the preferred stock in the calculation of earnings per share. This guidance is effective in fiscal periods ending after September 15, 2003 and is retroactively reflected in the financial statements of prior quarters. This guidance resulted in a reduction of the gains recorded on the retirement of our Series B preferred stock during 2003 of $727,000 to reflect the amount
of the issuance costs of the preferred stock retired. The net loss available to common stockholders for 2003 reflects these adjustments. This guidance did not impact our net loss or financial position.
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