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SIRIUS XM HOLDINGS INC. 10-Q 2008
Form 10-Q Period Ended 9/30/2008
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

Commission file number 0-24710

 

 

SIRIUS XM RADIO INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   52-1700207

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1221 Avenue of the Americas, 36th Floor

New York, New York 10020

(Address of principal executive offices)

(Zip code)

212-584-5100

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  x

  Accelerated Filer  ¨   Non-Accelerated Filer  ¨   Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

(Class)

 

(Outstanding as of November 10, 2008)

Common Stock, $0.001 par value   3,513,400,974

 

 

 


Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q

 

          Page

PART I—FINANCIAL INFORMATION

  

Item 1.

  

Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007

   1
  

Condensed Consolidated Balance Sheets as of September 30, 2008 (Unaudited) and December 31, 2007

   3
  

Unaudited Condensed Consolidated Statements of Stockholders’ Equity (Deficit) for the nine months ended September 30, 2008

   5
  

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007

   7
  

Notes to Unaudited Condensed Consolidated Financial Statements

   9

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   37

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

   64

Item 4.

  

Controls and Procedures

   64

PART II—OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

   65

Item 1A.

  

Risk Factors

   66

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   75

Item 3.

  

Defaults upon Senior Securities

   75

Item 4.

  

Submission of Matters to a Vote of Security Holders

   75

Item 5.

  

Other Information

   75

Item 6.

  

Exhibits

   75
  

SIGNATURES

   76


Table of Contents

PART I: FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
(in thousands, except per share data)    2008     2007     2008     2007  

Revenue:

        

Subscriber revenue, including effects of rebates

   $   456,357     $     226,844     $ 978,516     $ 627,275  

Advertising revenue, net of agency fees

     14,674       8,524       31,413       24,422  

Equipment revenue

     11,271       6,290       25,290       17,216  

Other revenue

     6,141       128       6,590       3,337  
                                

Total revenue

     488,443       241,786       1,041,809       672,250  

Operating expenses (depreciation and amortization shown separately below)(1)

        

Cost of services:

        

Satellite and transmission

     19,526       7,409       34,800       22,732  

Programming and content

     106,037       59,015       222,975       173,324  

Revenue share and royalties

     85,592       32,978       177,635       89,953  

Customer service and billing

     47,432       21,058       97,218       64,529  

Cost of equipment

     13,773       6,086       28,007       19,930  

Sales and marketing

     63,637       38,488       151,237       126,348  

Subscriber acquisition costs

     86,616       101,798       257,832       307,580  

General and administrative

     57,310       44,837       148,555       118,651  

Engineering, design and development

     10,434       9,736       28,091       33,397  

Impairment of goodwill

     4,750,859       —         4,750,859       —    

Depreciation and amortization

     66,774       26,072       120,793       79,142  

Restructuring and related costs

     7,430       —         7,457       —    
                                

Total operating expenses

     5,315,420       347,477         6,025,459         1,035,586  
                                

Loss from operations

     (4,826,977 )     (105,691 )     (4,983,650 )     (363,336 )

 

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Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS—(Continued)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
(in thousands, except per share data)    2008     2007     2008     2007  

Other income (expense)

        

Interest and investment income

     4,940       5,604       9,167       16,399  

Interest expense, net of amounts capitalized

     (49,216 )     (19,499 )     (83,636 )     (50,441 )

Equity in net loss of equity method investment

     (3,089 )     —         (3,089 )     —    

Other (expense) income

     (3,870 )     4       (3,935 )     14  
                                

Total other expense

     (51,235 )     (13,891 )     (81,493 )     (34,028 )
                                

Loss before income taxes

     (4,878,212 )     (119,582 )     (5,065,143 )     (397,364 )

Income tax expense

     (1,215 )     (555 )     (2,301 )     (1,665 )
                                

Net loss

   $ (4,879,427 )   $ (120,137 )   $ (5,067,444 )   $ (399,029 )
                                

Net loss per common share (basic and diluted)

   $ (1.93 )   $ (0.08 )   $ (2.76 )   $ (0.27 )
                                

Weighted average common shares outstanding (basic and diluted)

       2,527,692         1,464,147         1,836,834         1,461,200  
                                

 

(1)    Amounts related to share-based payment expense included in operating expenses were as follows:

 

      

Satellite and transmission

   $ 1,331     $ 557     $ 2,887     $ 1,834  

Programming and content

     3,529       2,707       7,477       6,857  

Customer service and billing

     596       166       1,137       543  

Sales and marketing

     3,672       6,575       11,376       15,068  

Subscriber acquisition costs

     —         800       14       2,687  

General and administrative

     12,904       10,953       36,359       34,056  

Engineering, design and development

     1,973       969       4,167       2,959  
                                

Total share-based payment expense

   $     24,005     $ 22,727     $ 63,417     $ 64,004  
                                

See accompanying Notes to the unaudited condensed consolidated financial statements.

 

2


Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(in thousands, except share and per share data)    September 30,
2008
   December 31,
2007
     (Unaudited)     
ASSETS      

Current assets:

     

Cash and cash equivalents

   $ 359,657    $ 438,820

Accounts receivable, net of allowance for doubtful accounts of $10,431 and $4,608, respectively

     76,284      44,068

Receivables from distributors

     51,610      60,004

Inventory, net

     31,935      29,537

Prepaid expenses

     84,448      31,392

Related party current assets

     109,734      —  

Restricted investments

     —        35,000

Other current assets

     25,096      40,036
             

Total current assets

     738,764      678,857

Property and equipment, net

     1,700,279      806,263

FCC licenses

     2,083,654      83,654

Restricted investments, net of current portion

     141,250      18,000

Deferred financing fees, net

     45,969      13,864

Intangible assets, net

     694,212      —  

Goodwill

       1,875,645      —  

Related party long-term assets, net of current portion

     129,351      —  

Other long-term assets

     93,950      93,511
             

Total assets

   $   7,503,074    $   1,694,149
             
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)      

Current liabilities:

     

Accounts payable and accrued expenses

   $ 823,022    $ 464,943

Accrued interest

     51,084      24,772

Deferred revenue

     881,710      548,330

Current maturities of long-term debt

     572,646      35,801

Related party current liabilities

     75,618      —  
             

Total current liabilities

     2,404,080      1,073,846

Long-term debt, net of current portion

     2,800,107      1,278,617

Deferred revenue, net of current portion

     287,067      110,525

Deferred credit on executory contracts

     1,091,599      —  

Other long-term liabilities

     904,472      23,898
             

Total liabilities

     7,487,325      2,486,886
             

 

3


Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS—(Continued)

 

(in thousands, except share and per share data)    September 30,
2008
    December 31,
2007
 
     (Unaudited)        

Commitments and contingencies (Note 14)

     —         —    

Stockholders’ equity (deficit):

    

Series A convertible preferred stock, par value $0.001 (liquidation preference of $51,370 and $0 at September 30, 2008 and December 31, 2007, respectively); 50,000,000 authorized at September 30, 2008 and December 31, 2007, 24,808,959 and zero shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively

     25       —    

Common stock, par value $0.001; 4,500,000,000 and 2,500,000,000 shares authorized at September 30, 2008 and December 31, 2007, respectively; 3,250,404,357 and 1,471,143,570 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively

     3,250       1,471  

Accumulated other comprehensive loss, net of tax

     (764 )     —    

Additional paid-in capital

     9,479,654       3,604,764  

Accumulated deficit

     (9,466,416 )     (4,398,972 )
                

Total stockholders’ equity (deficit)

     15,749       (792,737 )
                

Total liabilities and stockholders’ equity (deficit)

   $   7,503,074     $     1,694,149  
                

See accompanying Notes to the unaudited condensed consolidated financial statements.

 

4


Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

 

    Series A
Convertible
Preferred Stock
  Common Stock   Additional
Paid-in
Capital
  Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Total
Stockholders’
Equity (Deficit)
 
(in thousands, except share data)   Shares   Amount   Shares   Amount        

Balance at December 31, 2007

  —     $ —     1,471,143,570   $ 1,471   $   3,604,764   $   (4,398,972 )   $ —       $ (792,737 )

Net loss

  —       —     —       —       —       (5,067,444 )         —         (5,067,444 )

Other comprehensive income:

               

Unrealized gain (loss) on available-for-sale securities, net of zero tax benefit

  —       —     —       —       —       —         (307 )     (307 )

Foreign currency translation adjustment

  —       —     —       —       —       —         (457 )     (457 )
                     

Total comprehensive loss

                  (5,068,208 )

Common stock issued to XM Satellite Radio Holdings stockholders

  —       —     1,440,858,219       1,441     5,459,412     —         —         5,460,853  

Restricted common stock issued to XM Satellite Radio Holdings stockholders

  —       —     29,739,201     30     66,598     —         —         66,628  

Issuance of common stock to employees and employee benefit plans, net of forfeitures

  —       —     4,029,282     4     10,484     —         —         10,488  

Issuance of common stock issued under share borrow agreements

  —       —     262,399,983     262     —       —         —         262  

Series A convertible preferred stock issued to XM Satellite Radio Holdings stockholders

  24,808,959     25   —                     —       47,070     —         —         47,095  

Compensation in connection with the issuance of stock-based awards

  —                       —     —       —       48,657     —         —         48,657  

 

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Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)—(Continued)

 

    Series A
Convertible
Preferred Stock
  Common Stock   Additional
Paid-in
Capital
    Accumulated
Deficit
  Accumulated
Other
Comprehensive
Loss
    Total
Stockholders’
Equity (Deficit)
 
(in thousands, except share data)   Shares   Amount   Shares   Amount        

Conversion of XM Satellite Radio Holdings vested stock-based awards

  —       —     —       —       94,616       —       —         94,616  

Conversion of XM Satellite Radio Holdings outstanding warrants

  —       —     —       —       115,784       —       —         115,784  

Exercise of options, $1.45 to $3.36 per share

  —       —     117,442     —       208       —       —         208  

Exercise of warrants, $2.392 per share

  —       —     899,836     1     (1 )     —       —         —    

Exercise of XM Satellite Radio Holdings outstanding warrants

      17,085,669     17     (17 )         —    

Exchange of 3 1/2% Convertible Notes due 2008, including accrued interest

  —       —     24,131,155     24     33,478                   —       —         33,502  

Restricted shares withheld for tax upon vesting

  —       —     —       —       (1,399 )     —       —         (1,399 )
                                                 

Balance at September 30, 2008

  24,808,959   $             25   3,250,404,357   $           3,250   $   9,479,654     $   (9,466,416)   $           (764 )   $   15,749  
                                                 

See accompanying Notes to the unaudited condensed consolidated financial statements.

 

6


Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Nine months ended
September 30,
 
     2008     2007  
(in thousands)             

Cash flows from operating activities:

    

Net loss

   $ (5,067,444 )   $ (399,029 )

Adjustments to reconcile net loss to net cash used in operating activities:

    

Depreciation and amortization

         114,923             79,142  

Goodwill Impairment

     4,750,859       —    

Non-cash interest expense, net of amortization of premium

     (1,933 )     2,452  

Provision for doubtful accounts

     11,125       6,663  

Amortization of deferred income related to equity method investment

     (471 )     —    

Loss on disposal of assets

     4,879       92  

Equity in net loss of equity method investment

     3,089       —    

Share-based payment expense

     63,417       64,004  

Deferred income taxes

     2,301       1,665  

Other

     1,643       —    

Changes in operating assets and liabilities net of effects of acquisition:

    

Accounts receivable

     1,575       (6,627 )

Inventory

     2,952       (2,533 )

Receivables from distributors

     9,595       (9,032 )

Related party assets

     (1,357 )     —    

Prepaid expenses and other current assets

     3,528       14,571  

Other long-term assets

     37,110       (14,825 )

Accounts payable and accrued expenses

     (137,442 )     (58,713 )

Accrued interest

     (2,810 )     (7,826 )

Deferred revenue

     10,590       76,803  

Related party liabilities

     3,315       —    

Other long-term liabilities and deferred credits on executory contracts

     (26,436 )     759  
                

Net cash used in operating activities

     (216,992 )     (252,434 )
                

Cash flows from investing activities:

    

Additions to property and equipment

     (102,705 )     (66,801 )

Sales of property and equipment

     105       116  

Purchases of restricted and other investments

     (3,000 )     (310 )

Acquisition of acquired entity cash

     819,521       —    

Merger related costs

     (13,047 )     —    

Sale of restricted and other investments

     65,642       35,842  
                

Net cash provided by (used in) investing activities

     766,516       (31,153 )
                

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS—(Continued)

 

     Nine months ended
September 30,
 
     2008     2007  
(in thousands)             

Cash flows from financing activities:

    

Proceeds from exercise of warrants and stock options

     471       2,677  

Long term borrowings, net of related costs

     533,941       245,199  

Payment of premiums on redemption of debt

     (18,693 )     —    

Payments to minority interest holder

     (1,479 )     —    

Repayment of long term borrowings

     (1,142,829 )     —    

Other

     (98 )     —    
                

Net cash (used in) provided by financing activities

     (628,687 )     247,876  
                

Net decrease in cash and cash equivalents

     (79,163 )     (35,711 )

Cash and cash equivalents at beginning of period

     438,820       393,421  
                

Cash and cash equivalents at end of period

   $       359,657     $     357,710  
                

Supplemental Disclosure of Cash and Non-Cash Flow Information:

    

Cash paid during the period for:

    

Interest, net of amounts capitalized

   $ 91,309     $ 56,053  

Income taxes

     281       162  

Non-cash operating activities:

    

Common stock issued in satisfaction of accrued compensation

     8,729       7,949  

Non-cash investing and financing activities:

    

Common stock issued in exchange of 3 1/2% Convertible Notes due 2008, including accrued interest

     33,502       2,923  

Common stock issued in exchange of 2 1/2% Convertible Notes due 2009, including accrued interest

     —         2  

Common stock issued to third parties

     —         82,941  

Equity issued in the acquisition of XM

     5,784,976       —    

See accompanying Notes to the unaudited condensed consolidated financial statements.

 

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Table of Contents

SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollar amounts in thousands, unless otherwise stated)

(1) Business

We provide satellite radio in the United States. We broadcast music, sports, news, talk, entertainment, traffic and weather for a subscription fee through proprietary satellite radio systems—the SIRIUS system and the XM system. On July 28, 2008, our wholly owned subsidiary, Vernon Merger Corporation, merged (the “Merger”) with and into XM Satellite Radio Holdings Inc. and, as a result, XM Satellite Radio Holdings Inc. is now our wholly owned subsidiary. The SIRIUS satellite radio system consists of three in-orbit satellites, approximately 120 terrestrial repeaters that receive and retransmit signals, satellite uplink facilities and studios. The XM satellite radio system consists of four in-orbit satellites, over 700 terrestrial repeaters that receive and retransmit signals, satellite uplink facilities and studios. Subscribers can also receive music channels and certain other channels over the internet.

SIRIUS and XM radios are primarily distributed through retailers; automakers, or OEMs; and through our websites. On September 30, 2008, SIRIUS and XM radios were available at more than 20,000 retail locations. We also have agreements with every major automaker, Acura/Honda, Aston Martin, Audi, Automobili Lamborghini, Bentley, BMW, Chrysler, Dodge, Ford, General Motors, Honda, Hyundai, Infiniti/Nissan, Jaguar, Jeep, Kia, Land Rover, Lincoln, Lexus/Toyota/Scion, Maybach, Mazda, Mercedes-Benz, Mercury, MINI, Mitsubishi, Rolls-Royce, Volvo and Volkswagen, to offer either SIRIUS or XM satellite radios as factory or dealer-installed equipment in their vehicles. SIRIUS and XM radios are also offered to customers of rental car companies, including Hertz and Avis.

As of September 30, 2008, we had 18,920,911 subscribers compared with 8,321,785 subscribers as of December 31, 2007 and 7,667,476 subscribers as of September 30, 2007. Our current subscriber total includes 9,716,070 XM subscribers that we acquired as a result of the Merger. Our subscriber totals include subscribers under our regular pricing plans; subscribers that have prepaid, including payments received from automakers for prepaid subscriptions included in the sale or lease price of a new vehicle; active SIRIUS radios under our agreement with Hertz; active XM radios under our agreement with Avis; and subscribers to SIRIUS Internet Radio and XM Internet Radio, our Internet services.

Our primary source of revenue is subscription fees, with most of our customers subscribing on an annual, semi-annual, quarterly or monthly basis. We offer discounts for pre-paid and long-term subscriptions as well as discounts for multiple subscriptions. We also derive revenue from activation fees, the sale of advertising on select non-music channels, the direct sale of satellite radios and accessories, and other ancillary services, such as our Backseat TV, data and weather services.

In certain cases, automakers include a subscription to our radio services in the sale or lease price of vehicles. The length of these prepaid subscriptions varies, but is typically three months to one year. In many cases, we receive subscription payments from automakers in advance of the activation of our service. We also reimburse various automakers for certain costs associated with satellite radios installed in their vehicles.

We also have an interest in the satellite radio services offered in Canada. SIRIUS Canada Inc. (“SIRIUS Canada”), a Canadian corporation that we jointly own with Canadian Broadcasting Corporation and Standard Radio Inc., offers a satellite radio service in Canada. SIRIUS Canada offers 120 channels of commercial-free music and news, sports, talk and entertainment programming, including 11 channels offering Canadian content. Canadian Satellite Radio Holdings Inc. (“XM Canada”), a Canadian corporation in which we have an ownership interest, also offers satellite radio service in Canada. XM Canada offers 130 channels of music and news, sports, talk and entertainment programming. Subscribers to the SIRIUS Canada service and the XM Canada service are not included in our subscriber count.

Sirius Satellite Radio Inc. was incorporated in the State of Delaware as Satellite CD Radio, Inc. on May 17, 1990. On December 7, 1992, Satellite CD Radio, Inc. changed its name to CD Radio Inc., and Satellite CD Radio, Inc. was formed as a wholly owned subsidiary. On November 18, 1999, CD Radio Inc. changed its name to Sirius Satellite Radio Inc.

On August 5, 2008, we changed our name from Sirius Satellite Radio Inc. to Sirius XM Radio Inc. XM Satellite Radio Holdings Inc., together with its subsidiaries, is operated as an unrestricted subsidiary under our existing indebtedness. As an unrestricted subsidiary, transactions between the companies are required to comply with various contractual provisions in our respective debt instruments.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Unless otherwise indicated,

 

   

“we,” “us,” “our,” the “company” and similar terms refer to Sirius XM Radio Inc. and its consolidated subsidiaries;

 

   

“SIRIUS” refers to Sirius XM Radio Inc. and its consolidated subsidiaries, excluding XM Satellite Radio Holdings Inc. and XM Satellite Radio Inc.;

 

   

“XM Holdings” refers to XM Satellite Radio Holdings Inc. and its consolidated subsidiaries, including XM Satellite Radio Inc.; and

 

   

“XM” refers to XM Satellite Radio Inc. and its consolidated subsidiaries.

(2) Principles of Consolidation and Basis of Presentation

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements of Sirius XM Radio Inc. and subsidiaries have been prepared in accordance with U.S. generally accepted accounting principles, the instructions to Form 10-Q and Article 10 of Regulation S-X of the United States Securities and Exchange Commission (“SEC”) for interim financial reporting. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. We consolidate variable interest entities, as defined by Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46(R), Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51, in which we are the primary beneficiary. All intercompany transactions have been eliminated in consolidation.

Basis of Presentation

In presenting unaudited condensed consolidated financial statements, management makes estimates and assumptions that affect the amounts reported and related disclosures. Additionally, estimates were used when recording the fair values of assets acquired and liabilities assumed in the Merger. Estimates, by their nature, are based on judgment and available information. Actual results could differ from those estimates. In the opinion of management, all normal recurring adjustments necessary for a fair presentation of the condensed consolidated financial statements as of September 30, 2008 and for the three and nine months ended September 30, 2008 and 2007 have been recorded.

The results of XM’s operations have been included in the accompanying unaudited condensed consolidated financial statements of Sirius XM Radio Inc. from the date of the Merger. Although the effective date of the Merger was July 28, 2008, due to the immateriality of the results of operations for the period between July 28 and July 31, 2008, we have accounted for the Merger as if it had occurred on July 31, 2008 with the results and balances of XM Holdings included as of July 31, 2008.

Interim results are not necessarily indicative of the results that may be expected for a full year. This Quarterly Report on Form 10-Q should be read together with our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC on February 29, 2008, as amended by Amendment No. 1 on Form 10-K/A, filed with the SEC on April 29, 2008.

