The recent buyout proposal for Sirius XM (SIRI) by Liberty Media (LMCA) dramatically undervalues the company. From a shareholder perspective, it is almost insulting that Liberty Media would make such a proposal with the actual expectation that shareholders would accept. The proposal amounts to a buyout price of $3.68 per share. Even without any detailed financial analysis, shareholders can see that this offer is well below par because Sirius XM shares traded above this level for much of the later half of 2013, reaching a high of $4.18 in October 2013. Furthermore, shares are currently trading at above the buyout price, implying that shareholders do not expect the current offer to be accepted.
This article will explore Sirius XM's true valuation and give a detailed analysis of a valuation that Sirius XM shareholders can expect within 5 years, if the current buyout offer fails. But before I get started, let me qualify two points. The premise behind Sirius XM's value increasing by five fold over the next five years is based on the assumption that the company does not get bought out by its present controlling shareholder, Liberty Media which currently is trying to takeover the company. Furthermore I would like to make clear that all of the points I mention below are not overtly hypothetical. I will not be making outlandish claims about growth or new products or innovation. I will simply be outlining a continuation of the current growth trend which we have seen over the last few years within the company. With that out of the way, let's begin.
The Path To 36 million Subscribers
I can stand on my soap box and proclaim massive subscriber growth over the next 5 years. I can draw a pretty graph showing Sirius XM reaching 100 million subscribers. I won't do that because I want this article to be realistic and not simply provocative. I am setting a very conservative goal for Sirius XM to reach 36 million paying subscribers by the start of 2019. Some analysts have projected figures of up to 50 million subscribers, but I am specifically choosing to be conservative. Netflix (NFLX) has a similar subscription based model and they currently boast over 40 million global subs and analysts predict that the company can ultimately serve about 60 to 90 million subscribers. In the radio field, Pandora currently has 3 million subs and a total of over 70 million listeners. For Sirius XM, considering their current churn rate, a ramp in OEM installation rates, and their push into the used car market, the company should very easily be able to add an average of 2 million subscribers per year over the next 5 years. This would give the company 36 million paying subscribers by 2019. I hope that most Sirius XM investors will not see that projection as being outlandish. In fact, most will probably admit that it seems a bit low, but, when making projections far out into the future, it is usually better to be safe than sorry.
Increasing Average Revenue
I have written before about how I think Sirius XM will be focusing on increasing average revenue per user (ARPU) in the years to come. In 2011 the company increased the base package rate by $1.54, and in January 2014 a further increase of 50 cents will occur. Over the next five years I expect the company to continue raising the basic package rate and to also focus on augmenting the prices for the more comprehensive packages so as to significantly increase ARPU from its current overall rate of $12.29 per month to $15.55 per month by 2019. This would represent a yearly increase of 4% per year, in line with analyst estimates for an overall 4% to 5% increase in package rates per year.
"Gabelli expects ARPU to increase at a measured pace over the next three to five years, with assumed pricing growth of 4 percent through 2015." Gabelli & Company Analyst Brett Harris
Although there will always be some users who pay below the average, due to promotional discounts and grandfathered plan prices, investors have seen clear evidence that the company intends to continue raising overall rates, and we should expect this sentiment to continue for the foreseeable future.
I have already mentioned in a past article how I think Sirius XM will continue with their goal of reducing operating expenses. Sirius XM has worked hard over the last years to reduce debt expenses by retiring high yield notes and refinancing long term debt at highly favorable rates.
"Our strong cash position and growing free cash flow profile have put us in a position to retire these notes three years ahead of their maturity, at the first available redemption date. The early retirement of these notes will reduce interest expense." David Frear, Executive Vice President and Chief Financial Officer, SiriusXM.
Furthermore, the company has been making great progress in reducing the salaries of some of its highest paid radio personalities. Martha Stewart and Bubba The Love Sponge both accepted to reduce their compensation and if Howard Stern chooses to renew his contract in 2015, the terms might be far more favorable to Sirius XM. Analysts have long expected the company to reduce Stern's hefty salary and now that Sirius XM has a satellite radio monopoly, Stern might just be willing to accept a salary cut in return for retaining his huge audience and the censorship freedom he has grown accustomed to. With Howard Stern currently making about $80 per year, any sizable reduction in his salary would have a noticeable impact on Sirius XM's bottom line.
Sirius XM will likely be able to leverage its satellite radio monopoly to prevent the sports broadcasting rights costs from increasing considerably. Sports rights have a long history of continuous increases, but Sirius XM is in a unique position now that it is the only satellite radio broadcaster and it has a paying user base of almost 26 million subscribers. The fact that the company is also controlled by Liberty Media only adds to its bargaining power.
Music royalties will continue to increase in the future, but we should note that the company has been successful in the past at passing off a sizable portion of the increased royalty fees to the end subscribers. Overall, with the agreement reached with the Copyright Royalty Board in late 2012, Sirius XM will see a marginal increase in royalty fees through 2017. The company and investors were very satisfied with the results of the negotiations and it can be argued that the terms were quite favorable to Sirius XM. Overall, with music only comprising about 50% of the company's content, the increase in royalty rates will have a muted effect on future cash flows and profits.
