Sirius XM Defies Short Sellers to Thrive in World of Online Streaming

Despite being one of the most heavily shorted companies trading on the NASDAQ Composite, Sirius XM (SIRI -4.43%) has proven satellite radio is here to stay as it launches new growth initiatives to shore up its long-term future with connected cars and SXM17.

And in the world of beer, MillerCoors is feeling the pressure from increasing craft beer sales as it closes one of its eight U.S. breweries.

A full transcript follows the video.

Sean O'Reilly: Is Sirius XM here to stay in the streaming music world? On this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly recording at Fool headquarters in Alexandria, Virginia. Joining me today is the extraordinary Vincent Shen. How's it going, Vince?

Vincent Shen: I'm doing well. How are you, Sean?

O'Reilly: Not too bad. Back to 80 degrees here in Alexandria. It was a little cold the other day.

Shen: It's nice.

O'Reilly: It's nice?

Shen: I prefer this weather.

O'Reilly: I agree. Fall is wonderful. Before we dive into talking about Sirius XM and its competitive position I wanted to briefly discuss big news in the world of beer, this morning. What's been going on here?

Shen: Yeah. MillerCoors joint venture between SAB Miller (NASDAQOTH: SBMRY) and Coors Brewing (TAP -1.38%) -- I was actually at their brewery in Denver.

O'Reilly: You just had to drop that little tidbit, didn't you?

Shen: It was awesome. Yeah. It was really awesome. Very fun tour of the brewery there, but they have eight, right?

O'Reilly: Right.

Shen: They'll actually be closing one of their main breweries.

O'Reilly: I was shocked at this because they still have 24% market share between all these brands. It's them and Budweiser. They still have two-thirds of the U.S. market. They've got Coors Light, Miller High Life, Miller Lite, and Blue Moon -- my personal favorite, there -- and they're closing their Eden, North Carolina plant. It's going to close by September 2016.

They're doing this under their new CEO, Gavin Hattersley, and 520 people are getting laid off. They're going to ship production to another one of their facilities, and they just cited the fact that the number of microbreweries and regional breweries grew 19% last year to around 3418, according to the Brewers Association.

This has the makings of a beer bubble, and it's not the good kind of beer bubbles.

Shen: I think this unfortunately means that with closing the brewery they're losing some employees, but as you mentioned earlier they see the writing on the wall with the way craft breweries have grown. The breakdown is about 74% non-craft domestic brewers, 11% craft -- which is huge growth considering how recently it came about.

O'Reilly: 20 years ago it was a fraction of 1%.

Shen: Exactly.

O'Reilly: It was minuscule.

Shen: The fact of the matter is, it does present some operational efficiencies. They have another brewery in Elkton, Virginia which is 200 miles away. The distribution coverage area for these two breweries overlaps significantly, so it makes a lot of sense for them to consolidate.

O'Reilly: This isn't like a bankruptcy shudder or have to go under type thing -- it's an efficiency thing?

Shen: Exactly. They also had that recent buyout of St. Archer, and the fact that they bought out this craft brewer -- again, they're trying to diversify their products a bit -- they just see the growth in the popularity of some of these craft brews and they'll have to adjust.

O'Reilly: Before we move on to our main event, I want to throw this out there: they've generated tons of profit, but I wonder how long -- with the immense competition that we're seeing in the beer market with all these microbreweries opening up -- how long the number one craft brewer, Boston Beer -- maker of my personal favorite which is Sam Adams -- they're going to keep going before they start feeling the heat.

There was 19% growth last year. That's excessive.

Shen: The numbers I mentioned earlier of 74% non-craft domestic, 11% craft, 15% import -- that's still a lot of room for them to move up and take parts of the market. At least that's my opinion. Since Coors formed the joint venture seven years ago their volume has fallen 10 million barrels.

O'Reilly: I wonder if Sam Adams, or Boston Beer is the Budweiser of the United States in 30 years. They're huge, everyone just buys them for barbeques.

Shen: It's possible. In the end, when I go to the grocery store and I go to the beer aisle, it's still dominated by the main ones like Budweiser, Bud Light, that kind of stuff. I have noticed an increasing offering of the smaller craft brews, but I think that Coors and Budweiser are going to dominate for a long time to come.

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Today, Vince, we're going to be talking about Sirius XM, everybody's favorite satellite radio provider.

Shen: The only satellite radio provider.

O'Reilly: The only satellite radio provider. They have a monopoly, but they don't. I don't know how to describe it. I took an hour or two this morning to review their operations. We found out they have 12 glorious satellites circling the planet. What has this company surprised you with so far?

Shen: That it still exists and it's doing well, I think. I'm not bearish on this company, but as we'll discuss soon, there are a lot of short sellers and bears that think that -- or thought previously -- that Sirius was circling the drain, essentially.

O'Reilly: Let's not forget, this stock was $0.05 or $0.10 per share in the depths of the financial crisis in 2009.