(3) Summary of Significant Accounting Policies

Revenue Recognition

We derive revenue primarily from subscribers, advertising and direct sales of merchandise. Revenue from subscribers consists of subscription fees; revenue derived from our agreement with Hertz; non-refundable activation fees; and the effects of rebates. Revenue is recognized as it is realized or realizable and earned.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

We recognize subscription fees as service is provided to the subscriber. Prepaid subscription fees are recorded as deferred revenue and amortized to revenue ratably over the term of the applicable subscription plan.

At the time of sale, vehicle owners purchasing or leasing a vehicle with a subscription to our service typically receive between a three-month and one-year prepaid subscription. Prepaid subscription fees received from automakers are recorded as deferred revenue and amortized to revenue ratably over the service period, upon activation and sale to a customer. We reimburse automakers for certain costs associated with the satellite radio installed in the applicable vehicle at the time the vehicle is manufactured. The associated payments to the automakers are included in Subscriber acquisition costs. Although we receive payments from the automakers, they do not resell our service; rather, automakers facilitate the sale of the service to their customers, acting similarly to an agent. In the opinion of management, this is the appropriate characterization of our relationship since we are responsible for providing the service to the customers, including being obligated to the customers in the case of an interruption of service.

Activation fees are recognized ratably over the estimated term of a subscriber relationship, currently estimated to be approximately 3.5 years. The estimated term of a subscriber relationship is based on market research and management’s judgment and, if necessary, will be revised in the future.

As required by Emerging Issues Task Force (“EITF”) No. 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products), an estimate of rebates that are paid by us to subscribers is recorded as a reduction to revenue in the period the subscriber activates service. For certain rebate promotions, a subscriber must remain active for a specified period of time to be considered eligible. In those instances, the estimate is recorded as a reduction to revenue over the required activation period. We estimate the effects of mail-in rebates based on actual take-rates for rebate incentives offered in prior periods, adjusted as deemed necessary based on take-rate data available at the time. In subsequent periods, estimates are adjusted when necessary. For instant rebate promotions, we record the consideration paid to the consumer as a reduction to revenue in the period the customer participates in the promotion.

We recognize revenue from the sale of advertising as the advertising is broadcast. Agency fees are calculated based on a stated percentage applied to gross billing revenue for our advertising inventory and are reported as a reduction of Advertising revenue. We pay certain third parties a percentage of Advertising revenue. Advertising revenue is recorded gross of such revenue share payments in accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, as we are the primary obligor in the transaction. Advertising revenue share payments are recorded to Revenue share and royalties during the period in which the advertising is broadcast.

Equipment revenue from the direct sale of satellite radios and accessories is recognized upon shipment, net of discounts and rebates. Shipping and handling costs billed to customers are recorded as revenue. Shipping and handling costs associated with shipping goods to customers are recorded to Cost of equipment.

EITF No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, provides guidance on how and when to recognize revenues for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets. Revenue arrangements with multiple deliverables are required to be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration must be allocated among the separate units of accounting based on their relative fair values.

Stock-Based Compensation

We account for equity instruments granted to employees in accordance with SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R requires all share-based compensation payments to be recognized in the financial statements based on their fair value using an option pricing model. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. We use the Black-Scholes option-pricing model to value stock option awards and have elected to treat awards with graded vesting as a single award.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Fair value determined using Black-Scholes varies based on assumptions used for the expected life, expected stock price volatility and risk-free interest rates. We estimate the fair value of awards granted using the implied volatility of actively traded options on our common stock. The expected life assumption represents the weighted-average period stock-based awards are expected to remain outstanding. These expected life assumptions are established through a review of historical exercise behavior of stock-based award grants with similar vesting periods. Where historical patterns do not exist, contractual terms are used. The risk-free interest rate represents the daily treasury yield curve rate at the reporting date based on the closing market bid yields on actively traded U.S. treasury securities in the over-the-counter market for the expected term. Our assumptions may change in future periods.

The fair value of equity instruments granted to non-employees is measured in accordance with EITF No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The final measurement date of equity instruments with performance criteria is the date that each performance commitment for such equity instrument is satisfied or there is a significant disincentive for non-performance.

Stock-based awards granted to employees, non-employees and members of our board of directors generally include warrants, stock options, restricted stock and restricted stock units. The stock-based compensation cost recognized includes compensation cost for all stock-based awards granted to employees and members of our board of directors (i) prior to, but not vested as of, January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and (ii) subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R.

Subscriber Acquisition Costs

Subscriber acquisition costs include hardware subsidies paid to radio manufacturers, distributors and automakers, including subsidies paid to automakers who include a satellite radio and a prepaid subscription to our service in the sale or lease price of a new vehicle; subsidies paid for chip sets and certain other components used in manufacturing radios; device royalties for certain radios; commissions paid to retailers and automakers as incentives to purchase, install and activate radios; product warranty obligations; provisions for inventory allowance; and compensation costs associated with stock-based awards granted in connection with certain distribution agreements. Subscriber acquisition costs do not include advertising, loyalty payments to distributors and dealers of radios and revenue share payments to automakers and retailers of radios.

Subsidies paid to radio manufacturers and automakers are expensed upon shipment or installation. Commissions paid to retailers and automakers are expensed either upon activation or sale of radios. Chip sets that are shipped to radio manufacturers and held on consignment are recorded as inventory and expensed as Subscriber acquisition costs when placed into production by radio manufacturers. Costs for chip sets not held on consignment are expensed as Subscriber acquisition costs when the chip sets are shipped to radio manufacturers.

We record product warranty obligations in accordance with FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. FIN No. 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. We warrant that certain products sold through our retail and direct to consumer distribution channels will perform in all material respects in accordance with specifications in effect at the time of the purchase of the products by the customer. As of April 2008, SIRIUS changed its warranty period to 90 days on products from the purchase date for repair or replacement of components and/or products that contain defects of material or workmanship. Products purchased prior to April 2008 contained a warranty period of 12 months from the purchase date. Customers may exchange products directly to the retailer within 30 days of purchase. We recorded a liability for costs that we expect to incur under our warranty when the product is shipped from the manufacturer. Factors affecting the warranty liability include the number of units sold and historical and anticipated rates of claims and costs per claim. We periodically assess the adequacy of our warranty liability based on changes in these factors.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Research & Development Costs

Research and development costs are expensed as incurred and primarily include the cost of new product development, chip set design, software development and engineering. During the three and nine months ended September 30, 2008, we recorded research and development costs of $13,932 and $30,006, respectively. For the comparable periods in 2007, we recorded research and development costs of $9,487 and $30,019, respectively. These costs are reflected in Engineering, design and development expense in our unaudited condensed consolidated statements of operations.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, and FIN No. 48, Accounting for Uncertainty in Income Taxes. Deferred income taxes are recognized for the tax consequences related to temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for tax purposes at each year-end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. A valuation allowance is established when necessary based on the weight of available evidence, if it is considered more likely than not that all or some portion of the deferred tax assets will not be realized. Income tax expense is the sum of current income tax plus the change in deferred tax assets and liabilities.

Net (Loss) Income per Common Share

We compute net (loss) income per common share in accordance with SFAS No. 128, Earnings Per Share. Basic net (loss) income per common share is calculated using the weighted average common shares outstanding during each reporting period. Diluted net (loss) income per common share adjusts the weighted average common shares outstanding for the potential dilution that could occur if common stock equivalents (convertible debt and preferred stock, warrants, stock options and restricted stock shares and units) were exercised or converted into common stock. Common stock equivalents of approximately 795,000,000 and 802,000,000 for the three and nine months ended September 30, 2008, respectively, and 168,000,000 and 167,000,000 for the three and nine months ended September 30, 2007, respectively, were not included in the calculation of diluted net loss per common share as the effect would have been anti-dilutive.

Inventory

Inventory consists of finished goods, refurbished goods, chip sets and other raw material components used in manufacturing radios. Inventory is stated at the lower of cost, determined on a first-in, first-out basis, or market. We record an estimated allowance for inventory that is considered slow moving and obsolete or whose carrying value is in excess of net realizable value. The provision related to products purchased for our direct to consumer distribution channel is recorded to Cost of equipment in our unaudited condensed consolidated statements of operations. The remaining provision is recorded to Subscriber acquisition costs in our unaudited condensed consolidated statements of operations.

Inventory, net, consists of the following:

 

     September 30,
2008
   December 31,
2007

Raw materials

   $       13,941    $ 9,987

Finished goods

     17,994      19,550
             

Total inventory

   $ 31,935    $       29,537
             

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Investments

Marketable Securities—We account for investments in marketable securities in accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Marketable securities consist of certificates of deposit, auction rate certificates and investments in debt and equity securities of other entities. The basic objectives of our investment policy are the preservation of capital, maintaining sufficient liquidity to meet operating requirements and maximizing yield. Marketable securities are classified as available-for-sale securities. Available-for-sale securities are carried at fair market value. Unrealized gains and losses are included in Accumulated other comprehensive (loss) income, net of tax, as a separate component of Stockholders’ equity (deficit). Realized gains and losses, dividends and interest income, including amortization of the premium and discount arising at purchase, are included in Interest and investment income. The specific-identification method is used to determine the cost of all securities and the basis by which amounts are reclassified from Accumulated other comprehensive (loss) income into earnings.

We received proceeds from the sale or maturity of marketable securities of $0 and $10,842 for the nine months ended September 30, 2008 and 2007, respectively. There were no unrealized gains or losses on marketable securities as of September 30, 2008 and December 31, 2007.

Restricted Investments—We have escrow deposits, certificates of deposit, money market funds and interest-bearing accounts which are restricted as to their withdrawal.

Equity Method Investments—Investments in which we have the ability to exercise significant influence but not control are accounted for using the equity method. We recognize our share of net earnings or losses of the affiliate as they occur in Other income (expense) in our unaudited condensed consolidated statements of operations. We evaluate our equity method investments for impairment whenever events or changes in circumstances indicate that the carrying amounts of such investments may not be recoverable. The difference between the carrying value of the equity method investments and their estimated fair values is recognized as an impairment when the loss in value is deemed other than temporary.

Cost Method Investments—Investments in equity securities that do not have readily determinable fair values and in which we do not have a controlling interest or are unable to exert significant influence are recorded at cost.

We adopted the provisions of SFAS No. 157, Fair Value Measurements, on January 1, 2008 as it applies to financial assets and liabilities. SFAS No. 157 establishes a fair value hierarchy for input into valuation techniques as follows: i) Level 1 input—unadjusted quoted prices in active markets for identical instrument; ii) Level 2 input—observable market data for same or similar instrument but not Level 1; and iii) Level 3 input—unobservable inputs developed using management’s assumptions about the inputs used for pricing the asset or liability. We use Level 3 inputs to fair value our investments in auction rate certificates issued by student loan trusts and 8% convertible unsecured subordinated debentures issued by XM Canada. These investments are not material to our unaudited condensed consolidated results of operations or financial position.

Investments are periodically reviewed for impairment and a write down is recorded whenever declines in fair value below carrying value are determined to be other than temporary. In making this determination, we consider, among other factors, the severity and duration of the decrease as well as the likelihood of a recovery within a reasonable timeframe.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Property and Equipment

Property and equipment is stated at cost less accumulated depreciation and amortization. Equipment under capital leases is stated at the present value of minimum lease payments. Depreciation and amortization are calculated using the straight-line method over the following estimated useful lives:

 

Satellite system

   2 – 15 years

Terrestrial repeater network

  

5 – 15 years

Broadcast studio equipment

   3 – 15 years

Capitalized software and hardware

  

3 – 7 years

Satellite telemetry, tracking and control facilities

   3 – 17.5 years

Furniture, fixtures, equipment and other

  

2 – 7 years

Building

   20 or 30 years

Leasehold improvements

  

Lesser of useful life

or remaining lease term

We operate three in-orbit satellites in our SIRIUS system and have one ground spare satellite. The three in-orbit SIRIUS satellites were launched in 2000 and the spare satellite was delivered to ground storage in 2002. The three-satellite constellation and terrestrial repeater network were placed into service in 2002. SIRIUS has an agreement with Space Systems/Loral for the design and construction of an additional two satellites which are expected to be launched in mid 2009 and not before the end of 2010. In January 2008, SIRIUS entered into an agreement with International Launch Services to secure two satellite launches on Proton rockets. This agreement with International Launch Services allows SIRIUS the flexibility to defer launch dates and to cancel the second of these launches upon payment of a cancellation fee.

We operate four in-orbit satellites in our XM system, two of which function as in-orbit spares. The two in-orbit spare satellites were launched in 2001 while the other two satellites were launched in 2005 and 2006, respectively. XM has an agreement with Space Systems/Loral to construct one additional satellite which we currently expect to launch in December 2009.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset.

Goodwill and Other Intangible Assets

Goodwill represents the purchase price in excess of the net amount assigned to assets acquired and liabilities assumed in the Merger. We will perform an impairment test at least annually or more frequently if indicators of impairment exist. We are required to perform a two-step impairment test of goodwill under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. The fair value of the entity is compared to its carrying value and if the fair value exceeds its carrying value then goodwill is not impaired. If the carrying value exceeds the fair value then we will compare the implied fair value of goodwill to the carrying value of goodwill. If the implied fair value exceeds the carrying value then goodwill is not impaired; otherwise, an impairment loss will be recorded by the amount the carrying value exceeds the implied fair value.

Other intangible assets with indefinite lives are tested for impairment at least annually or more frequently if indicators of impairment exist under the provisions of SFAS No. 142.

 

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(Dollar amounts in thousands, unless otherwise stated)

 

Other intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment under the provisions of SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.

Reclassifications

Certain amounts in the prior period unaudited condensed consolidated financial statements have been reclassified to conform to the current period presentation. Specifically, during the first nine months of 2008, we reclassified equipment related retention costs from Cost of equipment to Sales and marketing expense. Equipment related retention costs are associated with efforts to retain existing subscribers that we believe will result in higher revenue and lower churn.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measurements. In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13 and FSP 157-2, Effective Date of FASB Statement No. 157. FSP 157-1 amends SFAS No. 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all nonfinancial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on at least an annual basis, until January 1, 2009 for calendar year end entities. We adopted the provisions of SFAS No. 157 on January 1, 2008, except as it applies to nonfinancial assets and liabilities as noted in FSP 157-2. The partial adoption had no significant impact on our consolidated results of operations or financial position. We have not determined the impact, if any, that the adoption of SFAS No. 157, as it relates to nonfinancial assets and liabilities, will have on our consolidated results of operations or financial position.

In November 2007, the FASB issued SFAS No. 141R, Business Combinations, which continues to require that all business combinations be accounted for by applying the acquisition method. Under the acquisition method, the acquirer recognizes and measures the identifiable assets acquired, the liabilities assumed, and any contingent consideration and contractual contingencies, as a whole, at their face value as of the acquisition date. Under SFAS No. 141R, all transaction costs are expensed as incurred. SFAS No. 141R rescinds EITF No. 93-07, Uncertainties Related to Income Taxes in a Purchase Business Combination. Under EITF No. 93-07 the effect of any subsequent adjustments to uncertain tax positions were generally applied to goodwill, except for post-acquisition interest on uncertain tax provisions, which was recognized as an adjustment to income tax expense. Under SFAS No. 141R, all subsequent adjustments to these uncertain tax positions that otherwise would have impacted goodwill will be recognized in the income statement. The guidance in SFAS No. 141R will be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning after December 15, 2008. SFAS No. 141R does not impact the accounting for the Merger.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities—An amendment of FASB Statement No. 133, which requires enhanced qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption permitted. We will adopt this Statement effective January 1, 2009. The adoption of SFAS No. 161 will not impact on our consolidated results of operations or financial position.

In December 2007, the FASB ratified EITF No. 07-1, Accounting for Collaborative Agreements, which provides guidance on how the parties to a collaborative agreement should account for costs incurred and revenue generated on sales to third parties, how sharing payments pursuant to a collaboration agreement should be presented in the income statement and certain related disclosure requirements.

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

This EITF is effective for the first annual or interim reporting period beginning after December 15, 2008, and should be applied retrospectively to all prior periods presented for all collaborative arrangements existing as of the effective date. We will adopt EITF No. 07-1 effective January 1, 2009. We are currently evaluating the impact, if any, that the adoption of EITF No. 07-1 will have on our consolidated results of operations and financial position.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 142-3, Determination of the Useful Life of Intangible Assets. FSP No. FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142, Goodwill and Other Intangible Assets. We will adopt FSP No. FAS 142-3 effective January 1, 2009. We are currently evaluating the impact, if any, that the adoption of FSP No. FAS 142-3 will have on our consolidated results of operations and financial position.

(4) Acquisition

On July 28, 2008, Vernon Merger Corporation, a wholly owned subsidiary of SIRIUS, merged (the “Merger”) with and into XM Satellite Radio Holdings Inc. As a result, XM Holdings became our wholly-owned subsidiary. The Merger was effected pursuant to an Agreement and Plan of Merger (the “Merger Agreement”), dated as of February 19, 2007, entered into by SIRIUS, XM Holdings and Vernon Merger Corporation.

The results of operations for XM have been included in our consolidated results of operations for the period August 1, 2008 through September 30, 2008. The effective date of the Merger was July 28, 2008; however, due to the immateriality of the results of operations for the period July 28, 2008 through July 31, 2008, we have accounted for the Merger as if it had occurred on July 31, 2008, with the results and balances of XM included as of July 31, 2008.

The Merger has been accounted for under the purchase method of accounting pursuant to the provisions of SFAS No. 141, Business Combinations. The application of purchase accounting under SFAS No. 141 resulted in the transaction being value at $5,836,363, based upon the average closing price of $3.79 of our common stock on The NASDAQ Global Select Market for the two days prior to, including, and two days subsequent to the public announcement of the Merger on February 19, 2007.

On that basis, the table below shows the value of the consideration paid in connection with the Merger:

 

     Total

Fair value of common stock issued to XM Holdings stockholders

   $ 5,460,853

Fair value of preferred stock issued to XM Holdings stockholders

     47,095

Fair value of converted stock options

     94,616

Fair value of restricted stock issued to XM Holdings stockholders

     66,628

Fair value of converted warrants

     115,784

Acquisition costs

     51,387
      

Total

   $   5,836,363

SFAS No. 141 requires that the total purchase price be allocated to the fair value of assets acquired and liabilities assumed based on their fair values at the acquisition date, with any excess recorded as goodwill. We have preliminarily allocated the purchase price based on current estimates of the fair values of assets acquired and liabilities assumed in connection with the Merger.

The table below summarizes the preliminary estimates of fair value of the XM assets acquired, liabilities assumed and related deferred income taxes as of the acquisition date. These preliminary estimates will be revised in future periods and the revisions may

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

materially affect the presentation of our consolidated financial results. Any changes to the initial estimates of the fair value of the assets and liabilities will be recorded as adjustments to those assets and liabilities and residual amounts will be allocated to goodwill. You should not place undue reliance on the preliminary analysis of XM’s tangible and intangible assets and liabilities set forth below.

 

     Preliminary
July 31, 2008
     (unaudited)

Acquired assets:

  

Current assets

   $ 1,078,148

Property and equipment

     905,319

Non-amortizable intangible assets

     2,250,000

Amortizable intangible assets

     453,444

Goodwill

     6,626,504

Other assets

     329,948
      

Total assets

   $     11,643,363
      

Assumed liabilities:

  

Current liabilities

     776,448

Total Debt

     2,576,512

Deferred income taxes

     849,148

Other non-current liabilities and deferred credit on executory contracts

     1,604,892
      

Total liabilities

   $ 5,807,000
      

Total consideration

   $ 5,836,363
      

In connection with the Merger, we recorded a preliminary estimate of goodwill in the amount of $6,626,504. During the three and nine months ended September 30, 2008, we recorded $4,750,859 of impairment loss (see Note 5, Goodwill Impairment).

In connection with the Merger, $2,250,000 of the purchase price was allocated to certain indefinite lived intangible assets of XM, including $2,000,000 associated with XM’s FCC license and $250,000 associated with trade names. During the three and nine months ended September 30, 2008, no impairment loss was recorded for intangible assets with indefinite lives.

In connection with the Merger, $378,444 of the purchase price was allocated to certain intangible assets of XM which are subject to amortization on a straight line basis. Acquired definite lived intangible assets include $360,000 associated with subscriber relationships (9-year useful life), $16,444 associated with proprietary software (6-year weighted average useful life), and $2,000 associated with developed technology (10-year useful life). During the three and nine months ended September 30, 2008, we recorded amortization expense of $7,596.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

As of September 30, 2008, we recorded $61,513 of costs recognized under EITF No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination, as liabilities assumed in the Merger. These costs are primarily associated with XM employee severance benefits for involuntary separations.

