Why I'm Buying Sirius XM

The notion of satellite radio as an economically viable enterprise seemed greater parts fanciful pipe dream than viable business in early days. XM and Sirius cut each other off at the knees for sport -- bidding up content costs, marketing like crazed televangelists, and launching satellites like it was the Cold War. Worse, would-be members could, or the perception went, get the same thing for free. I never thought I'd consider Sirius or XM worthy of investment.

Go forward 10 years and a lot's changed: the merger and formation of Sirius XM  (NASDAQ: SIRI  ) , management finding religion in cost discipline, and superinvestor John Malone (of Liberty Media and Liberty Interactive fame) entering the fray. Now Sirius XM more closely resembles a subscription-based premium content service, like the cable business where Malone minted his fortune, with a highly recurring revenue stream and robust free cash flow, than the speculative satellite play of yore. Even so -- and somewhat legitimately -- the investing public remains cautious, fretting over competing streaming services from Apple, Pandora, and Spotify.

I'd wager Sirius XM still has meaningful growth potential, underpinned by a long-delayed vehicle replacement cycle, a business operating at scale and solidly entrenched moat, and differentiated offering. Smart capital allocation a la the Malone influence, a market gradually appreciating the less-risky characteristics of Sirius' core business, and long-term potential in a just-completed acquisition are cherries on an already-tasty sundae.

And so, while Sirius XM shares look a bit expensive at 25 times free cash flow, I don't think shareholders' happy days are a thing of the past. That's why I'm buying a position equal to 3% of my Real Money Portfolio.

This is Voyager, calling cash flow
For its erstwhile runt status among media players -- probably on par with newspapers-- Sirius XM's done a remarkable about-face. On the heels of the Sirius-XM marriage, management's studiously set to work reducing costs, finding religion in places the well seemed dry. It's shown in the numbers: As subscriber count swelled to 25 million last quarter, programming and subscriber acquisition costs -- two of the biggest line items-- have declined 50% as a percentage of revenue.

Previously piddling sales yielded to a delightfully recurring revenue stream: Self-paid membership churn is just 2% per month, and for every member, Sirius books $12 a month. (Ask anyone in the membership biz, and they'll tell you a 2% monthly churn is positively tantalizing.) Since the lion's share of Sirius' costs are fixed -- satellites, programming costs, marketing, and administrative expenses -- the result is a remarkably scalable business. Adjusted EBITDA margin (management's preferred measure, which is something like a cash flow margin) has ballooned to greater than 25%, and incremental subscriptions generate 70% EBITDA margin.

Sirius' success derives from a simple formula: Unique content -- from such varied sources as the NFL, CNBC, MLB, NPR, Fox News, and Howard Stern -- in addition to music. As the single-largest player in the radio biz, Sirius XM has consistently proven able to exert influence in content negotiations. And truly, if the recent past is indicative, there's not a single act it can't land at reasonable cost. There's a virtuous cycle in this: Sirius' bargaining power enables favorable terms on content, and it provides a unique offering when compared to its radio and streaming peers. That, in turn, attracts and retains members. To wit: After the company set a 5% price hike, subscriber churn hasn't budged.

Some market-watchers contend that Sirius XM is on notice, as emerging streaming players introduce cheaper alternatives and threaten to bid up content costs. And, yes, there's some cause for concern. But that argument also misses the nuance: a.) Sirius caters to users who aren't looking to curate their listening experience, or make active efforts; b.) it offers unique content (besides music) where streaming services do not; c.) for the avid driver/commuter, the two are complementary (which as a D.C. Metro area resident, I'm unfortunately aware); and d.) most importantly, streaming options really aren't that cheap.

That's because streaming services use a lot of data, a whopper of a hidden cost. Wireless spectrum doesn't just fall out of the sky, and the legions of Facebook-obsessed, Miley Cyrus-listening, hyper-social smartphone users isn't in decline. Expect AT&T and Verizon to keep jacking the rate on data plans, in response. That can and will change the economics of streaming services dramatically.

Then there's the matter of content costs. While I expect they'll march higher as competition emerges, it's not in anyone's interest to bid them out of the park. Moreover, Sirius' position still endows significant leverage in negotiations and the ability to attract acts a cut above the rest. There's one last thorny bit: None of the emerging players have profitably monetized their models. So, do I worry? A little. But only a little.

