Two prominent financial media outlets recently gave strong recommendations for Sirius XM Radio (NASDAQ: SIRI) suggesting it could return as much as 50% within the next year. In fact, the consensus estimates among analysts who cover Sirius XM put the stock's price target at $4.50. Shares bounced slightly after the positive reports but have since settled and even moved lower.
Cruising in the fast lane
For Sirius XM, times are very good. Subscribers are at an all-time high, having surpassed 25 million in July. The company is also seeing a 69% penetration rate in new car sales – an important metric for future earnings growth. Of those new car buyers, Sirius XM is successfully converting 44% of them to self-pay subscribers. These are car buyers who continue to pay for monthly service after the initial 6-month free trial.
A new and potentially very profitable catalyst is Sirius XM's plan to reach used car buyers by enticing them with a free 90-day trial. About half of the country's used car dealers are already on board including Motley Fool favorite CarMax (NYSE: KMX).
Having an agreement with CarMax, the largest used car dealer in the United States, is a huge impetus for Sirius XM's long-term strategy. CarMax, with its hip and unorthodox approach to sales, is seeing consistent double-digit earnings growth as the market for used vehicles is at all-time highs.
Given that CarMax controls just 3% of the 40.5 million unit used car market there's tremendous opportunity for expansion. Importantly, the majority of CarMax's inventory consists of cars that are at most 6 years old; meaning those cars are much more likely to have a satellite radio system installed. Consumers are clearly drawn to CarMax's efficient, no-haggle, superstore approach. It's the kind of environment that should be very conducive to Sirius' future growth in the secondary market.
Ultimately, agreements with used car dealers will help Sirius XM rescue lost revenue from orphaned OEM satellite radios in vehicles that have since been sold by their original owners. Since most late model cars now have systems installed, the secondary market has reached a critical tipping point. In addition to all of those positive factors, Sirius XM has cut a significant amount of its high-interest debt and recently the board of directors approved $2 billion in additional share buybacks.
Valuation appears lofty
So, what's the catch? Well, the problem isn't Sirius XM's growth or balance sheet anymore. The days of impending financial doom ended in 2009 when the company received a half-billion-dollar cash infusion from Liberty Media. Sirius hasn't looked back since. Subscribership isn't an issue either, especially given the current rate of penetration and increasing new car sales. No, the problem lies in the fact that the company's stock has already seen overwhelming returns over the past four years – easily outpacing the S&P 500 Index -- and that has left the stock overvalued by several key metrics.
Currently, Sirius sells for 30 times forward earnings and a mind-numbing 6 times sales. The company's expected five-year PEG sits at 1.82 and the company's price to book value is 8. Granted, margins are high and revenues are growing at 10.9% but earnings still aren't growing anywhere near fast enough to justify the stock's current valuation. Moreover, the company still carries $3.71 billion in debt and there's no guarantee that thrifty used car owners will convert to self-pay subscribers.
Headwinds on the horizon
Other competitors are also creating headwinds for future Sirius XM growth, including Pandora Media (NYSE: P), Apple's (NASDAQ: AAPL) new iTunes Radio and privately held Spotify. With the advent of multiple, free, streaming music services and large cell-phone data plans, many drivers are opting to provide their own music rather than pay for it, or listen to ads.
However, despite their many advantages, the streaming services have problems of their own. Pandora's stock valuation is stratospheric and the company is currently cash flow negative. Spotify recently unveiled free mobile streaming but the company is on an everlasting hunt for more funding, while facing sharp criticism over what it pays music artists. Meanwhile, iTunes Radio has been criticized for being noticeably less random in song selection and lacking some of the functionality of Pandora.
In conclusion, Sirius XM is a great company and it's certainly moving in the right direction. There are several catalysts that should translate into increased earnings over the next two years. However, despite the opportunities for increased earnings per share, the stock appears fully valued at current levels. Considering that a more reasonable valuation could easily reduce the shares to something closer to $2 a share (a 41% haircut from its recent price) there's considerably more downside risk than potential gain. For these reasons, I recommend long-term investors look elsewhere for more compelling investments.