The following schedule presents unaudited consolidated pro forma results of operations as if the Merger had occurred on January 1, 2007. This information does not purport to be indicative of the actual results that would have occurred if the Merger had actually been completed on the date indicated, nor is it necessarily indicative of the future operating results or the financial position of the combined company:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  
Total revenue    $           589,560     $           511,149     $         1,746,982     $       1,435,804  

Net loss

     (4,951,528 )     (307,882 )     (5,446,604 )     (988,651 )

Net loss per common share (basic and diluted)

     (1.65 )     (0.11 )     (1.84 )     (0.34 )

(5) Goodwill Impairment

We recorded a preliminary estimate of goodwill in the amount of $6,626,504 in connection with the Merger. Pursuant to the provisions of SFAS No. 141, we have made allocations of fair value to acquired assets and assumed liabilities. These allocations are preliminary and we may update them prior to July 28, 2009, the first anniversary of the Merger.

SFAS No. 142 requires that we assess goodwill for impairment at least annually or more frequently if indicators of impairment exist. The price of our common stock declined significantly from February 19, 2007, the measurement date for valuation of the Merger, indicating a potential impairment. Under SFAS No. 142, the fair value of the entity (based upon market capitalization) is compared to its carrying value and if the fair value exceeds its carrying value then goodwill is not impaired. If the carrying value exceeds the fair value then we will compare the implied fair value of goodwill to the carrying value of goodwill. If the implied fair value exceeds the carrying value then goodwill is not impaired; otherwise, an impairment loss will be recorded by the amount the carrying value exceeds the implied fair value. Our impairment analysis indicated that the carrying value of goodwill exceeded the implied fair value of goodwill, resulting in an estimated impairment charge of $4,750,859. To the extent there are significant changes in the recorded amount of goodwill as a result of the final allocations of fair value to the acquired assets and assumed liabilities, there may be significant adjustments to this estimate of impairment loss.

(6) Subscriber Revenue

Subscriber revenue consists of subscription fees, revenue derived from our agreement with Hertz, non-refundable activation fees and the effects of rebates. Revenues received from automakers for prepaid subscriptions included in the sale or lease price of a new vehicle are also included in subscriber revenue over the service period upon activation and sale to the customer.

Subscriber revenue consists of the following:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Subscription fees

   $           451,660     $           222,136     $           961,574     $           617,591  

Activation fees

     4,920       5,288       17,271       15,456  

Effect of rebates

     (223 )     (580 )     (329 )     (5,772 )
                                

Total subscriber revenue

   $ 456,357     $ 226,844     $ 978,516     $ 627,275  
                                

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

(7) Interest Costs

We capitalize a portion of the interest on funds borrowed to finance the construction and launch of our satellites. The following is a summary of our interest costs:

 

     Three months ended
September 30,
   Nine months ended
September 30,
     2008    2007    2008    2007

Interest costs charged to expense

   $       49,216    $       19,499    $       83,636    $       50,441

Interest costs capitalized

     7,791      2,365      14,340      5,973
                           

Total interest costs incurred

   $ 57,007    $ 21,864    $ 97,976    $ 56,414
                           

(8) Related Party Transactions

In 2005, SIRIUS entered into a license and services agreement with SIRIUS Canada. Pursuant to such agreement, SIRIUS is reimbursed for certain costs incurred to provide SIRIUS Canada service, including certain costs incurred for the production and distribution of radios, as well as information technology support costs. In consideration for the rights granted pursuant to this license and services agreement, SIRIUS Canada pays SIRIUS a royalty based on a percentage of its annual gross revenues, as long as SIRIUS Canada maintains a positive cash flow position for twelve consecutive months. Additionally, the initial financing SIRIUS provided to SIRIUS Canada is by way of subscription to non-voting shares which carry an 8% cumulative dividend.

Total costs that have been or will be reimbursed by SIRIUS Canada for the three and nine months ended September 30, 2008 were $3,345 and $11,175, respectively. For the comparable periods in 2007, the costs were $2,220 and $4,862, respectively. Royalty income was recorded to Other income in our unaudited condensed consolidated statements of operations. Dividend income was included in Interest and investment income in our unaudited condensed consolidated statements of operations.

The amount due from SIRIUS Canada at September 30, 2008 was $4,196, of which $959 and $3,237 are included in Other current assets and Other long-term assets, respectively, in our condensed consolidated balance sheets. The amount due from SIRIUS Canada at December 31, 2007 was $5,398, of which $2,161 and $3,237 are included in Other current assets and Other long-term assets, respectively, in our condensed consolidated balance sheets. The amounts payable to SIRIUS Canada at September 30, 2008 and December 31, 2007 to fund its remaining capital requirements, were $1,365 and $1,148, respectively, and is included in Other long-term liabilities in our condensed consolidated balance sheets.

In November 2005, XM entered into agreements to provide XM Canada with the right to offer XM satellite radio service in Canada. The agreements have an initial term of ten years and XM Canada has the unilateral option to extend the term of the agreements for an additional five years at no additional cost beyond the current financial arrangements. XM Canada has expressed its intent to exercise this option at the end of the initial term of the agreements. XM has the right to receive a 15% royalty for all subscriber fees earned by XM Canada each month for its basic service and a nominal activation fee for each gross activation of an XM Canada subscriber on XM’s system. XM Canada is obligated to pay XM a total of $71,800 for the rights to broadcast and market National Hockey League (“NHL”) games for the 10-year term of XM’s contract with the NHL. In accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, we recognize these payments on a gross basis as a principal. The deferred income was fair valued at $35,000, and will be amortized on a straight-line basis over the remaining expected term of the agreements. The remaining carrying value of Deferred income related to XM Canada was $34,524 as of September 30, 2008.

XM has extended a C$45,000 standby credit facility to XM Canada which can be utilized to purchase terrestrial repeaters or finance the payment of subscription fees. The facility matures on December 31, 2012 and bears interest at a rate of 17.75% per annum. XM has the right to convert unpaid principal amounts into Class A subordinate voting shares of XM Canada at the price of C$16.00 per share. As of September 30, 2008, XM Canada had drawn $7,831 on this facility in lieu of payment of subscription fees.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

The royalty fees which XM earns related to subscriber and activation fees are recorded as Other revenue in our unaudited condensed consolidated statements of operations. We recorded royalty fees of $146 for the three and nine months ended September 30, 2008. XM Canada pays XM a licensing fee and reimburses XM for advertising, both of which are recorded to Other revenue in our unaudited condensed consolidated statements of operations. We recorded licensing fees of $1,000 for the three and nine months ended September 30, 2008. We recorded no reimbursements for advertising for the three and nine months ended September 30, 2008. The amount due from XM Canada at September 30, 2008 was $12,815, and is included in Related party current assets in our condensed consolidated balance sheets.

XM has agreements with General Motors (“GM”) and American Honda Motor Co., Inc. (“American Honda”), both of which hold shares of our common stock and have one representative each on SIRIUS’ board of directors. GM and American Honda install XM radios and promote the XM radio service, and XM will make available use of bandwidth. Subscriber revenues received from GM and American Honda for these programs are recorded as Related party revenue.

We recorded total revenue from GM, primarily consisting of subscriber revenue, of $6,733 for the three and nine months ended September 30, 2008. We recorded total revenue from American Honda, primarily consisting of subscriber revenue, of $3,321 for the three and nine months ended September 30, 2008, respectively.

We rely on GM and American Honda for marketing and we are responsible for certain revenue share payments to these related parties. We recorded Sales and marketing expense with GM of $38,069 for the three and nine months ended September 30, 2008. We recorded Sales and marketing expense with American Honda of $1,848 for the three and nine months ended September 30, 2008. We recorded Revenue share and royalty expense with GM of $26,021 for the three and nine months ended September 30, 2008. We recorded Revenue share and royalty expense with American Honda of $747 for the three and nine months ended September 30, 2008.

As of September 30, 2008, we recorded, within Related party assets, $10,955 and $213,703 of amounts due from GM and prepaid expenses with GM, respectively. As of September 30, 2008, we recorded $1,612 within Related party current assets for amounts due from American Honda.

As of September 30, 2008, we recorded $70,640 within Related party current liabilities for amounts due to GM. As of September 30, 2008, we recorded $4,978 within Related party current liabilities for amounts due to American Honda.

(9) Investments

Investments consist of the following:

 

     September 30,
2008
   December 31,
2007
Marketable securities    $ 11,521    $ 469

Restricted investments

     141,250      53,000
Embedded derivative accounted for separately from the host contract      420      —  

Equity method investments

     37,337      —  
             

Total investments

   $       190,528    $         53,469
             

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

SIRIUS Canada

We have a 49.9% economic interest in SIRIUS Canada. Our investment in SIRIUS Canada is recorded using the equity method since we have a significant influence, but less than a controlling voting interest in SIRIUS Canada. Under this method, our investment in SIRIUS Canada, originally recorded at cost, is adjusted quarterly to recognize our share of net earnings or losses as they occur, rather than at the time dividends or other distributions are received, limited to the extent of our investment in, advances to and commitments to fund SIRIUS Canada. Our share of net earnings or losses of SIRIUS Canada is recorded to Equity in net loss of equity method investment in our unaudited condensed consolidated statements of operations. We recorded no share of SIRIUS Canada’s net loss for the three and nine months ended September 30, 2008 and 2007. As of September 30, 2008, the carrying value of our equity method investment was $0.

XM Canada

We have a 23.33% economic interest in XM Canada. The amount of the Merger purchase price allocated to the fair value of our investment in XM Canada is $21,776. Our investment in XM Canada is recorded using the equity method since we have significant influence, but less than a controlling voting interest in XM Canada. Under this method, our investment in XM Canada is adjusted to recognize our share of net earnings or losses as they occur, rather than at the time dividends or other distributions are received, limited to the extent of our investment in, advances to and commitments to fund XM Canada. Our share of net earnings or losses of XM Canada is recorded to Equity in net loss of equity method investment in our unaudited condensed consolidated statements of operations. We recorded $3,088 for each of the three and nine months periods ended September 30, 2008 for our share of XM Canada’s net loss. In addition, XM Holdings holds an investment in C$4,000 face value of 8% convertible unsecured subordinated debentures issued by XM Canada for which the embedded conversion feature is required under SFAS No. 133 to be bifurcated from the host contract. The host contract is accounted for as an available-for-sale security at fair value with changes in fair value recorded as Accumulated other comprehensive loss, net of tax. The embedded conversion feature is accounted for as a derivative at fair value with changes in fair value recorded in earnings as Interest income. As of September 30, 2008, the carrying value of our equity method investment was $37,337, while the carrying value of the host contract and embedded derivative related to our investment in the debentures was $2,804 and $420, respectively.

Auction Rate Certificates

In connection with the Merger, we acquired an investment in auction rate certificates issued by student loan trusts. Auction rate certificates are long-term securities structured to reset their coupon by means of an auction. We account for our investment in auction rate certificates as available-for-sale securities. As of September 30, 2008, the carrying value of these securities was $8,717.

Restricted Investments

Restricted investments relate to deposits placed into escrow for the benefit of third parties pursuant to programming agreements and reimbursement obligations under letters of credit issued for the benefit of lessors of office space. In connection with the Merger, we acquired restricted investments in the form of a $120,000 escrow deposit for the benefit of Major League Baseball®. As of September 30, 2008 and December 31, 2007, the carrying value of our short-term restricted investments was $0 and $35,000, respectively, and primarily included certificates of deposit placed in escrow for the benefit of a third party pursuant to a programming agreement. As of September 30, 2008 and December 31, 2007, the carrying value of our long-term restricted investments was $141,250 and $18,000, respectively, and primarily included certificates of deposit and money market funds deposited in escrow for the benefit of third parties pursuant to programming agreements and certificates of deposit placed in escrow to secure reimbursement obligations under letters of credit issued for the benefit of lessors of office space.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

(10) Debt

Debt consists of the following:

 

     Conversion Price
(per share)
   September 30,
2008
    December 31,
2007
SIRIUS Debt        

Senior Secured Term Loan due 2012

     N/A    $         247,500     $         249,375

9 5/8% Senior Notes due 2013

     N/A      500,000       500,000

3 1/4% Convertible Notes due 2011

   $                5.30      230,000       230,000

2 1/2% Convertible Notes due 2009

     4.41      299,998       299,998

3 1/2% Convertible Notes due 2008

     1.38      —         33,301

8 3/4% Convertible Subordinated Notes due 2009

     28.46      1,744       1,744

XM and XM Holdings Debt

       

Senior Secured Term Loan due 2009

     N/A      100,000       N/A

13% Senior Notes due 2014

     N/A      778,500       N/A

Less: discount

     N/A      (76,328 )     N/A

9.75% Senior Notes due 2014

     N/A      5,260       N/A

10% Convertible Senior Notes due 2009

     10.87      400,000       N/A

Less: discount

        (20,988 )  

10% Senior Secured Discount Convertible Notes due 2009

     0.69      33,249       N/A

Add: premium

        47,758       N/A

Senior Secured Revolving Credit Facility due 2009

     N/A      250,000       N/A

Add: premium

        239    

7% Exchangeable Senior Subordinated Notes due 2014

     1.88      550,000       N/A

Other debt:

       

Capital leases

     N/A      25,821       N/A
                 

Total debt

        3,372,753       1,314,418
Less: current maturities         572,646       35,801
                 

Total long-term

      $     2,800,107     $     1,278,617
                 

SIRIUS Debt

Senior Secured Term Loan

In June 2007, SIRIUS entered into a term credit agreement with a syndicate of financial institutions. The term credit agreement provides for a Senior Secured Term Loan (the “SIRIUS Term Loan”) of $250,000, which has been fully drawn. Interest under the SIRIUS Term Loan is based, at our option, on (i) adjusted LIBOR plus 2.25% or (ii) the higher of (a) the prime rate and (b) the Federal Funds Effective Rate plus  1/2 of 1.00%, plus 1.25%. As of September 30, 2008, the interest rate was 5.44%. LIBOR borrowings may be made for interest periods, at our option, of one, two, three or six months (or, if agreed by all of the lenders, nine or twelve months). The SIRIUS Term Loan amortizes in equal quarterly installments of 0.25% of the initial aggregate principal amount for the first four and a half years, with the balance of the loan thereafter being repaid in four equal quarterly installments. The SIRIUS Term Loan matures on December 20, 2012.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

The SIRIUS Term Loan is guaranteed by our wholly owned subsidiaries, including Satellite CD Radio, Inc. (the “Guarantor”), and is secured by a lien on substantially all of SIRIUS’ and the Guarantors’ assets, including SIRIUS’ three in-orbit satellites and one ground spare satellite and the shares of the Guarantors.

The SIRIUS Term Loan contains customary affirmative covenants and event of default provisions. The negative covenants contained in the SIRIUS Term Loan are substantially similar to those contained in the indenture governing the 9 5/8% Senior Notes due 2013.

9 5/8% Senior Notes due 2013

In August 2005, SIRIUS issued $500,000 in aggregate principal amount of 9 5/8% Senior Notes due 2013 (the “9 5/8% Notes”) resulting in net proceeds of $493,005. The 9 5/8% Notes mature on August 1, 2013 and interest is payable semi-annually on February 1 and August 1 of each year. The obligations under the 9 5/8% Notes are not secured by any of our assets.

3 1/4% Convertible Notes due 2011

In October 2004, SIRIUS issued $230,000 in aggregate principal amount of 3 1/4% Convertible Notes due 2011 (the “3 1/4% Notes”) resulting in net proceeds of $224,813. The 3 1/4% Notes are convertible, at the option of the holder, into shares of our common stock at any time at a conversion rate of 188.6792 shares of common stock for each $1,000 principal amount, or $5.30 per share of common stock, subject to certain adjustments. The 3 1/4% Notes mature on October 15, 2011 and interest is payable semi-annually on April 15 and October 15 of each year. The obligations under the 3 1/4% Notes are not secured by any of our assets.

2 1/2% Convertible Notes due 2009

In February 2004, SIRIUS issued $250,000 in aggregate principal amount of 2 1/2% Convertible Notes due 2009 (the “2 1/2% Notes”) resulting in net proceeds of $244,625. In March 2004, SIRIUS issued an additional $50,000 in aggregate principal amount of the 2 1/2% Notes pursuant to an option granted in connection with the initial offering of the notes, resulting in net proceeds of $48,975. The 2 1/2% Notes are convertible, at the option of the holder, into shares of our common stock at any time at a conversion rate of 226.7574 shares of common stock for each $1,000 principal amount, or $4.41 per share of common stock, subject to certain adjustments. The 2 1/ 2% Notes mature on February 15, 2009 and interest is payable semi-annually on February 15 and August 15 of each year. The obligations under the 2 1/2% Notes are not secured by any of our assets.

3 1/2% Convertible Notes due 2008

In May 2003, SIRIUS issued $201,250 in aggregate principal amount of 3 1/2% Convertible Notes due 2008 resulting in net proceeds of $194,224. These notes matured on June 1, 2008 and were repaid on such date.

8 3/4% Convertible Subordinated Notes due 2009

In 1999, SIRIUS issued 8 3/4% Convertible Subordinated Notes due 2009 (the “8 3/4% Notes”). The 8 3/4% Notes are convertible, at the option of the holder, into shares of our common stock at any time at a conversion rate of 35.134 shares of common stock for each $1,000 principal amount, or $28.4625 per share of common stock, subject to certain adjustments. The remaining balance of the 8 3 /4% Notes mature on September 29, 2009 and interest is payable semi-annually on March 29 and September 29 of each year. The obligations under the 8 3/4% Notes are not secured by any of our assets.

Space Systems/Loral Credit Agreement

In July 2007, SIRIUS amended and restated its existing Credit Agreement with Space Systems/Loral (the “Loral Credit Agreement”). Under Loral Credit Agreement, Space Systems/Loral agreed to make loans to SIRIUS in an aggregate principal amount of up to $100,000 to finance the purchase of its fifth and sixth satellites. Loans made under the Loral Credit Agreement are secured by

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

SIRIUS’ rights under the Satellite Purchase Agreement with Space Systems/Loral, including its rights to these satellites. The loans are also entitled to the benefits of a subsidiary guarantee from Satellite CD Radio, Inc., the subsidiary that holds SIRIUS’ FCC license, and any future material subsidiary that may be formed by SIRIUS. The maturity date of the loans is the earliest to occur of (i) June 10, 2010, (ii) 90 days after the sixth satellite becomes available for shipment and (iii) 30 days prior to the scheduled launch of the sixth satellite. The Loral Credit Agreement contains certain drawing conditions, including a requirement that SIRIUS have a market capitalization of at least $1 billion. Any loans made under the Loral Credit Agreement generally will bear interest at a variable rate equal to three-month LIBOR plus 4.75%. The daily unused balance bears interest at a rate per annum equal to 0.50%, payable quarterly on the last day of each March, June, September and December. The Loral Credit Agreement permits SIRIUS to prepay all or a portion of the loans outstanding without penalty. SIRIUS has not borrowed under the Loral Credit Agreement.

XM and XM Holdings Debt

On the date of the Merger, XM and XM Holdings had debt in the aggregate amount of $2,600,000. Following the Merger, XM repurchased notes with aggregate principal amounts outstanding of $795,000 in accordance with “change of control put” terms of such indebtedness. In addition, XM repurchased for approximately $316,598 the transponders of one of its satellites in accordance with the terms of a sale-leaseback transaction. In order to effect these repurchases, XM issued approximately $1,328,500 in aggregate principal amount of new debt securities.

Senior Secured Term Loan

XM is party to a credit agreement dated May 2008 relating to a $100,000 Senior Secured Term Loan (the “XM Term Loan”) with UBS AG. The XM Term Loan matures on May 5, 2009. Interest is payable quarterly. At September 30, 2008 the interest rate was 5.5625%. The interest rate is reset quarterly to 225 basis points over the 9-month LIBOR. The XM Term Loan is secured on a pari passu basis with the XM Revolving Credit Facility (as defined below) by substantially all of XM’s assets.

