Sirius XM Holdings (NASDAQ:SIRI) has clearly impressed investors in recent years, surging over 3,000% from its 2009 lows. The company has a monopoly on the U.S. satellite radio market and a loyal customer base that generates a stable base of free cash flow.
Despite its stock price run-up, the market may not fully appreciate Sirius XM's business model. While streaming music offerings like Pandora's (NYSE: P) could pose a significant threat to satellite radio down the road, the threat may not be as big as it seems, allowing investors to scoop up Sirius XM at a bargain price.
Steaming toward streaming
Free streaming music services are the biggest threat to Sirius XM's earning power. Pandora and other streaming music apps are on the leading edge of music distribution. Although most audiophiles still consume music by purchasing CDs or downloading mp3s, an increasing number are streaming it. Nielsen reports that on-demand music streams increased nearly 55% in 2014, compared to an 11% drop in physical album sales and a 12.5% decline in digital track sales.
Evidence of Pandora's popularity is seen in iTunes' fading momentum. Last quarter, iTunes music sales plunged over 13% through October 2014, according to The Wall Street Journal. Industry experts attribute the decline to competition from streaming services.
However, where streaming services excel in attracting users, they fail in generating sufficient revenue. Pandora generates 80% of its revenue from advertisements and the rest from selling an ad-free version of its application. Pandora's $920 million in 2014 revenue was unable to cover its operating expenses and the company posted a $30 million loss.
A better model
While Pandora fends off competition from other streaming services, Sirius XM enjoys a monopoly on satellite radio. It owns nine orbiting satellites -- five for Sirius and four for XM. Satellites are enormously expensive to launch into orbit, but it does not cost any less to beam the signal to 1 million subscribers than to send it to 10 million subscribers. Thus, Sirius XM's economies of scale are likely to be too great for any new entrant to overcome.
Terrestrial radio is Sirius' primary radio competitor. Terrestrial radio is similar to Pandora in that it offers free music paid for by advertisements. Sirius' ad-free subscription model, however, has had enormous success. The company's product is placed in 70% of new vehicles sold in the U.S., placing Sirius satellite radio in millions of car dashboards each year.
Moreover, 41% of free-trial listeners convert to paying customers after the trial ends. Pandora can only hope to have such a high conversion rate; the vast majority of its users maintain free accounts, rather than paying for the ad-free platform.
In addition, Sirius attracts a sticky customer base that allows it to raise prices without fear of customer backlash. Exclusive content from CNBC, Rotten Tomatoes, the NFL, and other providers separates Sirius from terrestrial radio -- and what free streaming apps might offer once they are widely integrated into car dashboards. As a result of this rich content, fewer than 2% of Sirius' customers decline to renew their subscriptions -- even after price increases. That's a business model to bank on.
At 20 times trailing free cash flow, it's hard to take a pass on this growth stock that has such deep competitive advantages.