Shen: Exactly. I'm definitely one who appreciates a good underdog story, which this one definitely is. Like you mentioned, the stock was trading at about $0.05 in 2009 -- that was its bottom. It's trading at about $3.80 now. The thing is, there was a time when you frequently heard people talking about the death of satellite radio. The fact that it was a transitional technology that's basically bridging the gap between AM and FM radio and online streaming.

O'Reilly: Sirius Satellite Radio and XM Satellite Radio merged because they didn't know why they were fighting each other when they clearly had bigger fish to fry. I think one of them was losing money, too. You're surprised that they still exist?

Shen: I was definitely surprised by how well they're doing. Their 52-week range has been pretty consistent between $3.14 and $4.04 per share. The thing is, year-to-date they're up 9%. They're outpacing the NASDAQ where they trade, which is up less than 2%, and S&P 500 is down 5% year-to-date. It's doing pretty well in the short-term view.

O'Reilly: How are they pulling this profitability and strong share price? How are they doing all this?

Shen: It's actually really beautiful if you look at their business model. The more I've learned about this company the more I like it, despite some of the big picture, competitive headwinds that are coming. Their subscriber growth and stable cash flows are basically what's really driving the ship.

First of all, the company closed out their most recent quarter with a lot of all-time highs and good records. They had a record 28.4 million subscribers. That's a gain of nearly 700,000 from the previous quarter. They also had their self-pay subscribers increase to an all-time high of 23.4 million. Monthly churn is at 1.6%, which is basically the people who are not renewing.

O'Reilly: That's super low. That's awesome.

Shen: It's their lowest since the two companies merged seven years ago. Their trial funnel, which is the people who are potentially going through trial phases -- think Amazon Prime's one month free trial -- they're potentially going to roll over into self-paying subscribers...

O'Reilly: In my opinion, that's their competitive advantage. They have agreements with the big three auto makers and if you buy a new car through them, all three of them -- Ford, GM, and Chrysler -- all throw three free months of Sirius XM. My dad bought a Dodge Charger 2011, and they gave it to him. He wound up cancelling, but a staggering number of people keep it and just pay the $10 a month.

Shen: Exactly. That trial funnel of people, like your dad, is sitting at another all-time high of 8.2 million. This is all really impressive for their most recent quarter. The thing is, top line growth has been solid, but their bottom line growth has also been really solid. Earnings were up 29% year-over-year to $170 million, large share count which poses a bit of an issue puts the earnings per share at only $0.03.

Headline numbers seem low, but it's doing quite well with the growth. The thing is, that's 18 consecutive quarters for the profitability of the company. They have raised their monthly rate three times. Once in 2011, once in 2013, and once earlier this year. They're still seeing that growth, so there's a bit of stickiness there.

They've upped their guidance for 2015. Free cash flow, revenues, everything is looking really good for the rest of the year.

O'Reilly: I trolled The Motley Fool message boards and the community, and we have some great pieces put out regularly by The Motley Fool's own contributor Rick Munarriz about the company -- that's his company that he's been writing about for six years now. Everybody talks, and the reason you buy Sirius XM shares is because of its free cash flow number. As you noted, it's at $1.3 billion. That's very impressive, but what are they doing with all this money?

Shen: Two things: bringing down their share count by stock buybacks and also investing for growth for their future. First of all, in 2013/2014 the company repurchased 1.3 billion shares for $4.3 billion.

O'Reilly: How many shares are outstanding?

Shen: That was 2013/2014. They also purchased another 338 million shares as of the last earnings call. That's another $1.3 billion worth of stock. It's reduced their share count about 20% since early 2013, but they've only gone from 6.6 billion to 5.3 billion shares outstanding. This is about a $20 billion market cap company.

Huge share count. I have to say though, in two or three years that 20% reduction is big. This is an extremely successful repurchase program.

O'Reilly: Every single person that's left standing owns a bigger piece of the pie.

Shen: A couple weeks ago, the company authorized another $2 billion of repurchases. You can expect this trend to continue as they very aggressively try to reduce that share count. That's one thing where the free cash flow has given them some flexibility to attack that number. It's also giving them an opportunity to invest in a lot of stuff that will be important for their long-term growth.

First of all, you have new content. I thought it was really cool that recently they got the rights to major music festivals like Coachella and Bonnaroo. They've expanded beyond music to comedy and sports channels, everything under the sun. There's a lot of optionality.

O'Reilly: I have noticed when I looked at them last year, that was kind of their other competitive advantage. You could drive anywhere, and you've got your favorite stations, but they also have a lot of exclusive people like our friend Howard Stern that has 10 million fans, and they all just want to listen to him and are willing to pay $10 a month for it. The Coachellas, next they'll be at Burning Man.