7% Exchangeable Senior Subordinated Notes due 2014

In August 2008, XM issued $550,000 aggregate principal amount of 7% Exchangeable Senior Subordinated Notes due 2014 (the “Exchangeable Notes”). The Exchangeable Notes are senior subordinated obligations of XM and rank junior in right of payment to its existing and future senior debt and equally in right of payment with its existing and future senior subordinated debt. XM Holdings, XM Equipment LLC and XM Radio Inc. have guaranteed the Exchangeable Notes on a senior subordinated basis. The Exchangeable Notes are not guaranteed by SIRIUS or Satellite CD Radio, Inc. Interest is payable semi-annually in arrears on June 1 and December 1 of each year at a rate of 7% per annum. The Exchangeable Notes mature on December 1, 2014. The Exchangeable Notes are exchangeable at any time at the option of the holder into shares of our common stock, par value $0.001 per share, at an initial exchange rate of 533.3333 shares of common stock per $1,000 principal amount of Exchangeable Notes, which is equivalent to an approximate exchange price of $1.875 per share of common stock.

9.75% Senior Notes due 2014

XM has outstanding $5,260 aggregate principal amount of 9.75% Senior Notes due 2014 (the “9.75% Notes”). Interest on the 9.75% Notes is payable semi-annually on May 1 and November 1 at a rate of 9.75% per annum. The 9.75% Notes are unsecured and will mature on May 1, 2014. XM, at its option, may redeem the 9.75% Notes at declining redemption prices at any time on or after May 1, 2010, subject to certain restrictions. Prior to May 1, 2010, XM may redeem the 9.75% Notes, in whole or in part, at a price equal to 100% of the principal amount thereof, plus a make-whole premium and accrued and unpaid interest to the date of redemption.

Senior Floating Rate Notes due 2013

The aggregate principal amount of XM’s unsecured Senior Floating Rate Notes due 2013 (the “Floating Rate Notes”) outstanding as of December 31, 2007 was $200,000. Interest was payable quarterly on May 1, August 1, November 1 and February 1. XM repurchased all of the Floating Rate Notes in connection with the Merger.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

Debt of Consolidated Variable Interest Entity

On February 13, 2007, XM entered into a sale-leaseback transaction with respect to the transponders on its XM-4 satellite. XM sold the XM-4 transponders to Satellite Leasing (702-4) LLT (“Trust”), a third-party trust formed solely for the purpose of facilitating the sale-leaseback transaction. The Trust pooled the funds used to purchase the transponders from a $57,700 investment by an equity investor and the $230,800 in proceeds from the issuance of its 10% senior secured notes due 2013 (“Debt of consolidated variable interest entity”). XM accounted for the sale and leaseback of the transponders under sale-leaseback accounting with a capital lease, pursuant to SFAS No. 13, Accounting for Leases, as amended. XM also determined that the Trust was a variable interest entity, as that term is defined under FIN No. 46(R), and that XM was the primary beneficiary of the Trust. Pursuant to FIN No. 46(R), XM consolidated the Trust into its consolidated financial statements.

XM sold the XM-4 transponders to the Trust owned by Satellite Leasing (702-4) LLC (“Owner Participant”) for $288,500. XM leased the transponders for a term of nine years. These lease payment obligations, which were unconditional and guaranteed by XM Holdings, were senior unsecured obligations and ranked equally in right of payment with existing and future senior unsecured obligations. Under the terms of the lease, XM was obligated to make payments that total $437,400, of which $126,600 was interest, over the nine-year base lease term.

XM was obligated to provide credit support to the Owner Participant. To provide this credit support, XM retired the existing mortgages on its headquarters and data center properties in Washington, D.C. and put into place new mortgages on those properties in favor of the Owner Participant.

XM repurchased the transponders on its XM-4 satellite in connection with the Merger and terminated this sale leaseback arrangement.

13% Senior Notes due 2014

In July 2008, XM Escrow LLC (“Escrow LLC”), a Delaware limited liability company and wholly-owned subsidiary of XM Holdings, issued $778,500 aggregate principal amount of 13% Senior Notes due 2014 (the “13% Notes”). Interest is payable semi-annually in arrears on February 1 and August 1 of each year at a rate of 13% per annum. The 13% Notes are unsecured and mature in 2014, with such maturity to occur earlier in 2013, in certain circumstances. Escrow LLC deposited the proceeds of the offering of the 13% Notes into escrow. Upon consummation of certain refinancing transactions in connection with the Merger, the funds were released to Escrow LLC and Escrow LLC merged with and into XM, with XM as the surviving corporation. Upon this merger, the 13% Notes became obligations of XM and became guaranteed by XM Holdings, XM Equipment Leasing LLC and XM Radio Inc. The 13% Notes are not guaranteed by SIRIUS.

10% Convertible Senior Notes due 2009

XM Holdings has issued $400,000 aggregate principal amount of 10% Convertible Senior Notes due 2009 (the “10% Convertible Notes”). Interest is payable semi-annually at a rate of 10% per annum. The 10% Convertible Notes mature on December 1, 2009. The 10% Convertible Notes may be converted by the holder, at its option, into shares of our common stock at a conversion rate of 92.0 shares of our common stock per $1,000 principal amount, which is equivalent to a conversion price of $10.87 per share of common stock (subject to adjustment in certain events), at any time until December 1, 2009.

10% Senior Secured Discount Convertible Notes due 2009

XM Holdings and XM, as co-obligors, have outstanding $33,200 aggregate principal amount of 10% Senior Secured Discount Convertible Notes due 2009 (the “10% Discount Convertible Notes”). Interest accreted through December 31, 2005 and was thereafter payable semi-annually at a rate of 10% per annum. The 10% Discount Convertible Notes mature on December 31, 2009. At any time, a

 

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(Dollar amounts in thousands, unless otherwise stated)

 

holder of the notes may convert all or part of the accreted value of its notes at a conversion price of $0.69 per share. The 10% Discount Convertible Notes rank equally in right of payment with all of XM Holdings’ and XM’s other existing and future senior indebtedness, and are senior in right of payment to all of XM Holdings’ and XM’s existing and future subordinated indebtedness.

Senior Secured Revolving Credit Facility

XM is party to a $250,000 Senior Secured Revolving Credit Facility (the “XM Revolving Credit Facility”), which has been fully drawn. The XM Revolving Credit Facility matures on May 5, 2009. Borrowings under the XM Revolving Credit Facility bear interest at a rate of LIBOR plus 150 to 225 basis points or an alternate base rate, to be the higher of the JPMorgan Chase prime rate and the Federal Funds rate plus 50 basis points, in each case plus 50 to 125 basis points. For $187,500 of the drawn amount, the interest rate as of September 30, 2008 was 4.75%; and for $62,500 of the drawn amount, the interest rate as of September 30, 2008 was 5.25%. The XM Revolving Credit Facility is secured by substantially all the assets of XM, other than certain specified property.

Refinancing transactions

In connection with the Merger, we refinanced a substantial portion of XM’s existing indebtedness:

 

   

On July 31, 2008, XM Escrow LLC issued $778,500 aggregate principal amount, net of original issue discount of $78,395, of the 13% Notes; and

 

   

On August 1, 2008, XM issued $550,000 aggregate principal amount of the Exchangeable Notes.

XM used the proceeds from the transactions described above to:

 

   

repurchase 99% of its 9.75% Senior Notes due 2014 at 101%, plus $18,685 in accrued interest. The tender offer for the 9.75% Senior Notes due 2014 included a consent solicitation to amend the indenture governing the 9.75% Senior Notes due 2014;

 

   

repurchase 100% of its Senior Floating Rate Notes due 2013 at par, plus $1,501 in accrued interest; and

 

   

satisfy its $309,400 transponder repurchase obligation, for both debt and equity holders of a consolidated variable interest entity. XM’s debt repurchase obligation included a 1% of principal prepayment penalty and $6,668 in accrued interest.

In July 2008, XM Holdings amended the terms of its $400,000 aggregate principal amount of 1.75% Convertible Senior Notes due 2009 to increase the interest rate from 1.75% to 10% per annum effective July 2, 2008 as part of an agreement whereby holders of the notes waived any right to seek a change of control put in connection with the Merger. This change is expected to result in approximately $16,500 and $30,300 in incremental interest expense in 2008 and 2009, respectively.

In connection with these refinancing transactions, XM and XM Holdings paid in the aggregate approximately $69,200 in fees and expenses.

Covenants and Restrictions

The 9 5/8% Notes, Loral Credit Agreement, SIRIUS Term Loan, XM Term Loan, 13% Notes and XM Revolving Credit Facility require compliance with certain covenants that restrict our ability to, among other things, (i) incur additional indebtedness, (ii) incur liens, (iii) pay dividends or make certain other restricted payments, investments or acquisitions, (iv) enter into certain transactions with affiliates, (v) merge or consolidate with another person, (vi) sell, assign, lease or otherwise dispose of all or substantially all of our assets, and (vii) make voluntary prepayments of certain debt, in each case subject to exceptions as provided in the applicable indenture or credit agreement. SIRIUS operates XM Holdings as an unrestricted subsidiary for purposes of compliance with the covenants contained in its debt instruments. The XM Term Loan and the XM Revolving Credit Facility also require XM to maintain a level of cash and cash equivalents of at least $75,000. If we fail to comply with these covenants, the 9 5/8% Notes, SIRIUS Term Loan, XM Term Loan, 13% Notes, the Revolving Credit Facility and any loans outstanding under the Loral Credit Agreement, the SIRIUS Term Loan and the XM Term Loan could become immediately payable and the Loral Credit Agreement could be terminated.

 

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At September 30, 2008, we were in compliance with all such covenants.

(11) Stockholders’ Equity

Common Stock, par value $0.001 per share

We are authorized to issue up to 4,500,000,000 and 2,500,000,000 shares of common stock as of September 30, 2008 and December 31, 2007, respectively. At our annual meeting of stockholders scheduled to be held in December 2008, we will ask our stockholders to approve an increase to the amount of shares of common stock authorized under our certificate of incorporation to 8,000,000,000. There were 3,250,404,357 and 1,471,143,570 shares of common stock issued and outstanding as of September 30, 2008 and December 31, 2007, respectively.

As of September 30, 2008, approximately 888,696,000 shares of common stock were reserved for issuance in connection with outstanding convertible debt, preferred stock, warrants, incentive stock plans and common stock to be granted to third parties upon satisfaction of performance targets. During the nine months ended September 30, 2008, employees exercised 117,442 stock options at exercise prices ranging from $1.45 to $3.36 per share, resulting in proceeds to us of $208.

In January 2004, SIRIUS signed a seven-year agreement with the National Football League® (“NFL”). Upon execution of this agreement, SIRIUS delivered to the NFL 15,173,070 shares of common stock valued at $40,967. These shares of common stock are subject to transfer restrictions which lapse over time. We recognized expense associated with these shares of $1,641 during each three months periods ended September 30, 2008 and 2007, and $3,501 during each nine months periods ended September 30, 2008 and 2007. Of the remaining $15,624 in common stock value, $5,852 and $9,772 are included in Other current assets and Other long-term assets, respectively, in the condensed consolidated balance sheets as of September 30, 2008.

Convertible Preferred Stock, par value $0.001 per share

We are authorized to issue up to 50,000,000 shares of undesignated preferred stock as of September 30, 2008. There were 24,808,959 and zero shares of Series A convertible preferred stock issued and outstanding as of September 30, 2008 and December 31, 2007, respectively. The liquidation preference on the preferred stock issued and outstanding as of September 30, 2008 was $51,370.

The shares of Series A convertible preferred stock are convertible into common stock at the option of the holder and receive dividends, if declared, ratably with our common stock.

Warrants

We have issued warrants to purchase shares of common stock in connection with distribution and programming agreements, satellite purchase agreements and certain debt issuances. As of September 30, 2008, warrants to acquire 92,092,000 shares of common stock with an average exercise price of $4.12 per share were outstanding. These warrants vest over time or upon the achievement of milestones and expire at various times through June 2014. For the three and nine months ended September 30, 2008, we recognized a (benefit) expense of ($620) and $2,236, respectively. For the comparable periods in 2007, we recognized expense of $5,382 and $11,331, respectively, in connection with these warrants.

Share Lending Agreements

To facilitate the offering of the Exchangeable Notes, we entered into share lending agreements with Morgan Stanley Capital Services Inc. (“MS”) and UBS AG London Branch (“UBS”) under which we loaned MS and UBS an aggregate of approximately 263,000,000 shares of our common stock in exchange for a fee of $.001 per share. The obligations of MS to us under its share lending agreement are guaranteed by its parent company, Morgan Stanley.

 

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(Dollar amounts in thousands, unless otherwise stated)

 

Under each share lending agreement, the share loan will terminate in whole or in part, as the case may be, and the relevant borrowed shares must be returned to us upon the earliest of the following: (i) the share borrower terminates all or a portion of the loan between it and us, (ii) we notify the share borrower that some of the Exchangeable Notes as to which borrowed shares relate have been exchanged, repaid or repurchased or are otherwise no longer outstanding, (iii) the maturity date of the Exchangeable Notes, December 1, 2014, (iv) the date as of which the entire principal amount of the Exchangeable Notes ceases to be outstanding as a result of exchange, repayment, repurchase or otherwise or (v) the termination of the share lending agreement by the share borrower or by us upon default by the other party, including but not limited to the bankruptcy of us or the share borrower or, in the case of the MS share lending agreement, the guarantor. A share borrower may delay the return of borrowed shares for up to 30 business days (or under certain circumstances, up to 60 business days) if such share borrower is legally prevented from returning the borrowed shares to us, in which case the share borrower may, under certain circumstances, choose to pay us the value of the borrowed shares in cash instead of returning the borrowed shares. Once borrowed shares are returned to us, they may not be re-borrowed under the share lending agreements.

The shares that we loaned to the share borrowers are issued and outstanding for corporate law purposes, and holders of borrowed shares (other than the share borrowers) have the same rights under those shares as holders of any of our other outstanding common shares. Under GAAP as currently in effect, however, we believe the borrowed shares are not considered outstanding for the purpose of computing and reporting our net loss per common share. This accounting method is subject to change if the Financial Accounting Standards Board or the Emerging Issues Task Force adopts rules or issues guidance on the treatment of this type of share loan that requires an accounting method that is different from the method we are currently utilizing. The accounting method may also change if, due to a change in the credit conditions of either MS or UBS, or of Morgan Stanley, as guarantor, or otherwise, there is an increased likelihood that the borrowed shares, or the equivalent value of those shares, will not be returned to us as required under the share lending agreements. If we are required in the future to treat the borrowed shares as outstanding for purposes of computing earnings/loss per share, our earnings per share or loss per share, as the case may be, would be reduced.

(12) Benefit Plans

We maintain four share-based benefits plans. We satisfy awards and options granted under these plans through the issuance of new shares. During the three and nine months ended September 30, 2008, we recognized share-based payment expense of $24,005 and $63,417, respectively. For the comparable periods in 2007, we recognized share-based payment expense of $22,727 and $64,004, respectively. Compensation expense was recorded in our unaudited condensed consolidated statements of operations related to these plans. We did not capitalize any share-based payment cost during the three and nine months ended September 30, 2008 and 2007. We did not realize any income tax benefits from share-based benefits plans during the three and nine months ended September 30, 2008 and 2007, as a result of a full valuation allowance that is maintained for substantially all net deferred tax assets.

2003 Long-Term Stock Incentive Plan

SIRIUS maintains the Amended and Restated Sirius Satellite Radio 2003 Long-Term Stock Incentive Plan (the “2003 Plan”). Employees, consultants and members of our board of directors are eligible to receive awards under the 2003 Plan. The 2003 Plan provides for the grant of stock options, restricted stock, restricted stock units and other stock-based awards that the compensation committee of our board of directors may deem appropriate. Vesting and other terms of stock-based awards are set forth in the agreements with the individuals receiving the awards. Stock-based awards granted under the 2003 Plan are generally subject to a vesting requirement. Stock-based awards generally expire ten years from the date of grant. Each restricted stock unit entitles the holder to receive one share of common stock upon vesting. As of September 30, 2008, approximately 93,832,000 shares of common stock were available for future grant under the 2003 Plan.

2007 Stock Incentive Plan

XM Holdings maintains a 2007 Stock Incentive Plan (the “2007 Plan”) under which officers, other employees and other key individuals of XM may be granted various types of equity awards, including restricted stock, stock units, stock options, stock appreciation rights, dividend equivalent rights and other stock awards. Stock option awards under the 2007 Plan generally vest ratably

 

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over three years based on continuous service, while restricted stock generally vests ratably over one or three years based on continuous service. Stock option awards are granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. Grants of equity awards other than stock options or stock appreciation rights reduce the number of shares available for future grant by 1.5 times the number of shares granted under such equity awards. In connection with the Merger, the shares available for future grant under the 2007 Plan were adjusted using a conversion factor of 4.6 SIRIUS shares for each XM Holdings share. Since the Merger, there have been no grants of awards from the 2007 Plan. As of September 30, 2008, there were 60,084,705 shares available under the 2007 Plan for future grant.

1998 Shares Award Plan

XM Holdings maintains a 1998 Shares Award Plan (the “1998 Plan”) under which employees, consultants and non-employee directors of XM were granted stock options and restricted stock awards. Stock option awards and restricted stock awards under the 1998 Plan generally vest ratably over three years based on continuous service. Stock option awards are generally granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. The 1998 Plan terminated in June 2008 and shares are no longer available for future grant.

XM Talent Option Plan

XM Holdings maintains a Talent Option Plan (the “Talent Plan”) under which non-employee programming consultants to XM may be granted stock options awards. Stock option awards under the Talent Plan generally vest ratably over three years based on continuous service. Stock option awards are generally granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. In connection with the Merger, the shares available for future grant under the Talent Plan were adjusted using a conversion factor of 4.6 SIRIUS shares for each XM share. Since the Merger, there have been no grants of awards from the Talent Plan. As of September 30, 2008, there were 1,564,000 options available under the Talent Plan for future grant.

Merger

In connection with the Merger, all outstanding XM options and restricted stock were converted into the right to receive 4.6 shares of our common stock for each share issuable upon exercise or vesting of such XM option or share of restricted stock. The conversion rate was also applied to the original grant date exercise price. There was no acceleration of vesting solely as a result of the exchange and the original expiration dates of the options and restricted stock remain in effect. The fair value of these options was estimated using the Black-Scholes option pricing model.

The following table summarizes the weighted-average assumptions used to compute reported share-based payment expense to employees and members of our board of directors for the periods set forth below:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Risk-free interest rate

   3.1 %   4.5 %   2.7 %   4.8 %

Expected life of options—years

   4.06     4.45     4.06     4.45  

Expected stock price volatility

   80 %   60 %   80 %   60 %

Expected dividend yield

   N/A     N/A     N/A     N/A  

 

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(Dollar amounts in thousands, unless otherwise stated)

 

The following table summarizes the range of assumptions used to compute reported share-based payment expense to third parties, other than non-employee members of our board of directors, for the periods set forth below:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Risk-free interest rate

   2.0 - 3.0 %   4.0 - 4.8 %   1.6 - 3.3 %   4.0 - 5.0 %

Expected life of options—years

   1.50 - 4.06     2.50 - 8.91     1.50 - 4.08     2.50 - 8.91  

Expected stock price volatility

   80 %   60 %   80 %   60 %

Expected dividend yield

   N/A     N/A     N/A     N/A  

The following table summarizes stock option activity under our share-based payment plans for the nine months ended September 30, 2008 (shares in thousands):

 

     Shares     Weighted-Average
Exercise
Price
   Weighted-Average
Remaining
Contractual
Term (Years)

Outstanding, January 1, 2008

   79,600     $                 5.38   

Options exchanged for outstanding XM options

   67,711     $ 4.09   

Granted

   17,492     $ 2.89   

Exercised

   (117 )   $ 1.74   

Forfeited, cancelled or expired

   (2,862 )   $ 4.60   
           

Outstanding, September 30, 2008

               161,824     $ 4.59    6.03

Exercisable, September 30, 2008

   115,862     $ 4.91    5.24

The weighted average grant date fair value of options granted during the nine months ended September 30, 2008 and 2007 was $1.73 and $1.88, respectively. The total intrinsic value of stock options exercised during the nine months ended September 30, 2008 and 2007 was $127 and $1,792, respectively.

We recognized share-based payment expense associated with stock options of $13,940 and $36,465 for the three and nine months ended September 30, 2008, respectively. For the comparable periods in 2007, we recognized expense of $10,323 and $31,614, respectively.

