You're standing on a street corner when a metallic red Porsche comes whizzing by. The driver gets out and holds up the keys. She says, "It's yours for $200,000." You know that these cars can sell from $40,000 to $440,000. You don't know the model, the year, or the history of the car. All you know is that this is one attractive ride and you want it.
The market puts us into these situations every day. Young companies arrive on the scene with business models that we fall in love with. But they can have no earnings, sporadic revenues, little history, or more debt than they should have. Valuing these companies is like trying to solve a Rubik's Cube without opposable thumbs. Conventional pricing models fail to reveal an accurate fair value while the shiny metallic red sells us at the going price. This creates a "greater fool" scenario where each successive fool sells to the next until the greatest fool is left holding the goods nobody else wants after all have come to their senses.
There is one company that has attracted me like that shiny red Porsche: Sirius Satellite (NASDAQ:SIRI).
Let's kick the tires
You have probably heard the buzz about satellite radio: commercial-free music, tons of choices, all uncensored. I have no doubt that satellite radio will become mainstream in the future. However, the industry is young, and uncertainties remain, although I doubt the early satellite companies will be kicked to the ditch by new entrants because they have good market presence and have become entrenched with their products. Barriers to entry are great, with satellite launches, exclusive programming already accounted for, and customers locked into contracts. The most probable shake-up might come in the form of a buyout.
Sirius is playing catch-up to rival XM Satellite (NASDAQ:XMSR). XM has a considerable head start, and it shows. XM boasts more than 3 million subscribers versus Sirius' just more than 1 million. XM's revenues over the last four quarters were $244 million, compared with Sirius' $67 million. Despite Sirius' disadvantages, if the satellite TV industry is any decent comparison, there seems to be room for multiple competitors. Keeping subscribers happy and signed on will become the long-term goal for the successful players.
XM holds an eight-month head start in research and development. The company recently released a new portable unit that can record like TiVo and be carried on one's person. Sirius fans are still waiting for a worthy rival product. Both companies offer tuner units that integrate satellite radio into your home stereo system, offering the ability to record streams. Both products are vital to winning over conventional radio users to satellite.
One thing to watch will be whether Sirius can keep a handle on its expenses as it grows. Sirius is paying Howard Stern $500 million and Mel Karmazin a pre-bonus $6.25 million, plus 3 million shares of restricted stock along with an options purchase of 30 million common shares at $4.72. The options and the stock vest over five years.
The company will pay $506 million in flat salaries for these two guys over five years. At $13 per month per subscriber, Sirius will need 649,000 subscribers over five years just to bring its revenues to the amount -- in salary alone, not in bonuses or options -- going out the door to Howard and Mel.
Nobody knows what future margins will be because last year, Sirius lost 965% more than its revenues. In other words, for now, the company is, or at least was, spending $10.65 to bring in $1 of revenue. Obviously, this will change as economies of scale are realized and revenues begin to outpace operational expenses. Nevertheless, if Sirius' high-dollar contracts are any indication of its internal financial discipline -- and let's sure hope they're not -- then the company could be facing some serious cost-control issues.
What's under the hood?
Let's conduct a closer inspection of this company's financial engine. Sirius carries a debt-to-equity ratio of 0.66. For a company that is currently destroying value, this represents a fair chunk of leverage -- although Sirius hasn't run into trouble thus far.
The fuel in the Sirius financial engine is revenue growth. As long as Sirius can grow its subscriber base at its current rate of 45% per quarter and its revenues by 51% per quarter, its financial engine will be strong.
I made a deliberately ambitious financial model for Sirius that assumes subscriber growth this year that is equal to the company's 2004 subscriber growth, in percentage terms. My model then decays this growth over the next four years, leveling off to a steady 1% quarterly growth by 2010. I'm also assuming a gradual reduction in the cost of goods sold relative to revenues as Sirius matures and becomes more cost-efficient.
By 2010, Sirius would have roughly 19 million subscribers, according to my model. For comparison, DirecTV now sports 14 million subs, and Howard Stern has 10 million listeners. The company's 2010 revenues would be over $3.1 billion. The firm's first gross profit would be as soon as the third quarter of 2005, on quarterly revenues of $87 million.
That is a pretty sound engine, if it runs like it should. And let me by crystal clear: There are a lot of big ifs built into this model. In other words, Sirius will need to maintain some serious growth.
Taking a ride, or getting taken for one?
The bottom line is that in my mind, the ifs in the financial engine need to become reality to create a situation that even remotely justifies the current stock price.
I am inclined to look at Sirius' current market capitalization of $7.4 billion with hesitation. That's comparable to Nordstrom (NYSE:JWN), with $7.7 billion; Flextronics International (NASDAQ:FLEX), with $6.8 billion; and Office Depot (NYSE:ODP), with $6.9 billion. These companies have trailing-12-month revenues of $7.1 billion, $16.1 billion, and $13.6 billion, respectively, compared with Sirius's $67 million. All those companies have healthy debt-to-equity ratios and offer strong positive earnings. Even granting Sirius a rosy five-year future performance, its current price looks grossly inflated with respect to its prospects. For now, I am inclined to resist the shiny metallic red. But if ye be a fool, for your sake may there be a greater one.
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Fool contributor Cliff Malings is always happy to be a Motley Fool but constantly tries to avoid becoming a greater fool. He therefore cringes at the site of tulip bulbs, snake oils, time-shares in Death Valley, and overpriced story stocks. He does not own shares of Sirius or any other company mentioned here. The Motley Fool has a disclosure policy.
