On Monday, I made a case for why I felt the Street was still underestimating Sirius XM (SIRI). Not surprisingly, though, I got a few emails from readers wondering, "How can a stock that has already gained close to 25% on the year when factoring its $3.59 high, be discounted?" It's a fair question. The answer is hidden in how the company's valuation is assessed. But I'm realizing while the Street has been correcting its error over the past year, analysts still don't fully understand this company.
The valuation equation
The market is sometimes presumed to always be right. Depending on your frame of mind, sometimes this can work for you or against you. In that regard, a company's valuation is based on quite a bit of assumptions, some of which takes into account things like market dynamics, a company's performance history, management's guidance etc.
However, these metrics, as broad as they are, can fluctuate up or down depending on the news that may adversely impact or improve the competitive landscape of that company. In other words, stay on your toes. For Sirius XM, however, which has essentially doubled over the past year from $1.79 at the beginning of 2012 to $3.59 last week, there has been several mistakes along the way made by Street analysts, including under-projecting the rise in auto sales and an improved consumer spending environment.
Since projections are based on forward-looking assumptions, I think it's safe to assume here that the Street will continue to make these sorts of mistakes. The winners have been the retail investors, many of whom have ignored arguments from guys like me that had gotten this incredible story wrong in the past. But I've learned. And at this point, it's about the future. And since the start of the year, I think I've figured out how this company is going to continue to be a goldmine for retail investors. This is what's we've been discussing over the past couple of weeks. We've been looking at three things.
The three keys to success
The keys to Sirius' long-term growth recipe are three ingredients. Not necessarily in this order, but the company needs to continue retiring debt, increase its EBITDA and as it has been known to do very well, build its cash position. We can disagree about the priority order of these objectives, but we have to agree that they are the important metrics to Sirius' execution. So far, I have been impressed with how this company has performed in each of these categories.
In fact, Sirius only needed to do one of these things well to get the stock going. However, and remarkably, the company has done an impressive job in all three. If you were wondering how I've become so bullish after being bearish for all of last year, these are the metrics that I've begun to focus on. As these metrics improve, the stock has grown. And so far, Sirius has shown no meaningful signs of slowing down.
The upward correction to $4.00
However, investors have to understand why these metrics are so important and why I believe Sirius is still undervalued. What's beginning to stir the pot is Sirius' ongoing share buyback program. The Street has not adequately adjusted their models to factor in the effect of a reduced float. This throws off their enterprise value (EV) and EBITDA calculations. This is why I've argued that $4.00 per share is more realistic sometime in the third quarter.
For those who are unfamiliar, the market has historically priced SIRI by taking into account Sirius' EV and dividing that number by the company's EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To understand how to arrive at the enterprise value, you take Sirius' debt and then add in the amount of the float outstanding, while adjusting out the cash. You then take that number and divide it by the EBITDA. There's nothing wrong with this equation.
However, consider this; Sirius' operating cash flow, which serves as its key to debt reduction and stock buyback has soared 322% to $170 million. Just to give you an idea of how impressive this is, the industry average cash-flow growth rate is -3.04%. The market is realizing this error each quarter and has no choice but to correct its mistake with a higher share price.
But here's the problem; the market has only been focusing on what Sirius has reported. While there's nothing wrong with that, it doesn't always reflect Sirius' real value, especially when the market fails to understand that Sirius will outperform its guidance. This is why the stock has been consistently going up. Essentially, "the market has been correcting its error upwards." This is the opposite of the downward correction - hence why the stock has doubled over the past year, while outperforming all the major indexes.
I'm trying hard to not sound like too much of a "fanboy" here, but Sirius' prospects are looking good, which is an understatement, especially in an improving economy. What's more, factor in how Sirius plans to return capital to shareholders through its stock buyback program, which (at the same time) increases the enterprise value and EBITDA calculation, retail investors are looking smarter than the Street for hanging on.