The following table summarizes the non-vested restricted stock and restricted stock unit activity under our share-based payment plans for the nine months ended September 30, 2008 (shares in thousands):

 

     Shares     Weighted-Average
Grant Date

Fair Value

Nonvested, January 1, 2008

   3,623     $                 3.70

Shares exchanged for non-vested XM shares

   33,339     $ 2.93

Granted

   3,208     $ 2.87

Vested

   (12,438 )   $ 3.11

Forfeited

   (1,456 )   $ 2.86
            

Nonvested, September 30, 2008

                 26,276     $ 2.87
            

 

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The weighted average grant date fair value of restricted stock units granted during the nine months ended September 30, 2008 and 2007 was $2.87 and $3.58, respectively. The total intrinsic value of restricted stock units that vested during the nine months ended September 30, 2008 and 2007 was $19,529 and $8,667, respectively.

We recognized share-based payment expense associated with restricted stock units and shares of restricted stock of $5,342 and $9,956 for the three and nine months ended September 30, 2008, respectively. For the comparable periods in 2007, we recognized expense of $2,219 and $8,436, respectively.

For the three and nine months ended September 30, 2008, we recognized share-based payment expense of $1,507 and $4,477 for restricted stock units granted for services performed in 2008. For the comparable periods in 2007, we recognized share-based payment expense of $1,282 and $3,687, respectively, for restricted stock units granted for services performed in 2007.

Total unrecognized compensation costs related to unvested share-based payment awards granted to employees and members of our board of directors at September 30, 2008 and December 31, 2007, net of estimated forfeitures, was $114,092 and $80,635, respectively. The weighted-average period over which the compensation expense for these awards is expected to be recognized is three years as of September 30, 2008.

No income tax benefits have been realized from stock option exercises during the three and nine months ended September 30, 2008 and 2007 because a valuation allowance was maintained for all net deferred tax assets.

401(k) Savings Plans

We sponsor the Sirius Satellite Radio 401(k) Savings Plan (the “Sirius Plan”) and the XM Satellite Radio 401(k) Savings Plan (the “XM Plan”) for eligible employees. The Sirius Plan allows eligible employees to voluntarily contribute from 1% to 50% of their pre-tax salary subject to certain defined limits, while the XM Plan allows eligible employees to defer the maximum percentage of their compensation allowable under law on a pre-tax basis through contributions to the savings plan. Under the Sirius Plan, SIRIUS matches 50% of an employee’s voluntary contributions, up to 6% of an employee’s pre-tax salary, in the form of shares of common stock. Matching contributions under the Sirius Plan vest at a rate of 33 1/3 % for each year of employment and are fully vested after three years of employment. Under the XM Plan, XM matches 50% of an employee’s voluntary contributions, up to 6% of an employee’s pre-tax salary, in cash. Matching contributions under the XM Plan vest immediately. Expense resulting from the matching contribution to the plans was $857 and $2,086 for the three and nine months ended September 30, 2008, respectively. For the comparable periods in 2007, the expense was $430 and $1,223, respectively.

SIRIUS may also elect to contribute to the profit sharing portion of the Sirius Plan based upon the total compensation of eligible participants. These additional contributions, referred to as profit-sharing contributions, are determined by the compensation committee of our board of directors. SIRIUS employees are only eligible to receive profit-sharing contributions during any year in which they are employed on the last day of the year. Profit-sharing contribution expense was $1,665 and $5,025 for the three and nine months ended September 30, 2008, respectively. For the comparable periods in 2007, the expense was $1,450 and $4,213, respectively.

(13) Income Taxes

We recorded income tax expense of $1,215 and $2,301 for the three and nine months ended September 30, 2008, respectively. For the comparable periods in 2007, the expense was $555 and $1,665, respectively. Such expense represents the recognition of a deferred tax liability related to the difference in accounting for the FCC licenses, which are amortized over 15 years for tax purposes but are not amortized for book purposes.

 

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(14) Commitments and Contingencies

The following table summarizes our expected contractual cash commitments as of September 30, 2008:

 

(in thousands)    Remaining
2008
   2009    2010    2011    2012    Thereafter    Total

Long-term debt obligations

   $ 3,328    $   1,097,910    $ 12,512    $     235,143    $ 239,402    $   1,833,760    $   3,422,055

Cash interest payments

     44,432      269,411          210,281      209,190          196,314      316,583      1,246,211

Lease obligations

     10,573      41,460      37,078      23,146      18,271      29,990      160,518

Satellite and transmission

     52,599      159,859      106,308      46,500      7,671      41,038      413,975

Programming and content

     61,021      244,349      219,509      75,870      68,600      53,833      723,182

Marketing and distribution

     53,758      32,494      32,760      21,121      11,783      —        151,916

Chip set development and production

     3,354      —        —        —        —        —        3,354

Satellite performance incentive payments

     1,393      4,096      4,384      4,695      5,030      48,223      67,821

Other

     3,944      10,603      3,289      14      —        —        17,850
                                                

Total

   $     234,402    $ 1,860,182    $ 626,121    $ 615,679    $ 547,071    $ 2,323,427    $ 6,206,882
                                                

Debt Obligations. Long-term debt obligations include principal payments on outstanding debt.

Cash Interest Payments. Cash interest payments include interest due on outstanding debt through maturity.

Lease Obligations. We have entered into operating leases related to certain studios, office space, terrestrial repeaters and equipment.

Satellite and Transmission. We have entered into agreements with third parties to operate and maintain the off-site satellite telemetry, tracking and control facilities and certain components of our terrestrial repeater networks. We have also entered into various agreements to design and construct satellites for use in our systems and to launch those satellites.

SIRIUS has entered into an agreement with Space Systems/Loral to design and construct a fifth and sixth satellite. SIRIUS plans to launch one satellite on a Proton rocket under an existing contract with International Launch Services. In January 2008, SIRIUS entered into an agreement with International Launch Services to secure two additional satellite launches on Proton rockets. SIRIUS plans to use one of these rockets to launch its sixth satellite. This agreement provides SIRIUS with the flexibility to defer launch dates if it chooses, and the ability to cancel the second of these launches upon payment of a cancellation fee.

XM has also entered into an agreement with Space Systems/Loral to construct its fifth satellite, XM-5. On July 15, 2003, Space Systems/Loral, Loral Space & Communications Ltd. and certain other affiliated entities commenced voluntary Chapter 11 bankruptcy cases under the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. The Bankruptcy Court approved XM’s agreement with Space Systems/Loral, pursuant to which XM may make construction payments on XM-5 into an escrow account until the occurrence of an “Emergence Date,” as defined in the agreement. In August 2007, XM’s agreement with Space Systems/Loral was amended to defer payments on the remaining construction costs until the earlier of post-launch or January 2010.

Boeing Satellite Systems International, Inc., the manufacturer of XM’s four in-orbit satellites, may be entitled to future in-orbit performance payments with respect to two of XM’s four satellites. As of September 30, 2008, we have accrued $35,780 related to contingent in-orbit performance payments for XM-3 and XM-4 based on expected operating performance over their fifteen year design

 

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life. Boeing may also be entitled to an additional $10,000 if XM-4 continues to operate above baseline specifications during the five years beyond the satellite’s fifteen year design life.

Programming and Content. We have entered into various 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.

Marketing and Distribution. We have entered into various marketing, sponsorship and distribution agreements to promote our brand and are obligated to make payments to sponsors, retailers, automakers and radio manufacturers under these agreements. Certain programming and content agreements also require us to purchase advertising on properties owned or controlled by the licensors. We also reimburse automakers for certain engineering and development costs associated with the incorporation of satellite radios into vehicles they manufacture. In addition, in the event that certain new products are not shipped by a distributor to its customers within 90 days of the distributor’s receipt of goods, we have agreed to purchase and take title to the product.

Chip Set Development and Production. We have entered into agreements with third parties to develop, produce and supply chip sets, to develop products and, in certain instances, to license intellectual property related to chip sets.

Other. We have entered into various agreements with third parties for general operating purposes. In addition to the contractual cash commitments described above, we have entered into agreements with automakers, radio manufacturers, distributors and others that include per-radio, per-subscriber, per-show and other variable cost arrangements. These future costs are dependent upon many factors, including subscriber growth, and are difficult to anticipate; however, these costs may be substantial. We may enter into additional programming, distribution, marketing and other agreements that contain similar provisions.

We are required under the terms of certain agreements to provide letters of credit and deposit monies in escrow, which place restrictions on cash and cash equivalents. As of September 30, 2008 and December 31, 2007, $141,250 and $53,000, respectively, was classified as Restricted investments as a result of reimbursement obligations under these letters of credit and escrow deposits.

Other than those disclosed herein, we have not entered into any other material off-balance sheet arrangements or transactions.

Legal Proceedings

FCC Matters. In August 2008, we entered into two Consent Decrees to settle with the Enforcement Bureau of the Federal Communications Commission outstanding enforcement matters pending against SIRIUS and XM. In 2006, the FCC commenced investigations regarding the compliance of certain radios that include FM transmitters with the Commission’s rules, and the compliance of certain terrestrial repeaters with the special temporary authority granted by the Commission. The Consent Decrees terminated these inquiries.

As part of the Consent Decrees, we agreed, among other things, to:

 

   

adopt comprehensive compliance plans, and take steps to address any potentially non-compliant radios in the hands of consumers;

 

   

in the case of XM, within 60 days of the order adopting the Consent Decrees, shut down 50 variant terrestrial repeaters, and shut down or bring into compliance an additional 50 variant terrestrial repeaters;

 

   

in the case of SIRIUS, receive special temporary authority to operate two of its eleven variant terrestrial repeaters. These eleven terrestrial repeaters were shut off by SIRIUS in October 2006; and

 

   

make voluntary contributions to the United States Treasury of approximately $17,000 in the case of XM, and approximately $2,000 in the case of SIRIUS.

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

We have taken all of these actions, and are in compliance with the terms of the Consent Decrees.

FCC Merger Order. On July 25, 2008, the FCC adopted an order approving the Merger. The order became effective immediately upon adoption. This order was published in the Federal Register on September 8, 2008. On September 4, 2008, Mt. Wilson FM Broadcasters, Inc. filed a Petition for Reconsideration of the FCC’s merger order. This Petition for Reconsideration remains pending.

Appellate Review of FCC Merger and Consent Decree Orders. Two different parties, U.S. Electronics and Michael Hartleib, have sought appellate review of the FCC’s decision regarding the Merger. Each party also challenged the FCC’s decision to enter into the consent decrees mentioned above. These matters were both filed in the United States Court of Appeals for the D.C. Circuit, and have been consolidated by the court. We have moved to intervene, and that motion has been granted. Subsequent to filing its initial request for appellate review, U.S. Electronics moved to both amend its original filing and submit an additional notice of appeal in order to comply with the statutory requirements for review of agency decisions. The FCC has moved to dismiss both the Hartleib and the U.S. Electronics requests for review on the grounds that neither party has standing to challenge the merger order or the consent decrees, and has further argued that the agency’s decision to enter into a consent decree is not reviewable by the court in these circumstances. Separately, the court issued a show cause order on its own motion that requires U.S. Electronics to demonstrate why its additional notice of appeal should not be dismissed as untimely.

Copyright Royalty Board Proceeding. In January 2008, the Copyright Royalty Board, or CRB, of the Library of Congress issued its decision regarding the royalty rate payable by us under the statutory license covering the performance of sound recordings over our satellite digital audio radio services for the six-year period starting January 1, 2007 and ending December 31, 2012. Under the terms of the CRB’s decision, we will pay a royalty of 6.0% of gross revenues, subject to certain exclusions, for 2007 and 2008, 6.5% for 2009, 7.0% for 2010, 7.5% for 2011 and 8.0% for 2012. SoundExchange has appealed the decision of the CRB to the United States Court of Appeals for the District of Columbia Circuit. Final briefs in this matter are scheduled to be submitted to the United States Court of Appeals for the District of Columbia Circuit by the end of February 2009.

U.S. Electronics Arbitration. In May 2006, U.S. Electronics Inc., a former licensed distributor and manufacturer of SIRIUS radios, commenced an arbitration proceeding against SIRIUS. U.S. Electronics alleged that SIRIUS breached its contract; failed to pay monies owed under the contract; tortiously interfered with U.S. Electronics’ relationships with retailers and manufacturers; and otherwise acted in bad faith. U.S. Electronics sought up to $133,000 in damages. In August 2008, following a 20-day arbitration hearing, a panel of three arbitrators unanimously issued a 149-page Final Award dismissing with prejudice all of U.S. Electronics’ claims, including its claims for lost profits.

Atlantic Recording Corporation, BMG Music, Capital Records, Inc., Elektra Entertainment Group Inc., Interscope Records, Motown Record Company, L.P., Sony BMG Music Entertainment, UMG Recordings, Inc., Virgin Records, Inc and Warner Bros. Records Inc. v. XM Satellite Radio Inc. In May 2006, the plaintiffs filed this action in the United States District Court for the Southern District of New York. The complaint seeks monetary damages and equitable relief, and alleges that XM radios that include advanced recording functionality infringe upon plaintiffs’ copyrighted sound recordings. XM filed a motion to dismiss this matter, and that motion was denied in January 2007. XM has resolved the lawsuit with respect to Universal Music Group, Warner Music Group, Sony BMG Music Entertainment and EMI Group, and each of these parties have withdrawn as a party to the lawsuit and this lawsuit has been dismissed.

Music publishing companies and certain other record companies also have filed lawsuits, purportedly on a class basis, with similar allegations. XM believes these allegations are without merit and that these products comply with applicable copyright law, including the Audio Home Recording Act, and intends to vigorously defend this matter. There can be no assurance regarding the ultimate outcome of these matters, or the significance, if any, to our business, consolidated results of operations or financial position.

Matthew Enderlin v. XM Satellite Radio Holdings Inc. and XM Satellite Radio Inc. In January 2006, the plaintiff filed this action in the United States District Court for the Eastern District of Arkansas on behalf of a purported nationwide class of all XM subscribers. The complaint alleges that XM engaged in a deceptive trade practices under Arkansas and other state laws by representing that its music

 

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SIRIUS XM RADIO INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollar amounts in thousands, unless otherwise stated)

 

channels are commercial-free. The court stayed the litigation and directed the parties to arbitration. XM instituted arbitration with the American Arbitration Association pursuant to the compulsory arbitration clause in its customer service agreement. The plaintiff has filed a counterclaim in the arbitration on behalf of the class that he seeks to represent. XM believes the matter is without merit and intends to vigorously defend the ongoing arbitration. There can be no assurance regarding the ultimate outcome of this matter, or the significance, if any, to our business, consolidated results of operations or financial position.

Other Matters. In the ordinary course of business, we are a defendant in various lawsuits and arbitration proceedings, including actions filed by former employees, parties to contracts or leases and owners of patents, trademarks, copyrights or other intellectual property. None of these actions are, in our opinion, likely to have a material adverse effect on our business, consolidated results of operations or financial results.

(15) Subsequent Events

Since September 30, 2008, we have issued or entered into agreements to issue an aggregate of 262,911,513 shares of our common stock, par value $0.001 per share, in exchange for $90,772 principal amount of the 2 1/2% Notes beneficially owned by institutional holders.

We did not receive any cash proceeds as a result of the exchange of our common stock for the 2 1/2% Notes, which notes were retired and cancelled. We executed these transactions to reduce our debt and interest cost, increase our equity, and improve our balance sheet. We may engage in additional exchanges in respect of our outstanding indebtedness if and as favorable opportunities arise.

The issuance of the shares of our common stock was made pursuant to the exemption from the registration requirements of the Securities Act of 1933, as amended, contained in Section 3(a)(9) of such Act.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
     (All dollar amounts referenced in this Item 2 are in thousands, unless otherwise stated)

Special Note Regarding Forward-Looking Statements

The following cautionary statements identify important factors that could cause our actual results to differ materially from those projected in forward-looking statements made in this Quarterly Report on Form 10-Q and in other reports and documents published by us from time to time. Any statements about our beliefs, plans, objectives, expectations, assumptions, future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimated,” “intend,” “plan,” “projection” and “outlook.” Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout our Annual Report on Form 10-K for the year ended December 31, 2007 (the “Form 10-K”) and in other reports and documents published by us from time to time, particularly the risk factors described under “Business—Risk Factors” in Item 1A of the Form 10-K.

Among the significant factors that could cause our actual results to differ materially from those expressed in the forward-looking statements are:

 

   

our substantial indebtedness, which could adversely affect our financial health, and our need to refinance substantial portions of our debt in the near term, which refinancing may not be available on favorable terms, if at all;

 

   

our merger with XM, including the possibility that the anticipated benefits of the merger may not be fully realized or may take longer to realize; and the risks associated with the undertakings made to the FCC and its affects on our business in the future;

 

   

the useful life of SIRIUS’ and XM’s satellites, which have experienced failures on their solar arrays and other component failures and, in certain cases, are not insured;

 

   

our dependence upon third parties, including manufacturers and distributors of satellite radios, retailers, automakers and programming providers; and

 

   

our competitive position versus other forms of audio and video entertainment including terrestrial radio, HD radio, internet radio, mobile phones, iPods and other MP3 devices, and emerging next generation networks and technologies.

Because the risk factors referred to above could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any of these forward-looking statements. In addition, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which the statement is made, to reflect the occurrence of unanticipated events or otherwise. New factors emerge from time to time, and it is not possible for us to predict which will arise or to assess with any precision the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

Executive Summary

We provide satellite radio in the United States. We broadcast music, sports, news, talk, entertainment, traffic and weather for a subscription fee through proprietary satellite radio systems – the SIRIUS system and the XM system. On July 28, 2008, our wholly owned subsidiary, Vernon Merger Corporation, merged (the “Merger”) with and into XM Satellite Radio Holdings Inc. and, as a result, XM Satellite Radio Holdings Inc. is now our wholly owned subsidiary. The SIRIUS satellite radio system consists of three in-orbit satellites, approximately 120 terrestrial repeaters that receive and retransmit signals, satellite uplink facilities and studios. The XM satellite radio system consists of four in-orbit satellites, over 700 terrestrial repeaters that receive and retransmit signals, satellite uplink facilities and studios. Subscribers can also receive music channels and certain other channels over the internet.

Our radios are primarily distributed through retailers; automakers, or OEMs; and through our websites. On September 30, 2008, SIRIUS and XM radios were available at more than 20,000 retail locations. We also have agreements with every major automaker, Acura/Honda, Aston Martin, Audi, Automobili Lamborghini, Bentley, BMW, Chrysler, Dodge, Ford, General Motors, Honda, Hyundai, Infiniti/Nissan, Jaguar, Jeep, Kia, Land Rover, Lincoln, Lexus/Toyota/Scion, Maybach, Mazda, Mercedes-Benz, Mercury, MINI, Mitsubishi, Rolls-Royce, Volvo and

 

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Volkswagen, to offer either SIRIUS or XM satellite radios as factory or dealer-installed equipment in their vehicles. SIRIUS and XM radios are also offered to customers of rental car companies, including Hertz and Avis.

As of September 30, 2008, we had 18,920,911 subscribers compared with 17,348,622 pro-forma subscribers (8,321,785 actual subscribers) as of December 31, 2007 and 16,234,070 pro-forma subscribers (7,667,476 actual subscribers) as of September 30, 2007. Our current subscriber total includes 9,716,070 XM subscribers that we acquired as a result of the Merger. Our subscriber totals include subscribers under our regular pricing plans; subscribers that have prepaid, including payments received from automakers for prepaid subscriptions included in the sale or lease price of a new vehicle; active SIRIUS radios under our agreement with Hertz; active XM radios under its agreement with Avis; and subscribers to SIRIUS Internet Radio and XM Internet Radio, our Internet services.

Our primary source of revenue is subscription fees, with most of our customers subscribing on an annual, semi-annual, quarterly or monthly basis. We offer discounts for pre-paid and long-term subscriptions as well as discounts for multiple subscriptions. Currently, we receive an average of approximately eight months of prepaid revenue per subscriber upon activation. We also derive revenue from activation fees, the sale of advertising on select non-music channels, the direct sale of satellite radios and accessories, and other ancillary services, such as our Backseat TV, data and weather services. We believe our ability to attract and retain subscribers depends in large part on creating and sustaining distribution channels for satellite radios, the strength of our brands, and the quality and entertainment value of our programming.

In certain cases, automakers include a subscription to our radio services in the sale or lease price of vehicles. The length of these prepaid subscriptions varies, but is typically three months to one year. In many cases, we receive subscription payments from automakers in advance of the activation of our service. We also reimburse various automakers for certain costs associated with satellite radios installed in their vehicles.

