Sirius XM: Share Price vs. Share Value

Dec.19.13 | About: Sirius XM (SIRI)

A bear market is often defined as a decline of more than 20%. On that basis, Sirius XM Holdings (NASDAQ:SIRI) unofficially entered bear territory on Wednesday when it touched $3.32. That price was down just over 20% from its intra-day high of $4.18 reached on October 23rd. Should investors care?

Clearly, when a stock drops 20% in a short period of time, the holders feel some pain - or at least regret that they failed to sell or lock in the gain in some other fashion. That really doesn't address the issue of whether they should care. For that answer, the long term investor - not the trader - should consider:

  1. Were there any significant changes to the fundamentals of the investment?
  2. Was the investment valued correctly when it was $4.18?
  3. Is the investment correctly valued today?

Investing vs. Trading

When it comes to Sirius XM, I have often been accused of being a closet bear, a pessimist, someone that can't see the forest for the trees, seeing the glass as half-empty and worse. Less often, I have been categorized as a cautious or conservative investor. Either way, labels get in the way of objectively assessing the material presented in most articles.

I consider myself a long term investor, however I do not adhere to a buy and hold "forever" strategy. If the share prices get too far ahead of what I perceive to be fundamental or fair value, I am willing to close a position. This can be "dangerous" with a stock like Sirius XM, where the share prices can be extremely volatile and will often trade at prices that I consider to be substantially above and below my perception of fair value.

It's dangerous because the temptation is to begin second guessing when prices move far out of that fair value range. To remove some of this temptation, I often employ covered call strategies.

In December of last year I wrote an article titled Sirius XM: Investing For A 25% Gain that looked at the volatility of the Sirius XM share price and the significant changes that occurred that year. The article focused on a relatively conservative way to generate a 25% yield with a low risk of loss, but it also reduced the opportunity for significant gains. The method used involved buying the stock and selling covered calls, a strategy I use not only with Sirius XM, but also many of my other investments.

At that time Sirius XM shares were trading at $2.73, and the analyst targets ranged from $2.25 to $4.00 with an average of $3.18. The article recommended buying the shares at $2.76 and selling a $3.00 January 2014 call, giving the investor a breakeven point on the covered call strategy vs. a simple buy and hold position of $3.42. A trader could certainly have made significantly greater profits by successfully moving in and out of a long position multiple times over the course of the past year. And, the buy and hold longer term investor would have been slightly ahead to slightly behind during the past few weeks.

A few months later I wrote another article when the shares were trading around $3 suggesting a similar covered call strategy by selling $3.50 January 2014 covered calls. The break-even point on that position was around $3.76. Over the past year, there were times that both strategies looked prescient and at times where both looked foolish. The analysts have moved up their price targets significantly since those recommendations, and they now range from $3.65 to $5.80 with the mean at $4.59. These are future targets for up to 12 months away.

Note that the current analyst targets have an average that is 44% higher than it was a year ago.

($4.59 - $3.18) / $3.18 x 100% = 44.3%

Has that much changed at Sirius XM? Is the company now "worth" more than 44% that it was a year ago? Was the target too low in December of 2012? Is it too high today?

Part of the increase in the share price is due to the share buyback program taking place at Sirius XM. But, without knowing precisely how each analyst arrived at their target, we don't know how much of their price per share is based on the their view of the current buyback program. Or, more importantly, how much is based on cash flow improvements at the company or their assumptions that went into their cash flow estimates.

Fundamental Changes

A number of fundamental changes have been taking place at Sirius XM over the past year. These include Liberty Media (NASDAQ:LMCA) taking a majority position at the company and installing its own Board of Directors, the $530 million purchase of the connected vehicle unit from Agero, offering a low priced subscription for a suite of Hispanic targeted stations and a major shift at one of its OEM partners where that company will no longer pay Sirius XM for the free trials it offers its customers. There have been other changes that were started in previous years, but have continued or accelerated. These include the refinancing of most of its high interest debt, a small price increase, and a significant expansion of its free trial program with more used car trial dealers and Service Lane.

At the start of the year, investors and analysts were told to focus on Self-pay net additions to the subscriber base rather than total subscriber additions. This was related to the previously noted shift by its OEM partner. On the Q3 earnings call, investors were told that the self-pay guidance that they should focus on was being reduced:

We have seen that our existing new car subscribers are turning over their vehicles sooner than what would have been predicted based on historical industry trends. As a result, our subscribers are migrating from one radio to another in a newer car. This trend picked up in the third quarter and is ahead of our expectations and this trend of faster turnover is good for the business long-term as it leads to increased opportunities for used car subscriptions, but we are now estimating self-pay net adds of approximately 1.5 million for 2013.

I consider this reduction in self-pay net add guidance a significant change because it is unrelated to the OEM shift. As for the other changes, some are more significant than others, and it has become increasingly difficult to assess the impact of all the moving parts. It is fairly easy to calculate a range for the number of shares to be repurchased over the next year, or an approximation of the number of self-pay subscribers to come from new car sales and even the losses due to churn. For others, like the revenue and profitability of the CVU purchase from Agero, the success of the low priced subscription and its impact on ARPU or the impact of current subscribers turning in their cars sooner, it is much more difficult. For this reason, I continue to use a very simplistic measure - anticipated free cash flow per share.