Satellite launching?
But for the delectably attractive dynamics of Sirius business, I believe the market continues to underestimate its potential. Most notably, I believe cash flow per share's poised to head skyward as membership gains and margin expansion are compounded by leveraged share repurchases, a classic Malone move. This, alongside a cost of capital rerating and potential from the Agero deal, affords considerable upside potential in the shares.

Growth Potential: 25 million U.S. members may sound like a lot. It is. But against the market size, there's still great potential. Consider this: There are 200 million nonfleet light vehicles in the U.S., and almost 75% of U.S. workers spend 30 minutes or more commuting every day. Of course, Sirius XM isn't exactly an everyman indulgence: It runs you $10-$15 per month, depending on the promotion. So, haircut those numbers for income, and I come up with an accessible market -- on price and value proposition -- approximating 85 million-100 million folks stateside.

Right now, Sirius hardware is installed in about 50 million vehicles, but that number's growing. A lot of folks delayed new car purchases during the Great Recession, but they're buying now as household wealth grows and their clunkers fail. For the foreseeable future, I believe North American auto sales should easily run 15 million annually, and about 70% of those vehicles come equipped with Sirius hardware and a free trial. Historically, about 45-ish percent of them convert to paying subscribers.

Taken together, it's conceivable that sub counts can grow to 35-40 million, or 45%-60% growth. Expansion into lower-price point, more niche offerings could grow the potential. A look at member counts for other specialized, discretionary content providers with similar price points confirms the potential: Time Warner's HBO had 41 million U.S. subscribers at last year's end, and at last quarter's close Netflix had almost 30 million U.S. streaming customers.

The Malone Playbook: Those who've read The Outsiders, or done this thing called investing, are no doubt apprised of Liberty magnate John Malone's prowess in all things capital allocation. He's a huge fan of taking assets with stable and recurring cash generation, levering them up, and using the proceeds from the debt and cash flow to repurchase shares.

A lovely and virtuous value-accruing cycle follows: Share repurchases supercharge growth to cash flow per share. It looks as if a similar routine's afoot at Sirius. Malone secured a 50% equity ownership and seats on the Sirius board after a Liberty-sponsored loan saved Sirius from bankruptcy in the credit crisis' darkest days. Now that things are looking brighter, Malone's up to old tricks.

Sirius management has announced intentions to take debt on up to 3.5 times EBITDA and use the proceeds alongside cash flow to repurchase shares. Right now, it has a $4 billion repurchase authorization outstanding -- roughly 15% of Sirius XM's market value. Across the next five years, I think Sirius could easily repurchase almost $10 billion worth of shares, or 40% of its current market value. That would not be bad.

Cost of capital rerating: For the fundamentally attractive qualities of Sirius XM's model, all of this talk would be remiss without a mention of risk. For a long time, Sirius was thought a has-been.

But I think we can agree that's changed. And so has Sirius' risk profile. There's bandwidth for value creation in two flavors here -- retiring Byzantine Era debt and the market's changing view. Of approximately $3.2 billion total debt, Sirius still has about $1 billion outstanding at 7% or higher rates. The company recently issued debt at about 5%.

Retiring the remaining 7% debt at a 5% rate could bring $15 million to the bottom line with a simple wave of the hand. And while that's good, the optics are more important: Should the market start to regard Sirius as greater-parts cable company than satellite start-up, it'd probably be willing to afford the shares a higher multiple for the perception of lower risk. And that could be huge.

Agero Who? Sirius recently completed an acquisition that, given a first glance, you might not think twice about. But it's actually a big deal. The company now owns the connected vehicle services unit of Agero. Basically, you take a modem, a bunch of chips, and the car becomes an intelligent being. Applications are myriad: Conveying data on driving habits to insurers, GM OnStar-type safety features, connecting to media via the modem, or diagnosing mechanical problems.

For Sirius XM, there are a few very tangible benefits. First is the obvious: revenue opportunities from Agero's platform as cars' connectedness evolves. Conceivably, this segment could one day be as large as Sirius. Second, it provides a means of installing Sirius in roughly 40% of cars, on account of Agero's existing relationships. Lastly, it could change Sirius' content distribution channel. Instead of satellite, it could use wireless spectrum. In a world where satellites run $300 million a pop, that's not chump change, and could propel Sirius' profitability ever higher.