We also have an interest in the satellite radio services offered in Canada. SIRIUS Canada Inc. (“SIRIUS Canada”), a Canadian corporation that we jointly own with Canadian Broadcasting Corporation and Standard Radio Inc., offers a satellite radio service in Canada. SIRIUS Canada offers 120 channels of commercial-free music and news, sports, talk and entertainment programming, including 11 channels offering Canadian content. Canadian Satellite Radio Holdings Inc. (“XM Canada”), a Canadian corporation in which we have an ownership interest, also offers satellite radio service in Canada. XM Canada offers 130 channels of music and news, sports, talk and entertainment programming. Subscribers to the SIRIUS Canada service and the XM Canada service are not included in our subscriber count.

On August 5, 2008, Sirius Satellite Radio Inc. changed its name to Sirius XM Radio Inc. XM Satellite Radio Holdings Inc., together with its subsidiaries, is operated as an unrestricted subsidiary under our existing indebtedness. As an unrestricted subsidiary, transactions between the companies are required to comply with various contractual provisions in our respective debt instruments.

Economic Outlook

Current economic conditions, particularly the dramatic and recent slowdown in auto sales, have negatively impacted our subscriber growth for 2008 and 2009.

FCC Conditions

In order to demonstrate to the FCC that the Merger was in the public interest, we agreed to implement a number of voluntary commitments. These programming, minority and public interest, equipment, subscription rates, and other service commitments are summarized as follows:

Programming

A La Carte Programming: We have committed to offer the following a la carte programming options to eligible radios:

 

   

50 channels will be available for $6.99 a month. Additional channels can be added for 25 cents each, with premium programming priced at additional cost. However, in no event will a customer subscribing to this a la carte option pay more than $12.95 per month for this programming.

 

   

100 channels, including channels from both services, will be available on an a la carte basis for $14.99 a month.

 

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We have, including channels from both services, introduced these packages and a radio capable of receiving them.

“Best of Both” Programming: We offer customers the ability to receive the best of both SIRIUS and XM programming at a monthly cost of $16.99.

Mostly Music or News, Sports and Talk Programming: We offer customers an option of “mostly music” programming or “mostly news, sports and talk” programming at a cost of $9.99 per month.

Discounted Family-Friendly Programming: We offer consumers a “family-friendly” version of existing SIRIUS or XM programming at a cost of $11.95 a month, representing a discount of $1.00 per month. We also offer SIRIUS and XM customers a family-friendly version of the Best of Both Programming. This programming costs $14.99 per month, representing a discount of $2.00 per month from the cost of the “best of” programming.

Public Interest and Qualified Entity Channels

We have agreed to set aside four percent of the full-time audio channels on the SIRIUS platform and on the XM platform, which currently represents six channels on the SIRIUS platform and six channels on the XM platform, for noncommercial, educational and informational programming within the meaning of the FCC rules that govern a similar obligation of direct broadcast satellite providers. We will not select a programmer to fill more than one non-commercial, educational or informational channel on each of the SIRIUS and XM platforms as long as demand for such channels exceeds available supply.

In addition, we have agreed to enter into long-term leases or other agreements to provide to a Qualified Entity or Entities, defined as an entity or entities that are majority-owned by persons who are African American, not of Hispanic origin; Asian or Pacific Islanders; American Indians or Alaskan Natives; or Hispanics, rights to four percent of the full-time audio channels on the SIRIUS platform and on the XM platform, which currently represents six channels on the SIRIUS platform and six channels on the XM platform. As digital compression technology enables us to broadcast additional full-time audio channels, we will ensure that four percent of full-time audio channels on the SIRIUS platform and the XM platform are reserved for a Qualified Entity or Entities.

The Qualified Entity or Entities will not be required to make any lease payments for such channels. We will have no editorial control over these channels. We expect the FCC to inform us how it plans to select these Qualified Entities in the future.

Equipment

We are required to provide, on commercially reasonable terms, our intellectual property necessary to permit any device manufacturer to develop equipment that can deliver our satellite radio services. Chip sets for satellite radios, which include the encryption, conditional access and security technology necessary to access our satellite radio services, may be purchased by licensees from manufacturers in negotiated transactions with such manufacturers. We will not enter into any agreement that grants, or that would have the effect of granting, a device manufacturer an exclusive right to manufacture, market and sell equipment that can deliver our satellite radio services.

We will also not execute any agreement or take any other action that would bar, or have the effect of barring, a car manufacturer or other third party from including non-interfering HD radio chips, iPod compatibility, or other audio technology in an automobile or audio device.

Service to Puerto Rico

We have filed applications with the FCC to provide the SIRIUS satellite radio service to the Commonwealth of Puerto Rico using terrestrial repeaters and will, upon grant of the necessary permanent authorizations, promptly introduce SIRIUS satellite radio service to the Commonwealth.

Interoperable Receivers

Within nine months of the consummation of the Merger, April 28, 2009, we will offer for sale an interoperable receiver in the retail after-market.

 

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Subscription Rates

We have agreed not to raise the retail price for, or reduce the number of channels in, our basic $12.95 per month subscription package, the a la carte programming packages or the new programming packages described above until July 28, 2011, thirty six months after consummation of the Merger. After July 29, 2009, the first anniversary of the consummation of the Merger, we may pass through cost increases incurred since the filing of our FCC merger application as a result of statutorily or contractually required payments to the music, recording and publishing industries for the performance of musical works and sound recordings or for device recording fees. We will provide customers, either on individual bills or on our website, specific costs passed through to consumers pursuant to the preceding sentence.

Local Programming and Advertising

We have committed not to originate local programming or advertising through our repeater networks.

Pro Forma Information

The following discussion of our pro forma information includes non-GAAP financial results and measures that assume the Merger occurred on January 1, 2007. These financial results exclude the impact of purchase price accounting adjustments and refinancing transactions. We believe this non-GAAP financial information provides meaningful supplemental information regarding our operating performance and is used for internal management purposes, when publicly providing the business outlook, and as a means to evaluate period-to-period comparisons. Please refer to the footnotes following our discussion of results of operations for the definitions and further discussion of usefulness of such non-GAAP financial measures.

Subscriber and Key Operating Metrics. The following tables contain our pro forma subscribers and key operating metrics for the three and nine months ended September 30, 2008 and 2007:

Pro Forma Subscribers and Metrics:

 

     Pro Forma
Three months ended
September 30,
    Pro Forma
Nine months ended
September 30,
 
     2008     2007     2008     2007  

Beginning subscribers

   18,576,830     15,394,319     17,348,622     13,653,107  

Gross subscriber additions

   1,846,996     1,950,842     5,999,714     5,751,123  

Deactivated subscribers

   (1,502,915 )   (1,111,092 )   (4,427,425 )   (3,170,161 )
                        

Net additions

   344,081     839,750     1,572,289     2,580,962  
                        

Ending subscribers

   18,920,911     16,234,069     18,920,911     16,234,069  
                        

Retail

   9,036,420     8,927,442     9,036,420     8,927,442  

OEM

   9,777,704     7,238,239     9,777,704     7,238,239  

Rental

   106,787     68,388     106,787     68,388  
                        

Ending subscribers

   18,920,911     16,234,069     18,920,911     16,234,069  
                        

Retail

   (149,416 )   46,730     (202,291 )   472,996  

OEM

   492,215     783,400     1,744,432     2,068,732  

Rental

   1,282     9,620     30,148     39,234  
                        

Net additions

   344,081     839,750     1,572,289     2,580,962  
                        

 

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     Pro Forma
Three months ended
September 30,
    Pro Forma
Nine months ended
September 30,
 
     2008     2007     2008     2007  

Average self-pay monthly churn (1)(7)

     1.7 %     1.6 %     1.7 %     1.7 %

Conversion rate (2)(7)

     47.0 %     50.7 %     49.2 %     50.6 %

ARPU (3)(7)

   $ 10.47     $ 10.75     $ 10.48     $ 10.69  

SAC, as adjusted, per gross subscriber addition (4)(7)

   $ 74     $ 86     $ 76     $ 87  

Customer service and billing expenses, as adjusted,
per average subscriber (5)(7)

   $ 1.05     $ 1.09     $ 1.18     $ 1.14  

Total revenue

   $ 612,776     $ 529,242     $ 1,792,632     $ 1,501,093  

Free cash flow (6)(7)

   $ (97,590 )   $ (102,852 )   $ (577,673 )   $ (510,274 )

Adjusted loss from operations (8)

   $ (36,851 )   $ (103,572 )   $ (168,096 )   $ (341,309 )

Net loss

   $ (217,010 )   $ (265,515 )   $ (653,867 )   $ (842,592 )

Subscribers. We ended the third quarter of 2008 with 18,920,911 subscribers, an increase of 17% from the 16,234,069 subscribers as of September 30, 2007. Gross subscriber additions decreased about 5% in the third quarter 2008 from the prior year period, but increased approximately 4% over the prior year period for the nine months ending September 30, 2008. Gross additions in our OEM channel continued to grow for both the three and nine month periods over the prior year as automakers continued to increase the portion of their production which incorporates satellite radio. The growth in OEM gross additions was offset by declines in retail gross additions. Deactivations for self-pay subscriptions remained consistent with historical levels; non-conversions of subscribers in paid promotional trial periods declined as production penetration rates increased.

ARPU. Total ARPU for the three months ended September 30, 2008 was $10.47, compared to $10.75 for the three months ended September 30, 2007. The decrease was driven by an increase in the mix of discounted OEM promotional trials, subscriber winback programs, second subscribers and a decline in net advertising revenue per average subscriber as subscriber growth exceeded the growth in ad revenues.

We expect ARPU to fluctuate based on the growth of our subscriber base, promotions, rebates offered to subscribers and corresponding take-rates, plan mix, subscription prices, advertising sales and the identification of additional revenue from subscribers.

SAC, As Adjusted, Per Gross Subscriber Addition. SAC, as adjusted, per gross subscriber addition was $74 and $86 for the three months ended September 30, 2008 and 2007, respectively. The decrease was primarily driven by lower retail and OEM subsidies due to better product economics.

We expect SAC, as adjusted, per gross subscriber addition to decline as the costs of subsidized components of SIRIUS and XM radios decrease in the future. If competitive forces or changes in retailer promotional strategies require us to increase hardware subsidies or promotions, SAC, as adjusted, per gross subscriber addition may increase. Our SAC, as adjusted, per gross subscriber addition will continue to be impacted by our increasing mix of OEM gross subscriber additions.

Customer Service and Billing Expenses, As Adjusted, Per Average Subscriber. Customer service and billing expenses, as adjusted, per average subscriber declined 4% to $1.05 for the third quarter of 2008 compared with $1.09 for the third quarter of 2007. The decline was primarily due to efficiencies across a larger subscriber base.

We expect customer service and billing expenses, as adjusted, per average subscriber to decrease on an annual basis as our subscriber base grows due to scale efficiencies in our call centers and other customer care and billing operations. Our customer service and billing expenses, as adjusted, per average subscriber are generally lower in the first three quarters of our fiscal year and increase in the fourth quarter due to the holiday selling season.

 

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Pro Forma Results of Operations. For ease of comparison, set forth below are certain pro forma items that give effect to the Merger as if it had occurred on January 1, 2007. The pro forma information below does not give effect to any adjustments as a result the purchase price accounting for the Merger. See footnote 8 for a reconciliation.

 

     Pro Forma
Three months ended
September 30,
    Pro Forma
Nine months ended
September 30,
 
(in thousands, except per share data)    2008     2007     2008     2007  

Total revenue

   $ 612,776     $ 529,242     $ 1,792,632     $ 1,501,093  

Operating expenses:

        

Satellite and transmission

     25,136       25,409       76,336       78,024  

Programming and content

     131,630       100,675       341,422       292,385  

Revenue share and royalties

     120,800       85,394       355,251       239,518  

Customer service and billing

     58,857       51,562       177,159       152,396  

Cost of equipment

     16,179       15,671       48,020       60,485  

Sales and marketing

     78,178       96,490       260,583       289,374  

Subscriber acquisition costs

     132,477       162,656       444,396       474,008  

General and administrative

     75,981       80,051       215,440       207,608  

Engineering, design and development

     10,389       14,906       42,121       48,604  

Impairment of goodwill

     —         —         —         —    

Depreciation and amortization

     64,111       72,474       196,051       218,931  

Share-based payment expense

     29,809       42,714       99,673       112,202  

Restructuring and related costs

     7,430       —         7,457       —    
                                

Total operating expenses

     750,977       748,002       2,263,909       2,173,535  
                                

Loss from operations

     (138,201 )     (218,760 )     (471,277 )     (672,442 )

Other expense

     (77,086 )     (46,095 )     (178,777 )     (169,555 )
                                

Loss before income taxes

     (215,287 )     (264,855 )     (650,054 )     (841,997 )

Income tax expense

     (1,723 )     (660 )     (3,813 )     (595 )
                                

Net loss

   $ (217,010 )   $ (265,515 )   $ (653,867 )   $ (842,592 )
                                

Highlights for the Three Months Ended September 30, 2008. Our revenue grew 16% or by $83,534 in the three months ended September 30, 2008. This revenue growth was driven by our 17% growth in subscribers. This increase was reflected in improved Adjusted loss from operations (excluding restructuring, goodwill impairment, and merger related costs) of $66,721, as increases in our variable costs were offset by decreases in sales and marketing and subscriber acquisition costs. Total operating expenses, excluding goodwill impairment, restructuring, depreciation and stock based compensation costs and a $27,500 one-time merger related payment to a programming partner, decreased by $10,687 in the quarter.

Programming and content costs for the three months ended September 30, 2008 increased $30,955 including a one-time payment to a programming partner of $27,500 due upon completion of the Merger.

Revenue Share and Royalties increased $35,406 over the prior year, increasing from 16.1% of revenue to 19.7% of revenue. This increase was primarily driven by an increase in the statutory royalties due for the performance of sound recordings. The decision imposing the new royalties was rendered in January 2008, retroactive to January 2007 and was not reflected in the prior year’s results until the fourth quarter. Customer service and billing costs increased 14%, or $7,295, from the prior year’s in line with the increase in our subscriber base. Sales and marketing cost declined 19%, or $18,312 due to reduced advertising and cooperative marketing spend, offset in part by higher customer retention spending.

 

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Subscriber acquisition costs declined nearly 19%, or $30,179, and as a percent of revenue improved from 30.7% to 21.6%. This improvement was primarily driven by a 15% improvement in SAC per gross addition due to improved product economics and lower retail and OEM subsidies. Subscriber acquisition costs also declined as a result of the 5% decline in gross additions in the quarter.

General and administrative costs decreased 5%, or $4,070, and declined as a percent of revenue, reflecting one time costs in connection with the Merger. Engineering, design and development costs decreased 30%, or $4,517, due to fewer new OEM platform launches and lower product development costs.

Actual Results of Operations

Our discussion of our results of operations, along with the selected financial information in the tables that follow, includes the following non-GAAP financial measures: average monthly self-pay churn; conversion rate; average monthly revenue per subscriber, or ARPU; SAC, as adjusted, per gross subscriber addition; customer service and billing expenses, as adjusted, per average subscriber; free cash flow; and adjusted loss from operations. We believe these non-GAAP financial measures provide meaningful supplemental information regarding our operating performance and are used for internal management purposes, when publicly providing the business outlook, and as a means to evaluate period-to-period comparisons. Please refer to the footnotes following our discussion of results of operations for the definitions and further discussion of usefulness of such non-GAAP financial measures.

The discussion of our results of operations for the three and nine months ended September 30, 2008 includes the financial results of XM for the last 61 days of each period. The inclusion of these results may render direct comparisons with results for prior periods less meaningful. Accordingly, the discussion below addresses, where appropriate, trends we believe are significant, separate and apart from the impact of the Merger.

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Beginning subscribers

   8,924,139     7,142,538     8,321,785     6,024,555  

Gross subscriber additions

   11,212,511     999,284     13,245,220     2,989,887  

Deactivated subscribers

   (1,215,739 )   (474,346 )   (2,646,094 )   (1,346,966 )
                        

Net additions

   9,996,772     524,938     10,599,126     1,642,921  
                        

Ending subscribers

   18,920,911     7,667,476     18,920,911     7,667,476  

Retail

   9,036,420     4,428,747     9,036,420     4,428,747  

OEM

   9,777,704     3,221,388     9,777,704     3,221,388  

Rental

   106,787     17,341     106,787     17,341  
                        

Ending subscribers

   18,920,911     7,667,476     18,920,911     7,667,476  

Retail

   4,359,721     64,101     4,395,710     386,922  

OEM

   5,546,161     462,749     6,112,073     1,262,378  

Rental

   90,890     (1,912 )   91,343     (6,379 )
                        

Net additions

   9,996,772     524,938     10,599,126     1,642,921  

 

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     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Average self-pay monthly churn (1)(7)

     1.7 %     1.6 %     1.7 %     1.6 %

Conversion rate (2)(7)

     47.0 %     47.6 %     49.1 %     47.3 %

ARPU (7)(9)

   $ 10.15     $ 10.71     $ 10.31     $ 10.63  

SAC, as adjusted, per gross subscriber addition (7)(10)

   $ 59     $ 101     $ 74     $ 103  

Customer service and billing expenses, as adjusted,
per average subscriber (7)(11)

   $ 1.01     $ 0.95     $ 0.98     $ 1.04  

Total revenue

   $
488,443
 
  $         241,786     $       1,041,809     $         672,250  

Free cash flow (7)(12)

   $ (52,722 )   $ (67,799 )   $ (270,344 )   $ (294,545 )

Adjusted income (loss) from operations (13)

   $ 22,091     $ (56,892 )   $ (41,124 )   $ (220,190 )

Net loss

   $ (4,879,427 )   $ (120,137 )   $ (5,067,444 )   $ (399,029 )

Subscribers. We ended the third quarter of 2008 with 18,920,911 subscribers, an increase of 147% from the 7,667,476 subscribers as of September 30, 2007. The increase was a result of the additional subscribers as a result of the Merger.

Gross additions for the three and nine months ended September 30, 2008 included 9,716,070 subscribers acquired in the Merger.

ARPU. Total ARPU for the three months ended September 30, 2008 was $10.15, compared to $10.71 for the three months ended September 30, 2007. The decrease was largely driven by the impact of the purchase price adjustment which resulted in a lower fair value of deferred revenue lowering revenue for the period by approximately $0.98; and a decline in net advertising revenue per average subscriber as subscriber growth exceeded the growth in ad revenues, offset by the effects of rebates.

We expect ARPU to fluctuate based on the growth of our subscriber base, promotions, rebates offered to subscribers and corresponding take-rates, plan mix, subscription prices, advertising sales and the identification of additional revenue from subscribers.

SAC, As Adjusted, Per Gross Subscriber Addition. SAC, as adjusted, per gross subscriber addition was $59 and $101 for the three months ended September 30, 2008 and 2007, respectively. The decrease was primarily a result of lower subsidy costs to OEMs and the impact of purchase price adjustments for contractual arrangements which resulted in lower subsidy expense.

We expect SAC, as adjusted, per gross subscriber addition to decline as the costs of subsidized components of SIRIUS and XM radios decrease in the future. If competitive forces or changes in retailer promotional strategies require us to increase hardware subsidies or promotions, SAC, as adjusted, per gross subscriber addition may increase. Our SAC, as adjusted, per gross subscriber addition will continue to be impacted by our increasing mix of OEM gross subscriber additions.

Customer Service and Billing Expenses, As Adjusted, Per Average Subscriber. Customer service and billing expenses, as adjusted, per average subscriber increased 6% to $1.01 for the third quarter of 2008 compared with $0.95 for the third quarter of 2007. The increase was primarily the result of higher blended costs as a result of the Merger.

We expect customer service and billing expenses, as adjusted, per average subscriber to decrease on an annual basis as our subscriber base grows due to scale efficiencies in our call centers and other customer care and billing operations. Our customer service and billing expenses, as adjusted, per average subscriber are generally lower in the first three quarters of our fiscal year and increase in the fourth quarter due to the holiday selling season.

Adjusted Income (Loss) from Operations. Our adjusted income (loss) from operations improved to $22,091 from an adjusted loss from operations of $56,892 for the three months ended September 30, 2008 and 2007, respectively. The net impact of the purchase price adjustments favorably impacted the adjusted income from operations for the three months ended September 30, 2008 by approximately $14,824.

 

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Three and Nine Months Ended September 30, 2008 Compared with Three and Nine Months Ended September 30, 2007

Total Revenue

Subscriber Revenue. Subscriber revenue includes subscription fees, activation fees and the effects of rebates.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, subscriber revenue was $456,357 and $226,844, respectively, an increase of 101% or $229,513. $181,153 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to growth of subscribers to our service.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, subscriber revenue was $978,516 and $627,275, respectively, an increase of 56% or $351,241. $181,153 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to the growth of subscribers to our service.