Shen: Fundamentally, Sirius is tied to the place where people are most likely to listen to anything: in their car. Its' really important. Going beyond that, they have really strong relationships with the car manufacturers, as you mentioned. Every new car that gets put on the road, Sirius has an opportunity to penetrate that market.

As that becomes more common for these connected cars coming out, some people will see that as a threat to their platform, but at the same time, now every car that goes into the used car market could potentially be a new Sirius XM subscriber.

Another big thing that's more specific to their offerings is their SXM 17 coming out. Details are a little scarce and they announced it earlier this year. Some people think it will be a big showcase for them at CES in January. Basically, it's going to be their new platform, it's expected to define their future strategy, integrating mobile, it will have higher levels of user and listener interaction.

O'Reilly: Are we talking about a Sirius XM app on my phone? What is it?

Shen: More interactions. The mobile app will give you the ability to control what you're listening to a bit more, where you can curate your playlist. You can 'thumbs up' and 'thumbs down' things kind of like you can with Pandora and other services and help you discover new music, new channels, and things along those lines.

O'Reilly: Got it. Stronger vehicle penetration, strong relationship with the car manufacturer; it sounds too good to be true. They're throwing all this cash flow, but satellites are expensive, and as I understand it they need to replace these puppies every 20 to 25 years. What's the deal here?

Shen: I'm glad you brought that up. Its business is inherently high fixed cost. They will have to bite the bullet eventually with that capex in the future. At the same time, once those big, one-time expenses come up, their revenue is very scalable as it grows. The satellites are in the air, every person that they sign up is...

O'Reilly: There's no doubt why there's a huge discrepancy between their earnings per share on a GAAP basis and this free cash flow number, because these depreciation charges that they have for the satellites that are floating 100km above our heads. Not that we care, because we're Foolish, long-term investors, but they have a huge shortage risk, don't they?

Shen: That's what made me chuckle when I was doing the research. For a time, they were the most heavily shorted company on the NASDAQ exchange space on volume.

O'Reilly: Why?

Shen: I think that has to do with the fact that they have a really high share count -- 5.3 billion shares is big. They've bucked some of these expectations for the past five to seven years with all these emerging technologies -- think mobile, and online streaming like we talked about -- people really thought that this industry wouldn't survive. Transitional technology wasn't going to make it, and I think a lot of people who were shorting the stock were very disappointed and probably lost quite a bit of money depending on how long they stayed in.

O'Reilly: Their conversion rate -- the people that have the service in their car a year after the trial subscription ends -- it's at a lower rate. Does that scare you at all?

Shen: That similarly fell to a low of 41% for the most recent quarter.

O'Reilly: I did video analysis on Sirius XM a little over a year ago, and I think it was in the mid-40s then. I can't quite remember.

Shen: There's a lot of all-time highs, but there's also some lows for the quarter. This is one of them. The conversion is very important; I won't deny that.

O'Reilly: That's still 40% of the people.

Shen: Yeah. That volume growth that they've seen, 700 thousand subscribers added, has been really able to offset that lower conversion rate. I think only time will tell where their baseline falls to, but it hasn't fallen that much.

O'Reilly: The cool thing about that, and the key for me, was the fact that -- okay. This year, the United States sells X number of cars through the Big Three, a bunch of them get offered a free subscription through Sirius XM, a year later when the subscription ends 40% of them are still paying $10 a month. All their costs of getting the satellites up in the air and maintaining it; that's all been spent already.

Shen: Exactly.

O'Reilly: All these subscribers go straight to the bottom line. That's extremely powerful.

Shen: It reminds me of what we were talking about with Keurig last week. Once you buy the machine it's all about the pods so they have this very strong cash flow. They've run into other headwinds, and that's kind of a similar situation here where a lot of people think technology is going to be pushing against their growth.

Their revenue growth has decelerated to the high, single digit rates for the most recent quarter. That's not surprising considering they have 20 million subscribers, and it's more of a mature industry at this point.

O'Reilly: They've got 8% or 9% of the U.S. population there. Talk to me about valuation before we sign off here.

Shen: With all that in mind -- and I think this all contributes to the fact that short interest is at such high levels -- the company is not cheap. It trades about 38 times trailing 12 month earnings; 25 times expected 2016 earnings; so considering the slowing growth rate...

O'Reilly: The market is at 16 or 17 right now.

Shen: Considering the slowing growth rate and the fact that this company is going to have negative headlines around it just like it did years ago, and it consistently will even though it's disproving a lot of the naysayers; that could impact the shares. It's really going to need to execute well on its upcoming initiatives like its SXM and the launching of the Nissan Connect.

It's starting to power the entire vehicle infotainment system and offering a lot of features like remote access, safety, security, vehicle monitoring; so it's branching out significantly beyond just radio. That's a new world for it and it's going to execute well on that front.

O'Reilly: Thank you for your thoughts, Vince. As always, it was a pleasure.

Shen: Thank you, Sean.

O'Reilly: If you are a loyal listener and have questions or comments we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!