Buying the satellite
Taken together, I expect Sirius' member count to increase to roughly 37 million over the next 10 years, and for EBITDA margins to expand to 38%- -- a bit shy of management's targets -- as increasing content costs take a bite, but are largely offset by higher member counts. Profitability expands at an outsized clip for a very logical reason: most of Sirius' costs are fixed. Along the way, I expect management to increase prices at about a 3% to 4% clip, and for debt and free cash flow to be regularly deployed to share repurchases. Put it all together, and I peg the shares' worth at $4.90.

I'll be watching a few bits along the way. First is the negotiation between the NFL and Sirius, as the league's contract comes up in 2015. Of the contracts, this one's big, and the NFL holds a lot of the chips. Should Sirius be forced to cede an above-market rate (relative to recent NFL renewals), that'd be worrisome. The same goes for Howard Stern, whose contract comes up in 2015. It's unclear the extent to which losing Howard Stern might impact Sirius' member retention, but it's worth watching.

Last is the general trend on content costs, as new competitors enter the fray, and the extent to which those costs pressure pricing and/or Sirius' growth prospects. In each of the above circumstances, Sirius' ability to raise prices without impacting churn, and the uniqueness of its content bin, give me confidence its cash-generating ability will remain intact. But even so, it's something that bears careful watching.

The takeaway
Just admit it. You've always wanted to own a drone, and you're not Jeff Bezos. So take the next best -- a satellite.

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Read/Post Comments (18) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2013, at 6:02 PM, buylowersellhigh wrote:

    What do you think of LMCA? Why not buy that?

  • Report this Comment On December 11, 2013, at 7:14 PM, sirifair6 wrote:

    I find your piece thoughtful with a deep understanding of siri's business, its potential and opportunities. It is even more remarkable that you maintain your point at a time where the stock has lost over 15% of its value in the last 45 days. It is healthy to get sound opinions once in a while. I see siri's future as bright as it can get.

    2014 -2016 are what I call "clean" years where all debt without exception has been refinnaced at low rates (over $500M at 7%+ will convert into about 270M shares at the end of 2014), capex is minimal and the company's steps are not shackled by so many burdens that it used to have. FCF in 2014 will exceed $1B, they will continue buybacks to the tune of $10B+ in the next five years and may even start paying dividends and paying off some debt. These are going to be remarkable times for today's longs.

  • Report this Comment On December 12, 2013, at 6:24 AM, zukerman wrote:

    Why hurry to buy now? You'll be able to purchase shares of this stock in February for the same price and that's only if Frear doesn't have another speaking engagement on CNBC. I haven't experienced a more damaging interview in a long time. It's almost like they prefer the share price stays where it is to buy back more shares. Why not address the issue on the new method of counting subs instead of taking a shot at Pandora's business model? Why expose your underbelly stating that ESPN is getting expensive when your core business is cable? I'm beginning to think my money would be better placed elsewhere for 2014.

  • Report this Comment On December 12, 2013, at 7:38 AM, sirifair6 wrote:

    Zukerman,

    I follow the company closely but I am not familiar of any Frear's engagement on CNBC as you claim. What I know of is both Meyer and Maffei being on CNBC. By the way, you are right that the appearance was not positive saying things that looked like they were trying to supress the stock. Meyer actually said that in 2013 siri would gain about 1.5M new subs from the used car market. Actually this is the entire number they are projecting for the year. What about OEMs then? Is their gains ZERO? Astounding!!!

    You may be right that it may make sense to buy siri after Q4/2013 CC in late January or early Fenraury because the price may even drop further, or may not. The GM deal will make a hit on the sub count because there will be no more hunfreds of thousands of temporary, I underscore temporary, GM partly sunsidized PROMOTIONAL subs as of Q4, 2013. However, as of the same period there will be no more exorbitant revenue sharing with GM and this deal will finally become PROFITABLE for sirius.

    To conclude, we are talking about a short-term negative GM only impact and a long-term large fcf gain. What would you choose? Profit or a loss! As a long, I choose profit in particular in light of a very comprehenisve an eye opening for many analysis of siri's business and its future presented by the author. So far in the last five years after near bankruptcy I have been dead right on siri and everybody like me who has been holding siri has benefited in folds. You appear to be where you were since I last read your comments. The siri caravan will keep marching in spite of sometimes quite noisy barking,

  • Report this Comment On December 12, 2013, at 8:09 AM, TJR wrote:

    TJR

    Great article, why is the point that data is the big downside of streaming services never really talked about by those who are always knocking Siris against Pandora and others. The big elephant in the room is data for those services and can add a cost greater then the cost to have Siris. Stay long and stay the course.