The following table contains a breakdown of our subscriber revenue for the periods presented (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Subscription fees

   $     451,660     $       222,136     $       961,574     $       617,591  

Activation fees

     4,920       5,288       17,271       15,456  

Effect of rebates

     (223 )     (580 )     (329 )     (5,772 )
                                

Total subscriber revenue

   $ 456,357     $ 226,844     $ 978,516     $ 627,275  
                                

Future subscriber revenue will be dependent upon, among other things, the growth of our subscriber base, promotions, rebates offered to subscribers and corresponding take-rates, plan mix, subscription prices and the identification of additional revenue streams from subscribers.

Advertising Revenue. Advertising revenue includes the sale of advertising on our non-music channels, net of agency fees. Agency fees are based on a stated percentage per the advertising agreements applied to gross billing revenue.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, net advertising revenue was $14,674 and $8,524, respectively, which represents an increase of $6,150. $5,165 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to an increase in advertisers compared to the three months ended September 30, 2007.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, net advertising revenue was $31,413 and $24,422, respectively, which represents an increase of $6,991. $5,165 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to an increase in advertisers compared to the nine months ended September 30, 2007.

We expect advertising revenue to grow as our subscribers increase, as we continue to improve brand awareness and content, and as we increase the size and effectiveness of our advertising sales force. Advertising revenue is subject to fluctuation based on the overall advertising environment. Our advertising revenue may also fluctuate in the short term as a result of an advertising backlog we acquired from XM and the integration of XM’s advertiser relationships.

Equipment Revenue. Equipment revenue includes revenue from the direct sale of SIRIUS and XM radios and accessories through our direct to consumer distribution channel.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, equipment revenue was $11,271 and $6,290, respectively, which represents an increase of $4,981. $3,351 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to a result of higher sales through our direct to consumer distribution channel, offset by the effects of promotional discounts.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, equipment revenue was $25,290 and $17,216, respectively, which represents an increase of $8,074. $3,351 of the increase was attributable to the Merger, and the remaining increase was primarily attributable to a result of higher sales through our direct-to-consumer distribution channel, offset by the effects of promotional discounts.

 

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We expect equipment revenue to increase as we introduce new products, integrate XM products and as sales grow through our direct to consumer distribution channel.

Operating Expenses

Satellite and Transmission. Satellite and transmission expenses consist of costs associated with the operation and maintenance of our satellites; satellite telemetry, tracking and control system; terrestrial repeater network; satellite uplink facility; and broadcast studios.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, satellite and transmission expenses were $19,526 and $7,409, respectively, which represents an increase of $12,117. Excluding stock-based compensation of $1,331 and $557 for the three months ended September 30, 2008 and 2007, respectively, satellite and transmission expenses increased $11,343 from $6,852 to $18,195. The increase was primarily due to the impact of the Merger. XM satellite and transmission expense accounted for $12,458 during the three months ended September 30, 2008. Excluding the impact of XM satellite and transmission expense, satellite and transmission expense decreased compared to September 30, 2007 as a result of decreased costs related to our terrestrial repeater network. As of September 30, 2008 and 2007, we had 820 and 120, terrestrial repeaters, respectively in operation, which included 700 XM repeaters acquired in the Merger.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, satellite and transmission expenses were $34,800 and $22,732, respectively, which represents an increase of $12,068. Excluding stock-based compensation of $2,887 and $1,834 for the nine months ended September 30, 2008 and 2007, respectively, satellite and transmission expenses increased $11,015 from $20,898 to $31,913. The increase was primarily due to the impact of the Merger. XM satellite and transmission expense accounted for $12,458 during the nine months ended September 30, 2008. Excluding the impact of XM satellite and transmission expense, satellite and transmission expense decreased compared to September 30, 2007 as a result of decreased costs related to our terrestrial repeater network.

We expect satellite and transmission expenses to decrease as we consolidate terrestrial repeater sites and realize other synergies as a result of the Merger. Such expenses may increase in future periods if we decide to increase our in-orbit satellite insurance.

Programming and Content. Programming and content expenses include costs to acquire, create and produce content and on-air talent costs. We have entered into various agreements with third parties for music and non-music programming. These agreements require us to pay license fees, share advertising revenue, purchase advertising on media properties owned or controlled by the licensor and pay other guaranteed amounts. Purchased advertising is recorded as a sales and marketing expense in the period the advertising is broadcast.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, programming and content expenses were $106,037 and $59,015, respectively, which represents an increase of $47,022. Excluding stock-based compensation of $3,529 and $2,707 for the three months ended September 30, 2008 and 2007, respectively, programming and content expenses increased $46,200 from $56,308 to $102,508. The increase was primarily due to the impact of the Merger. XM’s programming and content expense accounted for $18,046 during the three months ended September 30, 2008. The remaining increase was primarily attributable to a $27,500 one-time payment to a programming partner due upon completion of the Merger and license fees associated with new programming.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, programming and content expenses were $222,975 and $173,324, respectively, which represents an increase of $49,651. Excluding stock-based compensation of $7,477 and $6,857 for the nine months ended September 30, 2008 and 2007, respectively, programming and content expenses increased $49,031 from $166,467, to $215,498. The increase was primarily due to the impact of the Merger. XM’s programming and content expense accounted for $18,046 during the nine months ended September 30, 2008. The remaining increase was primarily attributable to a $27,500 one-time payment to a programming partner due upon completion of the Merger and license fees associated with new programming.

Our programming and content expenses, excluding stock-based compensation expense, will decrease as we reduce duplicate programming and content costs. We regularly evaluate programming opportunities and may choose to acquire and develop new content or renew current programming agreements in the future at different costs.

 

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Revenue Share and Royalties. Revenue share and royalties include distribution and content provider revenue share, residuals and broadcast and web streaming royalties. Residuals are monthly fees paid based upon the number of subscribers using SIRIUS and XM radios purchased from retailers. Advertising revenue share is recorded to revenue share and royalties in the period the advertising is broadcast.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, revenue share and royalties were $85,592 and $32,978, respectively, which represents an increase of $52,614. The increase was primarily due to the impact of the Merger. XM’s revenue share and royalties’ expense accounted for $38,539 during the three months ended September 30, 2008. The remaining increase was attributable to the growth in our revenues and an increase in the statutory royalties due for the performance of sound recordings. The decision imposing the new royalties was imposed in January 2008, retroactive to January 2007 and was not reflected in the prior year until the fourth quarter.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, revenue share and royalties were $177,635 and $89,953, respectively, which represents an increase of $87,682. The increase was primarily attributable to an increase in our revenues, the $38,539 effect of including XM’s revenue share and royalty expense from the date of the Merger and an increase in the statutory royalties due for the performance of sound recordings. The decision imposing the new royalties was imposed in January 2008, retroactive to January 2007 and was not reflected in the prior year until the fourth quarter.

We expect these costs to increase as we continue to experience revenue growth and expand our distribution of SIRIUS and XM radios through automakers and as a result of statutory increases in the royalty for sound recording performances.

Customer Service and Billing. Customer service and billing expenses include costs associated with the operation of our customer service centers and subscriber management systems as well as bad debt expense.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, customer service and billing expenses were $47,432 and $21,058, respectively, which represents an increase of $26,374. Excluding stock-based compensation of $596 and $166 for the three months ended September 30, 2008 and 2007, respectively, customer service and billing expenses increased $25,944 from $20,892 to $46,836. The increase was primarily due to the Merger. XM’s customer service and billing expense accounted for $23,819 during the three months ended September 30, 2008. The remaining increase was primarily attributable to higher call center operating costs necessary to accommodate the increase in the our subscriber base and higher total transaction fees on the larger base.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, customer service and billing expenses were $97,218 and $64,529, respectively, which represents an increase of $32,689. Excluding stock-based compensation of $1,137 and $543 for the nine months ended September 30, 2008 and 2007, respectively, customer service and billing expenses increased $32,095 from $63,986 to $96,081. The increase was primarily due to the Merger. XM’s customer services and billing expense accounted for $23,819 during the nine months September 30, 2008. The remaining increase was primarily attributed to higher call center operating costs necessary to accommodate the increase in our subscriber base and higher total transaction fees on the larger base.

We expect our customer care and billing expenses, excluding stock-based compensation expense, to decrease on a per subscriber basis, but increase overall as our subscriber base grows due to increased call center operating costs, transaction fees necessary to serve a larger subscriber base and bad debt expense.

Cost of Equipment. Cost of equipment includes costs for SIRIUS and XM radios and accessories sold through our direct to consumer distribution channel.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, cost of equipment was $13,773 and $6,086, respectively, which represents an increase of $7,687. $5,020 of the increase was attributable to the Merger.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, cost of equipment was $28,007 and $19,930, respectively, which represents an increase of $8,077. $5,020 of the increase was attributable to the Merger.

We expect cost of equipment to vary in the future with changes in sales through our direct to consumer distribution channel.

 

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Sales and Marketing. Sales and marketing expenses include costs for advertising, media and production, including promotional events and sponsorships; cooperative marketing; customer retention and compensation. Cooperative marketing costs include fixed and variable payments to reimburse retailers and automakers for the cost of advertising and other product awareness activities.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, sales and marketing expenses were $63,637 and $38,488, respectively, which represents an increase of $25,149. Excluding stock-based compensation of $3,672 and $6,575 for the three months ended September 30, 2008 and 2007, respectively, sales and marketing expenses increased $28,052, from $31,913 to $59,965. The increase was due to the impact of the Merger. XM’s sales and marketing expense accounted for $28,951 during the three months ended September 30, 2008.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, sales and marketing expenses were $151,237 and $126,348, respectively, which represents an increase of $24,889. Excluding stock-based compensation of $11,376 and $15,068 for the nine months ended September 30, 2008 and 2007, respectively, sales and marketing expenses increased $28,581 from $111,280 to $139,861. The increase was primarily due to the impact of the Merger. XM’s sales and marketing expense accounted for $28,951 during the nine months ended September 30, 2008.

We expect sales and marketing expenses, excluding stock-based compensation expense, to decrease as we consolidate our advertising and promotional activities, gain efficiencies in marketing management and eliminate overlapping distribution support costs.

Subscriber Acquisition Costs. Subscriber acquisition costs include hardware subsidies paid to radio manufacturers, distributors and automakers, including subsidies paid to automakers who include a SIRIUS or XM radio and a prepaid subscription to our service in the sale or lease price of a new vehicle; subsidies paid for chip sets and certain other components used in manufacturing radios; commissions paid to retailers and automakers as incentives to purchase, install and activate SIRIUS and XM radios; product warranty obligations; provisions for inventory allowance; and compensation costs associated with stock-based awards granted in connection with certain distribution agreements. The majority of subscriber acquisition costs are incurred and expensed in advance of acquiring a subscriber. Subscriber acquisition costs do not include advertising, loyalty payments to distributors and dealers of SIRIUS and XM radios and revenue share payments to automakers and retailers of SIRIUS and XM radios.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, subscriber acquisition costs were $86,616 and $101,798, respectively, which represents a decrease of 15% or $15,182. Excluding stock-based compensation of $0 and $800 for the three months ended September 30, 2008 and 2007, respectively, subscriber acquisition costs decreased 14%, or $14,382, from $100,998 to $86,616. This decrease was primarily attributable to lower retail and OEM subsidies due to better product economics.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, subscriber acquisition costs were $257,832 and $307,580, respectively, which represents a decrease of 16% or $49,748. Excluding stock-based compensation of $14 and $2,687 for the nine months ended September 30, 2008 and 2007, respectively, subscriber acquisition costs decreased 15%, or $47,075, from $304,893 to $257,818. This decrease was primarily driven by lower retail and OEM subsidies due to better product economics.

We expect total subscriber acquisition costs, excluding stock-based compensation expense, to decrease as increases in our gross subscriber additions are offset by continuing declines in the costs of subsidized components of SIRIUS and XM radios. We intend to continue to offer subsidies, commissions and other incentives to acquire subscribers.

General and Administrative. General and administrative expenses include rent and occupancy, finance, legal, human resources, information technology and investor relations costs.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, general and administrative expenses were $57,310 and $44,837, respectively, which represents an increase of $12,473. Excluding stock-based compensation of $12,904 and $10,953 for the three months ended September 30, 2008 and 2007, respectively, general and administrative expenses increased $10,522 from $33,884 to $44,406. The increase was due to the impact of the Merger. XM’s general and administrative expense accounted for $19,215 during the three months ended September 30, 2008. The increase was offset by a decrease in legal fees primarily attributable to the Copyright Royalty Board ruling.

 

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Nine Months: For the nine months ended September 30, 2008 and 2007, general and administrative expenses were $148,555 and $118,651, respectively, which represents an increase of $29,904. Excluding stock-based compensation of $36,359 and $34,056 for the nine months ended September 30, 2008 and 2007, respectively, general and administrative expenses increased $27,601 from $84,595 to $112,196. The increase was primarily due to the impact of the Merger. XM’s general and administrative expense accounted for $19,215 during the nine months ended September 30, 2008. The remaining increase was primarily attributable to higher compensation-related costs to support the growth of our business.

We expect our general and administrative expenses, excluding stock-based compensation expense, to decrease in future periods as we complete the integration of the Merger and gain efficiencies in staff, facilities, insurance, professional fees and information technology costs. General and administrative expenses could fluctuate in certain periods as a result of litigation costs.

Engineering, Design and Development. Engineering, design and development expenses include costs to develop our future generation of chip sets and new products, research and development for broadcast information, and costs associated with the incorporation of our radios into vehicles manufactured by automakers.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, engineering, design and development expenses were $10,434 and $9,736, respectively, which represents an increase of $698. Excluding stock-based compensation of $1,973 and $969, for the three months ended September 30, 2008 and 2007, respectively, engineering, design and development expenses decreased $306 from $8,767 to $8,461. This decrease was attributable to reduced OEM and product development costs, offset by an increase of $5,191 attributable to the Merger.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, engineering, design and development expenses were $28,091 and $33,397, respectively, which represents a decrease of $5,306. Excluding stock-based compensation of $4,167 and $2,959 for the nine months ended September 30, 2008 and 2007, respectively, engineering, design and development expenses decreased $6,514 from $30,438 to $23,924. This decrease was attributable to reduced OEM and product development costs, offset by an increase of $5,191 attributable to the Merger.

We expect engineering, design and development expenses, excluding stock-based compensation expense, to decrease in future periods as we complete the integration of SIRIUS and XM and gain efficiencies in engineering, design and development activities.

Other Income (Expense)

Interest and Investment Income. Interest and investment income includes realized gains and losses, dividends and interest income, including amortization of the premium and discount arising at purchase.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, interest and investment income was $4,940 and $5,604, respectively, which represents a decrease of $664. The decrease was primarily attributable to lower interest rates in 2008 and a lower cash balance.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, interest and investment income was $9,167 and $16,399, respectively, which represents a decrease of $7,232. The decrease was primarily attributable to lower interest rates in 2008 and a lower cash balance.

Interest Expense. Interest expense includes interest on outstanding debt, reduced by interest capitalized in connection with the construction of our satellites and launch vehicles.

 

   

Three Months: For the three months ended September 30, 2008 and 2007, interest expense was $49,216 and $19,499, respectively, which represents an increase of $29,717. An increase of $47,798 was attributed to the Merger, including the acquisition of $2,592,549 in additional debt. This increase was offset by a lower interest rate on the Term Loan which is LIBOR plus 2.25% compared to the third quarter 2007, as well as an offset due to the capitalized interest associated with satellite construction and the related launch vehicle.

 

   

Nine Months: For the nine months ended September 30, 2008 and 2007, interest expense was $83,636 and $50,441, respectively, which represents an increase of $33,195. Interest expense increased significantly as a result of the impact of the Merger, including the acquisition of $2,592,549 in additional debt. Increases in interest expense were offset by the capitalized interest associated with satellite construction and the related launch vehicle.

 

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Income Taxes

Income Tax Expense. Income tax expense represents the recognition of a deferred tax liability related to the difference in accounting for our FCC license, which is amortized over 15 years for tax purposes but not amortized for book purposes in accordance with U.S. generally accepted accounting principles.

 

   

Three Months: We recorded income tax expense of $1,215 and $555 for the three months ended September 30, 2008 and 2007, respectively.

 

   

Nine Months: We recorded income tax expense of $2,301 and $1,665 for the nine months ended September 30, 2008 and 2007, respectively.

Liquidity and Capital Resources

Cash Flows for the Nine Months Ended September 30, 2008 Compared with the Nine Months Ended September 30, 2007

As of September 30, 2008, we had $359,657 in cash and cash equivalents compared with $357,710 as of September 30, 2007 and $438,820 as of December 31, 2007. We acquired $820 million cash, in connection with the Merger.

The following table presents a summary of our cash flow activity for the periods set forth below (in thousands, except percentages):

 

     Nine months ended
September 30,
    Change  
     2008     2007     $     %  
Cash flows used in operating activities    $   (216,992)     $ (252,434 )   $ 35,442     -14 %

Cash flows provided by (used in) investing activities

     766,516       (31,153 )         797,669     -2560 %

Cash flows provided (used in) by financing activities

     (628,687 )     247,876       (876,563 )   -354 %
                          

Net decrease in cash and cash equivalents

     (79,163 )     (35,711 )     (43,452 )   122 %

Cash and cash equivalents at beginning of period

     438,820       393,421       45,399     12 %
                          
Cash and cash equivalents at end of period    $ 359,657     $     357,710     $ 1,947     1 %
                          

Net Cash Used in Operating Activities

Net cash used in operating activities decreased $35,442 to $216,992 for the nine months ended September 30, 2008 from $252,434 for the nine months ended September 30, 2007. Such decrease in the net outflows of cash was primarily attributable to an improvement in our operating results.

Net Cash Used in Investing Activities

Net cash provided in investing activities was $766,516 for the nine months ended September 30, 2008 compared with net cash used in investing activities of $31,153 for the nine months ended September 30, 2007. The $797,669 increase was primarily due to the inclusion of $819,521 million in net cash acquired from XM in the Merger. Additionally, capital expenditures increased by $35,904 as a result of costs associated with our satellite construction and launch vehicle and the increase in Merger related costs of $13,047 during the nine months ended September 30, 2008.

We will incur significant capital expenditures to construct and launch our new satellites and to improve our terrestrial repeater network and broadcast and administrative infrastructure. These capital expenditures will support our growth and the resiliency of our operations, and will also support the delivery of future new revenue streams.

 

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Net Cash Used In Financing Activities

Net cash used in financing activities decreased $876,563 to $628,687 used for the nine months ended September 30, 2008 from net cash provided by financing activities of $247,876 for the nine months ended September 30, 2007 primarily due to the proceeds received from the $250,000 Senior Secured Term Loan entered into in June of 2007. Our financing activities for the nine months ended September 30, 2008 included $550,000 in cash proceeds from the issuance of the Exchangeable Notes; $613,400 in cash used to extinguish 99% of the principal and accrued interest on XM’s 9.75% Notes; $203,500 in cash used to extinguish 100% of the principal, accrued interest and prepayment premiums on the XM’s Floating Rate Notes; and $309,400 for transponder repurchase obligation, for both debt and equity holders of a consolidated variable interest entity, including a prepayment premiums and interest accrued through the date of extinguishment.

Financings and Capital Requirements

We have historically financed our operations through the sale of debt and equity securities. It will be more difficult to obtain additional financing if prevailing instability in the credit and financial markets continues.

Future Liquidity and Capital Resource Requirements

Debt Maturing in 2009. SIRIUS, XM Holdings and XM have a substantial amount of debt maturing in 2009, including;

 

 

 

At SIRIUS, $209,228 of 2 1/2% Convertible Notes that mature on February 15, 2009;

 

 

 

At SIRIUS, $1,744 of 8 3/4% Convertible Subordinated Notes that mature on September 29, 2009;

 

   

At XM, a $250,000 revolving credit facility, which is fully drawn and matures on May 5, 2009;

 

   

At XM, a $100,000 term loan which matures on May 5, 2009;

 

   

At XM Holdings, $400,000 of 10% Convertible Senior Notes that mature on December 1, 2009; and

 

   

At XM Holdings and XM (as co-obligors), $33,200 of 10% Senior Secured Discount Convertible Notes that mature on December 31, 2009.

Since September 30, 2008, we have issued an aggregate of 262,911,513 shares of our common stock, par value $0.001 per share, in exchange for $90,772 principal amount of our 2 1/2% Convertible Notes due 2009 beneficially owned by institutional holders. We did not receive any cash proceeds as a result of the exchange of our common stock for the 2 1/2 % Notes, which notes have been retired and cancelled. We executed these transactions to reduce our debt and interest cost, increase our equity, and improve our balance sheet. We intend to engage in additional exchanges in respect of our outstanding indebtedness if and as favorable opportunities arise.