Fair Value

At the end of the day, it is the free cash flow ("FCF") that a company generates that can be used for the benefit of shareholders. It can be returned to shareholders directly in the form of dividends. It can be used to reduce or eliminate debt, lowering the interest expense and creating more FCF. It could be used to reinvest into the business for future growth or to make accretive acquisitions. Or it can be used to reduce the number of shares outstanding and increase the percentage ownership represented by each of the remaining shares.

Other than dividends and debt reductions, the alternatives carry varying degrees of risk for the investor. Will an acquisition result in growth or has the company overpaid? Will increased profits result from reinvesting in the business? Will the company overpay for shares in a buyback?

For 2013 Sirius XM has guided to $915 million of FCF, and it appears that it will end the year with 6,090,884,390 shares (based on the number of shares outstanding at the end of Q3 and the repurchase of 47 million shares from Liberty in Q4). This leads to $0.15 of FCF per share. When the price of the stock reached $4.18, the ratio of FCF to Share Price was a multiple of 27.9x. At the current price of ~$3.45, the multiple would be 23x. Even at that current price, fifteen cents represents a FCF yield of only 4.3%. Recently bondholders of Sirius XM debt, who take on less risk than shareholders, loaned money to the company at 5.875%.

Shareholders take on more risk than bondholders because they expect higher returns in the future. What can we expect for 2014? Sirius will be issuing guidance on FCF within the next two months, but since this article is being published today, I'll assume it will be $1.1 billion, an increase of just over 20%.

The next issue is the number of shares outstanding at year-end 2014. After Liberty completes its $500 million sale to the company, Sirius XM will have $1.9 billion under its current buyback authorization and 6,006,031,169 shares outstanding (ignoring the exercise of options). Assuming that the company will use the $1.9 billion to repurchase shares at an average price of $4, it will be able to purchase an additional 475 million shares. This purchase will be partially offset by the new issue of 273 million shares from the 7% Exchangeable Notes maturing in December of 2014, and a projected year-end balance of just over 5.8 billion shares outstanding.

Using the $1.1 billion of FCF and the 5.8 billion shares, one arrives at just under $0.19 of FCF per share. Each $100 million change in FCF would change that figure by $0.0172 per share. Changing the average price paid per share during the buyback by a dime up or down would change the number of shares repurchased by less than 12 million shares. A current share price of $3.45 and $0.19 FCF/share is a forward multiple of 18.2x.

Were the shares worth $4.18?

Whether one feels the shares were worth $4.18 would depend on many of the estimates made above. What is a reasonable expectation of future FCF? How many shares will $1.9 billion purchase? How much new debt will the company raise to fund the $1.9 billion of purchases, and how quickly will it be spending it? How much will it pay per share? And, most importantly, what multiple one is willing to pay.

When considering all these factors, an investor should also consider that, if the shares were worth $4.18, and remained there or moved higher, the $500 million purchase from Liberty and the remaining $1.9 billion buyback would result in the purchase of fewer shares than were calculated above.

It should be noted that I did not believe the shares were worth $4.18. Obviously the market disagreed and purchasers of the stock at that level disagreed. In the early March article referenced above, I wrote:

Most analysts are projecting a good year for Sirius XM in 2013, with 15 of the 16 analysts at Yahoo Finance rating the stock as hold (4) or better (11). They have target prices that range from a low of $2.45 to a high of $4.20 with an average around $3.50. That $3.50 average price target is slightly above the upper bound of my fair value estimate based on my 2014 anticipated FCF/share.

It's why I took the opportunity to re-open a large position in Sirius XM at that time, employing the covered call strategy outlined in that article and using a $3.50 January 2014 strike price.

Summary

I believe that there were significant fundamental changes to the business of Sirius XM and I am still struggling to assess the impact. I view the success and expansion of the used car program as a positive, and the higher than anticipated number of current subscribers trading in their cars sooner than anticipated as a negative. The change of the OEM to unpaid trials is a short term negative and perhaps a long term positive. The impact of the price increase, the low cost subscription option and the purchase from Agero are unknown at this time.

As to my position and the covered calls... even though the expiration is now less than one month away, it is still too soon to tell whether the decision will outperform the buy and hold strategy. The share prices can move rapidly in both directions in very short periods of time.

Long term, buy and hold, investors should probably not be too concerned about the recent price gyrations. There are enough positives to indicate continued growth in FCF per share. And even though I may consider the current price at the high end of my estimate of fair value, I believe that the shares will eventually grow into that value, although it may be growing at rates slower than some had anticipated.

Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. In addition to my long positions, I have January 2014 $3.50 covered calls written against many of my long positions in Sirius XM. I also trade blocks of Sirius XM on a regular basis.