  • Report this Comment On December 12, 2013, at 9:20 AM, CaribouPaku wrote:

    I always hear about the cost of satellites, as being expensive, but has anybody really did a cost study of streaming. The implementation, cost of equipment, etc.

    Another point is that, one wonders if there could be any truth to the actions by management to try and keep the stock currently suppressed in order to buy more stock. I would think that the objective would be that as many shares of stocks back as the market would allow at the lowest price the market would allow, excluding the Liberty buy back. What is surprising is the share price falling below the agreed upon price that Liberty was paid or about $3.68 per share. Sad to see the lost of all the gains made over the last year. Will we see these share continue to trade down and will it take another year to complete the additional $2billion in stock buyback. I for one think shareholders deserve better and this all could of been avoided with a reverse split of say 5 for 1 and the capital could of been used to reduce liabilities instead of providing Liberty with the capital that only they seem to be profiting on!!!

  • Report this Comment On December 12, 2013, at 9:52 AM, zukerman wrote:

    sirifair6,

    Thank you for the correction, sometimes the mind thinks one thing the fingers type another. We are talking about the same CNBC segment. Long time holder of Sirius and not ready to jump just yet. I'm frustrated with managements treatment of shareholders when they sit there all smug and apparently all too comfortable with the performance of late.

  • Report this Comment On December 12, 2013, at 10:02 AM, zukerman wrote:

    Following the money with a purchase @3.39 at 10:00, but wonder how low it can go.

  • Report this Comment On December 12, 2013, at 12:21 PM, sirifair6 wrote:

    Zukerman,

    $3.39 is a great buy but it may go down as low as $3. I recall last year it dropped in that range.

    Now, I about our worries that I consider without any doubt in my mind short term spanning three to six months maximum. The main worry remains the upcomingQ4 announcement of hopefully not negative subs because of the change in the GM sub count. However, if they hit about 300K subs in Q4 the stock will start coming back quickly.

    I am having a problem trying to pinpoint other concerns. The balance sheet in in the bst shape ever with all interest around 5.5%. All satellites have been launched, so capex is minimal. Most of the programming deals, including MLB have been renegotiated quite favorably. I am confident that MLB costs will go down at least 20%. Royalty increase in 2014 is negligible at 0.5%. The price increase of fifty cents is minor but helpful. Used car market penetration is catching up. OEM sales will keep growing. Recently announced Honda and Crysler deals are very impressive and many others will follow. Pioline joinging siri may play out huge in 2014 by bringing on board a few million Hispanic customers. Malone is selling $500M worth of shares relataively cheaply at $3.60 and change. Additional $2B buybacks will proceed. A holdco will be announced.

    I cannot see any major negatives other than additional borrowing to the tune of $1-$1.5B for buybacks. They may even announce a small dividend program.

    To conclude, starting Q4, 2013 the company is in execellent shape for at least another three years that we can see. Let them buy back as many cheap shares as possible while fools are selling. True longs should be happy!!!

  • Report this Comment On December 12, 2013, at 8:59 PM, ouarmy2012 wrote:

    So how do you account for Sirius Costing money and Pandora being free? As someone that has used Sirius and now currently Pandora i would never pay for Sirius. I doubt i am the only one that thinks this.

  • Report this Comment On December 12, 2013, at 9:05 PM, Kryptyk wrote:

    In the spirit of Peter Lynch's "invest in what you know", I'd like to weigh in on why I won't invest in Sirius XM. And that's because it sucks. I have been a subscriber for three years, with service in my car and add-on service for internet use on my computer and phone. The apps are terrible; they are difficult to navigate and often freeze up. Service in my car is good, especially in rural areas, but I am using it less and less. The two stations I listen to most are CNBC and Bloomberg, and I can get those via TD Ameritrade and TuneIn radio, and excellent, $3 app for iPhone. And for music, Spotify absolutely rocks; I rarely use even iTunes on my phone anymore.

    I am not renewing my subscription this year, and I don't plan on buying SIRI any time soon. I appreciate the thoughtful analysis here, but I suggest investors kick the tires on this one and try a subscription if possible.

  • Report this Comment On December 12, 2013, at 9:24 PM, prhea wrote:

    Ridiculous not to own siri long term. Every commercial truck driver wants it or is getting it for their long hauls and every new car will own it soon. Streaming is not the same at all and will never replace sat radio.