Except for these maturities, we expect that our cash flow from operating activities will be sufficient to fund our projected cash needs. We may renegotiate the terms of our maturing debt obligations; exchange common stock or new debt securities for these obligations; and/or issue equity or debt securities for cash to new holders. It may be difficult to obtain additional financing if the prevailing instability in the credit and financial markets continues. The incurrence of additional indebtedness would result in increased fiscal obligations and could contain restrictive covenants. The sale of additional equity or convertible debt securities may result in dilution to our stockholders. These additional sources of funds may not be available or, if available, may not be available on terms favorable to us. If we are unable to refinance our maturing debt in 2009, our failure to repay the debt will result in an event of default under the indentures and agreements governing our debt which, if not cured or waived, could cause us to discontinue operations or seek a purchaser for our business or assets.

Credit Agreement with Space Systems/Loral. In July 2007, SIRIUS amended and restated its Credit Agreement with Space Systems/Loral (the “Loral Credit Agreement”). Under the Loral Credit Agreement, Space Systems/Loral agreed to make loans to SIRIUS in an aggregate principal amount of up to $100,000 to finance the purchase of SIRIUS’ fifth and sixth satellites. Loans made under the Loral Credit Agreement will be secured by SIRIUS’ rights under the Satellite Purchase Agreement with Space Systems/Loral, including SIRIUS rights to its new satellites. The loans are also entitled to the benefits of a subsidiary guarantee from Satellite CD Radio, Inc., the subsidiary that holds SIRIUS’ FCC license, and any future material subsidiary that may be formed by SIRIUS. The maturity date of the loans is the earliest to occur of (i) June 10, 2010, (ii) 90 days after our sixth satellite becomes available for shipment, and (iii) 30 days prior to the scheduled launch of the sixth satellite. The Loral Credit Agreement contains certain drawing conditions, including a

 

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requirement that we have a market capitalization of at least $1 billion. Any loans made under the Loral Credit Agreement generally will bear interest at a variable rate equal to three-month LIBOR plus 4.75%. The Loral Credit Agreement permits SIRIUS to prepay all or a portion of the loans outstanding without penalty.

SIRIUS has not requested any loans under the Loral Credit Agreement with Space Systems/Loral. If SIRIUS requested loans under the Loral Credit Agreement to reimburse itself for payments in connection with the purchase of its fifth and sixth satellites, it is unclear whether those funds would be available. We are in discussions with Space Systems/Loral regarding ways in which SIRIUS can realize the financial benefits it expected to receive under the Loral Credit Agreement, including through deferred payments on SIRIUS’ satellite purchase agreements and other concessions, perhaps without drawing under the Loral Credit Agreement.

Operating Liquidity. Based upon our current plans, and other than our need to refinance our debt maturing in 2009, we believe that both SIRIUS and XM have sufficient cash, cash equivalents and marketable securities to cover their estimated funding needs through cash flow breakeven, the point at which revenues are sufficient to fund expected operating expenses, capital expenditures, merger related costs, working capital requirements, interest payments and taxes. Our financial projections are based on assumptions, which we believe are reasonable but contain significant uncertainties.

We are the sole stockholder of XM Holdings and its subsidiaries and its business is operated as an unrestricted subsidiary under our existing indebtedness. Under certain circumstances, SIRIUS may be unwilling or unable to contribute or loan XM capital to support its operations. Similarly, under certain circumstances, XM may be unwilling or unable to contribute or loan SIRIUS capital to support its operations. To the extent XM’s funds are insufficient to support its business, XM may be required to seek additional financing, which may not be available on favorable terms, or at all. Such additional financing would likely be obtained from the sale of additional debt securities, as part of concessions from vendors and other business relationships, or from other sources. If XM is unable to secure additional financing, its business and results of operations may be adversely affected.

Tightening credit policies could also adversely impact our operational liquidity by making it more difficult or costly for our subscribers to access credit, and could have an adverse impact on our operational liquidity as a result of possible changes to our payment arrangements that credit card companies and other credit providers could unilaterally make.

We regularly evaluate our plans and strategy. These evaluations often result in changes to our plans and strategy, some of which may be material and significantly change our cash requirements or cause us to achieve cash flow breakeven at a later date. These changes in our plans or strategy may include: the acquisition of unique or compelling programming; the introduction of new features or services; significant new or enhanced distribution arrangements; investments in infrastructure, such as satellites, equipment or radio spectrum; and acquisitions of third parties that own programming, distribution, infrastructure, assets, or any combination of the foregoing. In addition, our operations will also be affected by the FCC order approving the Merger which imposed certain conditions upon, among other things, our program offerings and our ability to increase prices. Our future liquidity also may be adversely affected by, among other things, the nature and extent of the benefits achieved by operating XM as a wholly-owned unrestricted subsidiary under our existing indebtedness.

In June 2007, SIRIUS entered into a Term Credit Agreement with a syndicate of financial institutions. The Term Credit Agreement provides for a term loan of $250,000, which has been drawn. Interest under the Term Credit Agreement is based, at our option, on (i) adjusted LIBOR plus 2.25% or (ii) the higher of (a) the prime rate and (b) the Federal Funds Effective Rate plus  1/2 of 1.00%, plus 1.25%. LIBOR borrowings may be made for interest periods, at our option, of one, two, three or six months (or, if agreed by all of the lenders, nine or twelve months). The loan amortizes in equal quarterly installments of 0.25% of the initial aggregate principal amount for the first four and a half years, with the balance of the loan thereafter being repaid in four equal quarterly installments. The loan matures on December 20, 2012. The loan is guaranteed by SIRIUS’ material wholly owned subsidiaries, including Satellite CD Radio, Inc. (the “Guarantors”). The Term Credit Agreement is secured by a lien on substantially all of SIRIUS’ and the Guarantors’ assets, including SIRIUS’ four satellites and the shares of the Guarantors. The Term Credit Agreement contains customary affirmative covenants and event of default provisions. The negative covenants contained in the Term Credit Agreement are substantially similar to those contained in the indenture governing SIRIUS’ 95/8% Senior Notes due 2013.

In February 2008, XM borrowed $187,500 under its $250,000 revolving credit facility (the “Revolving Credit Facility”). The proceeds were used for general corporate purposes, to fund XM’s annual payment to Major League Baseball (“MLB”), to pay its 2007 payment under the Copyright Royalty Board decision, and to fund the settlement with various record labels. The interest rate for this

 

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borrowing under the Revolving Credit Facility as of September 30, 2008 was 4.75% and is based on 9-month LIBOR. All amounts drawn under the Revolving Credit Facility are due on May 5, 2009. The loans under the Revolving Credit Facility are secured by a lien on substantially all of XM’s assets.

In May 2008, XM borrowed $62,500, or the balance of the amount available, under the Revolving Credit Facility. The proceeds were used for general corporate purposes, including funding the escrow required under XM’s agreement with MLB. The interest rate for this borrowing under the Revolving Credit Facility as of September 30, 2008 was 5.25% and is based on the prime rate plus a spread.

In June 2008, XM borrowed $28,957 under its $150,000 senior secured credit facility with GM (the “GM Facility”) to satisfy payment obligations under the distribution agreement with GM.

In June 2008, XM entered into, and borrowed the full amount available under, a $100,000 credit agreement with UBS AG for a senior secured term loan. A portion of the proceeds of this loan were used to repay the amounts outstanding under the GM Facility. The GM Facility terminated as a result of the Merger.

In connection with the Merger, in July 2008, XM refinanced a substantial portion of its existing indebtedness through the issuance of $778,500 in senior notes and $550,000 in senior subordinated exchangeable notes. XM used the proceeds received from these transactions to: tender for its $200,000 Senior Floating Rate Notes due 2013; tender for $600,000 of its 9.75% Senior Notes due 2014; and satisfy its $309,400 transponder repurchase obligation, both for debt and equity holders of a consolidated variable interest entity.

2003 Long-Term Stock Incentive Plan

SIRIUS maintains the Sirius Satellite Radio 2003 Long-Term Stock Incentive Plan (the “2003 Plan”). Employees, consultants and members of our board of directors are eligible to receive awards under the 2003 Plan. The 2003 Plan provides for the grant of stock options, restricted stock, restricted stock units and other stock-based awards that the compensation committee of our board of directors may deem appropriate. Vesting and other terms of stock-based awards are set forth in the agreements with the individuals receiving the awards. Stock-based awards granted under the 2003 Plan are generally subject to a vesting requirement. Stock-based awards generally expire ten years from date of grant. Each restricted stock unit entitles the holder to receive one share of our common stock upon vesting.

As of September 30, 2008, approximately 188,093,000 stock options, shares of restricted stock and restricted stock units were outstanding. As of September 30, 2008, approximately 93,832,000 shares of our common stock were available for grant under the 2003 Plan. During the nine months ended September 30, 2008, employees exercised 117,442 stock options at exercise prices ranging from $1.45 to $3.36 per share, resulting in proceeds to us of $208. The exercise of the remaining outstanding, vested options could result in an inflow of cash in future periods.

2007 Stock Incentive Plan

XM Holdings maintains a 2007 Stock Incentive Plan (the “2007 Plan”) under which officers, other employees and other key individuals of XM may be granted various types of equity awards, including restricted stock, stock units, stock options, stock appreciation rights, dividend equivalent rights and other stock awards. Stock option awards under the 2007 Plan generally vest ratably over three years based on continuous service; while restricted stock generally vests ratably over one or three years based on continuous service. Stock option awards are granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. Grants of equity awards other than stock options or stock appreciation rights reduce the number of shares available for future grant by 1.5 times the number of shares granted under such equity awards. In connection with the Merger, the shares available for future grant under the 2007 Plan were adjusted using a conversion factor of 4.6 SIRIUS shares for 1 XM Holdings share. Since the Merger, there have been no grants of awards from the 2007 Plan. As of September 30, 2008, there were 60,084,705 shares available for future grant under the 2007 Plan.

1998 Shares Award Plan

XM Holdings maintains a 1998 Shares Award Plan (the “1998 Plan”) under which employees, consultants and non-employee directors of XM were granted stock options and restricted stock awards. Stock option awards and restricted stock awards under the 1998

 

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Plan generally vest ratably over three years based on continuous service. Stock option awards are generally granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. The 1998 Plan terminated in June 2008 and shares are no longer available for future grant.

XM Talent Option Plan

XM Holdings maintains a Talent Option Plan (the “Talent Plan”) under which non-employee programming consultants to XM may be granted stock options awards. Stock option awards under the Talent Plan generally vest ratably over three years based on continuous service. Stock option awards are generally granted with an exercise price equal to the market price of our common stock at the date of grant and expire no later than ten years from the date of grant. In connection with the Merger, the shares available for future grant under the Talent Plan were adjusted using a conversion factor of 4.6 SIRIUS shares for 1 XM share. Since the Merger, there have been no grants of awards from the Talent Plan. As of September 30, 2008, there were 1,564,000 options available under the Talent Plan for future grant.

Contractual Cash Commitments

For a discussion of our “Contractual Cash Commitments” refer to Note 14 of to the unaudited condensed consolidated financial statements in Item 1. of this Form 10-Q.

Related Party Transactions

For a discussion of related party transactions, see Note 8 to the unaudited condensed consolidated financial statements in Item 1. of this Form 10-Q.

Critical Accounting Policies

For a description of our Critical Accounting Policies refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within our Annual Report on Form 10-K for the year ended December 31, 2007 and Note 3 to the unaudited condensed consolidated financial statements in Item 1. of this Form 10-Q.

Footnotes

 

(1) Average self-pay monthly churn represents the average of self pay deactivations by the quarter divided by the average self pay subscriber balance for the quarter.

 

(2) We measure the percentage of subscribers that receive the service and convert to self-paying after the initial promotion period. We refer to this as the “conversion rate.” At the time of sale, vehicle owners generally receive between three and twelve month prepaid trial subscriptions and we receive a subscription fee from the OEM. Promotional periods generally include the period of trial service plus 30 days to handle the receipt and processing of payments. We measure conversion rate three months after the period in which the trial service ends. Based on our experience it may take up to 90 days after the trial service ends for subscribers to respond to our marketing communications and become self-paying subscribers.

 

(3) ARPU is derived from total earned subscriber revenue and net advertising revenue divided by the daily weighted average number of subscribers for the period. ARPU is calculated as follows (in thousands, except for per subscriber amounts):

 

     Pro Forma
Three months ended
September 30,
   Pro Forma
Nine months ended
September 30,
     2008    2007    2008    2007

Subscriber revenue

   $ 569,591    $ 488,543    $ 1,661,800    $ 1,380,657

Net advertising revenue

     17,867      19,240      54,156      52,769
                           

Total subscriber and net advertising revenue

   $ 587,458    $ 507,783    $ 1,715,956    $ 1,433,426
                           

Daily weighted average number of subscribers

             18,710,940              15,743,059              18,187,927              14,905,060

ARPU

   $ 10.47    $ 10.75    $ 10.48    $ 10.69

 

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(4) SAC, as adjusted, per gross subscriber addition is derived from subscriber acquisition costs and margins from the direct sale of radios and accessories, excluding stock-based compensation divided by the number of gross subscriber additions for the period. SAC, as adjusted, per gross subscriber addition is calculated as follows (in thousands, except for per subscriber amounts):

 

     Pro Forma
Three months ended
September 30,
     Pro Forma
Nine months ended
September 30,
 
     2008    2007      2008      2007  

Subscriber acquisition cost

   $ 132,477    $ 163,456      $ 444,410      $ 476,695  

Less: stock-based compensation granted to third parties and employees

     —        (800 )      (14 )      (2,687 )

Add: margin from direct sales of radios and accessories

     3,323      5,071        9,333        28,004  
                                 

SAC, as adjusted

   $ 135,800    $ 167,727      $ 453,729        502,012  
                                 

Gross subscriber additions

                1,846,996                 1,950,842                   5,999,714                   5,751,123  

SAC, as adjusted, per gross subscriber addition

   $ 74    $ 86      $ 76      $ 87  

 

(5) Customer service and billing expenses, as adjusted, per average subscriber is derived from total customer service and billing expenses, excluding stock-based compensation, divided by the daily weighted average number of subscribers for the period. Customer service and billing expenses, as adjusted, per average subscriber is calculated as follows (in thousands, except for per subscriber amounts):

 

     Pro Forma
Three months ended
September 30,
     Pro Forma
Nine months ended
September 30,
 
     2008      2007      2008      2007  

Customer service and billing expenses

   $ 59,786      $ 52,454      $ 180,270      $ 154,602  

Less: stock-based compensation

     (929 )      (892 )      (3,111 )      (2,206 )
                                   

Customer service and billing expenses, as adjusted

   $ 58,857      $ 51,562      $ 177,159      $ 152,396  
                                   

Daily weighted average number of subscribers

            18,710,940               15,743,059               18,187,927               14,905,060  

Customer service and billing expenses, as adjusted, per average subscriber

   $ 1.05      $ 1.09      $ 1.18      $ 1.14  

 

(6) Free cash flow is calculated as follows (in thousands):

 

     Pro Forma
Three months ended
September 30,
     Pro Forma
Nine months ended
September 30,
 
     2008      2007      2008     2007  

Net change in cash and cash equivalents

   $                (44,329 )    $                 (111,244 )    $                 (235,849 )   $                 (22,740 )

Cash flow from financing activities

     (52,918 )      8,407        (350,902 )     (476,576 )

Other investing

     (343 )      (15 )      9,078       (10,958 )
                                  

Free cash flow

   $ (97,590 )    $ (102,852 )    $ (577,673 )   $ (510,274 )
                                  
(7) Average monthly self-pay churn; conversion rate; ARPU; SAC, as adjusted, per gross subscriber addition; customer service and billing expenses, as adjusted, per average subscriber; and free cash flow are not measures of financial performance under U.S. generally accepted accounting principles (“GAAP”). We believe these non-GAAP financial measures provide meaningful supplemental information regarding our operating performance and are used by us for budgetary and planning purposes; when publicly providing our business outlook; as a means to evaluate period-to-period comparisons; and to compare our performance to that of our competitors. We also believe that investors also use our current and projected metrics to monitor the performance of our business and to make investment decisions.

 

   We believe the exclusion of stock-based compensation expense in our calculations of SAC, as adjusted, per gross subscriber addition and customer service and billing expenses, as adjusted, per average subscriber is useful given the significant variation in expense that can result from changes in the fair market value of our common stock, the effect of which is unrelated to the operational conditions that give rise to variations in the components of our subscriber acquisition costs and customer service and billing expenses. Specifically, the exclusion of stock-based compensation expense in our calculation of SAC, as adjusted, per gross subscriber addition is critical in being able to understand the economic impact of the direct costs incurred to acquire a subscriber and the effect over time as economies of scale are reached.

 

   These non-GAAP financial measures are used in addition to and in conjunction with results presented in accordance with GAAP. These non-GAAP financial measures may be susceptible to varying calculations; may not be comparable to other similarly titled measures of other companies; and should not be considered in isolation, as a substitute for, or superior to measures of financial performance prepared in accordance with GAAP.

 

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(8) We refer to net loss before taxes; other income (expense)-including interest and investment income, interest expense, depreciation and amortization, restructuring and related costs and impairment of goodwill; and stock-based compensation expense as adjusted loss from operations. Adjusted loss from operations is not a measure of financial performance under U.S. GAAP. We believe adjusted loss from operations is a useful measure of our operating performance. We use adjusted loss from operations for budgetary and planning purposes; to assess the relative profitability and on-going performance of our consolidated operations; to compare our performance from period–to-period; and to compare our performance to that of our competitors. We also believe adjusted loss from operations is useful to investors to compare our operating performance to the performance of other communications, entertainment and media companies. We believe that investors use current and projected adjusted loss from operations to estimate our current or prospective enterprise value and to make investment decisions.

 

   Because we fund and build-out our satellite radio system through the periodic raising and expenditure of large amounts of capital, our results of operations reflect significant charges for interest and depreciation expense. We believe adjusted loss from operations provides useful information about the operating performance of our business apart from the costs associated with our capital structure and physical plant. The exclusion of interest and depreciation and amortization expense is useful given fluctuations in interest rates and significant variation in depreciation and amortization expense that can result from the amount and timing of capital expenditures and potential variations in estimated useful lives, all of which can vary widely across different industries or among companies within the same industry. We believe the exclusion of taxes is appropriate for comparability purposes as the tax positions of companies can vary because of their differing abilities to take advantage of tax benefits and because of the tax policies of the various jurisdictions in which they operate. We believe the exclusion of restructuring and related costs and impairment of goodwill is useful given the one-time nature of these transactions. We also believe the exclusion of stock-based compensation expense is useful given the significant variation in expense that can result from changes in the fair market value of our common stock. To compensate for the exclusion of taxes, other income (expense), depreciation and stock-based compensation expense, we separately measure and budget for these items.

 

   There are material limitations associated with the use of adjusted loss from operations in evaluating our company compared with net loss, which reflects overall financial performance, including the effects of taxes, other income (expense), depreciation and amortization, restructuring and related costs, impairment of goodwill and stock-based compensation expense. We use adjusted loss from operations to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Investors that wish to compare and evaluate our operating results after giving effect for these costs, should refer to net loss as disclosed in our unaudited consolidated statements of operations. Since adjusted loss from operations is a non-GAAP financial measure, our calculation of adjusted loss from operations may be susceptible to varying calculations; may not be comparable to other similarly titled measures of other companies; and should not be considered in isolation, as a substitute for, or superior to measures of financial performance prepared in accordance with GAAP.

 

   The reconciliation of the pro forma unadjusted Net loss to the pro forma Adjusted loss from operations is calculated as follows (See footnotes for reconciliation of the pro forma amounts to their respective GAAP amounts):

 

     Three months ended
September 30,
     Nine months ended
September 30,
 
(in thousands, except percentages)    2008      2007      2008      2007  

Reconciliation of Net loss to Adjusted loss from operations:

           

Net loss as reported

   $ (217,010 )    $ (265,515 )    $ (653,867 )    $ (842,592 )

Add back Net loss items excluded from Adjusted loss from operations:

           

Interest and investment income

     (5,534 )      (9,099 )      (12,180 )      (27,676 )

Interest expense, net of amounts capitalized

           70,153              47,256            164,380            138,230  

Income tax expense

     1,723        660        3,813        595  

Equity in net loss of equity method investment

     4,924        4,546