  • Report this Comment On December 13, 2013, at 12:42 AM, bikeboatski wrote:

    To put Howard Stern in the same sentence, or paragraph, with the NFL when it comes to drawing power seems ridiculous to me. Howard Stern sucks if you ask me....and I think quite a few others would agree!

    As to your main thesis I can't venture an opinion having not enough experience however in my area, which is a ski resort town, we have an NPR station that plays pure Jazz and a little R and B, continuously WITHOUT COMMERCIALS AND FREE For me this is about as good as it gets!

    I do think when traveling in my car it could be a good thing though. Do they have any competition in this venue other than local radio which stations usually suck?

  • Report this Comment On December 13, 2013, at 8:30 AM, ziq wrote:

    @bikeboatski: Howard Stern sucking is beside the point. Personally, I have little interest in either Howard Stern or NFL. Satellite radio supposedly has enough program streams to cater to nearly everyone's interests. What is to the point, though, is that the cost of Internet streaming, from the point of view of the consumer, only applies to mobile devices. High speed home Internet, while not universal, is becoming so. Almost every radio station on the dial nationwide is available fro free on the Internet as well as on good old analog (and now, "hybrid digital") radio if it is within range. So the appeal of satellite radio is essentially limited to automotive listening, where it is much more reliable than off the air (but not infallible). The analysis of growth potential within that niche may be right, but practically speaking that's the only place it exists.

  • Report this Comment On December 13, 2013, at 11:12 AM, DavidStHubbins wrote:

    Ohhhhh Yeaaaahhhh, I remember the BIG news 8 years ago XM was going to start turning a profit..very exciting...then 7 years ago they were going to start turning a profit..still pretty exciting. Then 5 years ago, they were going to start turning a profit ...for real this time... Uhhhhh, nope... And today? what? Still no profit?? Hmmmmm.. then they merged with Sirius. And, had some bankruptcy talks in there. Music playlists got pretty bad in the first year or two after the merger, but it seems that they got that mostly straightened out now. How is the profit now? ..what? still not there.... Really? Keep on holding the carrot out there..it seems that there are plenty of people out there that still want to believe.... Sounds like management is either totally garbage or massively brilliant genius stringing it along.

    I gave my neighbor my old XM radio to try in his car, but after calling for subscription, he found that streaming to his phone in the car was much cheaper. Yeah, I noticed my monthly bill creeping up...considering the internet/phone streaming now..

  • Report this Comment On December 13, 2013, at 11:17 AM, dcfool2013 wrote:

    This article led me to make my first comment on Fool. As a long time Sirius customer and now an XM customer I'm not interested in their product anymore for a few reasons. Their content is nice if you are interested in sports, but music has really stepped backwards. Favorite listening channels of mine have been decimated over time and I now find I prefer to listen to podcasts or Pandora. I recently bought a new car with XM and although I have paid the limited amount for the "Music only" 6 month subscription, I rarely listen anymore and will probably not renew. Where has the good music gone? Yes, they make things look good with expensive live events (none of which interest me).

    Another big issue I have is how split their content is, depending if you have "Sirius" or "XM". What's 'standard' content on one may be 'premium' content on the other. As a consumer, that's very frustrating.

    If I don't want to buy it as a consumer, why would I want to invest in it? Hopefully they can turn it around, because when we travel it's nice to have along. I don't feel like sports broadcasting will carry them, but I guess that's because I'm not a big fan of most of the sports they are paying high dollars for.

  • Report this Comment On December 13, 2013, at 11:22 AM, DavidStHubbins wrote:

    I almost forgot...I was totally excited when there were bankruptcy talks. That was a great opportunity for the company to get straightened out and match the programming and overhead costs to the revenue stream. How much does it cost to program music free music channels? Isn't most of the sports and news stuff few from other sources? Keep the other fluff to a minimum to give the people what they really want - the basics - commercial free music and nationwide reception of news and sporting events. Is it really that difficult? What the heck are they spending the money on?? Time for a good thorough housecleaning...

  • Report this Comment On December 13, 2013, at 3:31 PM, Whitermco wrote:

    I think Siri is headed for a fall. Their news and other than music programming is so full of advertisements that it is difficult to listen to. Their music is little more than fluf. I owned it, made a nice profit, and got out.

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