$100 Billion Market Cap
Putting it all together we can make some easy calculations, based on the above mentioned conservative estimates, to arrive at Sirius XM's expected market valuation for 2019. With 36 million paying subscriber at an average revenue per subscriber of $15.55 per month, we can estimate that the company will generate revenue of about $6.7 billion in 2019. Sirius XM has a 12 month trailing operating margin of 41% and currently has an operating margin of about 43%. Judging by the trend over the last years, margins look to be slowly increasing. This makes sense as most of the company's costs are fixed, and the expense of adding a new subscriber is consistent and relatively small.
I see no issue with the company being able to maintain and even grow this margin considerably by 2019. Being conservative, I will estimate that the company can only attain an operating margin of 45% by 2019. This would translate to an operating income of just over $3 billion in 2019. That would represent a tripling over the latest trailing 12 month operating earning of $1.01 billion. If the company can trade at a multiple to operating income of 33 by 2019, that would translate into a market cap for Sirius XM of $100 billion. This last sentence might sound like wishful thinking, but if growth can be sustained and the current low interest rate environment persists, a multiple of 33 times operating income is not unexpected. Furthermore, we should note that most of the other assumptions were rather conservative, so if the company just does marginally better than expected, it can reach a market cap of $100 billion with a considerably lower multiple. Also, an interesting note is that throughout September and October of 2013, as Sirius XM's shares traded close to or above $4 per share, the company was in fact trading at about 33 times the company's total cash flow from operating activities for 2012 of $800 million. So this multiple, although being relatively high, has been attained before.
The chart above shows Sirius XM's price to Free Cash Flow ratio over the last four years. We can see that the ratio has spiked several times and although the ratio has now fallen, it seems to have stabilized in the 25 to 30 range. This would lend credence to the idea that, should multiples spike again and based on future estimates, Sirius XM could see a $100 billion valuation by 2019.
We can examine a few other factors to see if it is truly a realistic possibility that Sirius XM can be worth $100 billion within 5 years. From the chart below we can see that as total revenue has increased dramatically over the last 4 years, total operating expense has stayed relatively flat. We should also note that depreciation and amortization, both non cash items, have actually been falling in the last years, having a positive impact on earnings. As discussed above, due to the low marginal cost of adding new subscribers, this trend should continue.
The figures shown in the chart below are taken directly from Sirius XM 10k filings from 2011 and 2013. The values have been adjusted by Sirius XM to "exclude the impact of certain purchase price accounting adjustments and share-based payment expense." The estimated values are from Sirius XM latest guidance.
Should this relationship continue to hold steady, and there is no reason to believe that it will not, then Sirius XM should be able to ramp revenue up to about $6.7 billion by 2019, while still maintaining operating expenses at around the $3 billion range. Free cash flow and EBITDA, which have already experienced dramatic growth since 2008, will continue to accelerate higher.
In the next chart we can see the EBITDA to Revenue and the Free Cash Flow to Revenue ratios for Sirius XM. Every year since 2008 the percentage of Free Cash flow and EBITDA which the company is able to generate from its revenue has increased. Once again this has to do with the high fixed cost and low variable cost of Sirius XM's business model. Continuing upon the current trend, and taking Sirius XM's guidance for $4 billion in revenue for 2014, I estimate that when Sirius XM reaches a total revenue of about $6.7 billion in 2019, it will likely have an EBITDA to revenue ratio of at least 45%, and a Free cash flow to Revenue ratio of 40%. This would translate to Free Cash flow of about $2.7 billion and EBITDA of $3 billion. These figures are in line with other metrics estimated earlier.
Fundamentally, the answer seems clear that Sirius XM will continue being a cash flow generating machine and, if anything, it's ability to generate incrementally more cash from its revenue will only increase in the years to come. Ultimately, the question of valuation revolves around the multiple which investors think adequately matches Sirius XM's growth potential. At anything close to a multiple of 30 times free cash flow or EBITDA, Sirius XM will likely be worth around $100 billion by 2019.
The most important thing to consider when estimating a future share price is the actual number of outstanding shares in the future. The fact that Sirius XM has an aggressive buyback plan makes estimating future shares difficult. The company recently completed a large share buyback from Liberty Media and 2 more block buybacks are to occur in January and April 2014. In total, the company has a buyback plan of $4 billion. Assuming share prices stay relatively flat, and the whole buyback takes place, this could translate into the company buying back and retiring 1 billion shares. Going forward, it is likely that the company will continue buying back shares as cash flow remains strong. Citibank analyst Jason Bazinet expects that company might be able to buy back almost $11 billion worth of shares by 2015. At the current share price, that would represent almost half the company. It sounds like an aggressive target, and share prices would likely rise considerably if the company announced a buyback of this size, which would reduce the overall shares bought back. I estimate that over the next 5 years Sirius XM repurchases about 2 billion shares, and its total outstanding share count in 2019 will be around 4.5 billion shares, down from the 6.287 billion fully diluted share count from September 30th, 2013. The slight variation has to do with the company continuing to issue shares as compensation.
Assuming a peak market cap in 2019 of 100 billion and an average of 4.5 billion shares outstanding, we can expect the share price to reach just over $20 per share. Considering that shares are trading at about $3.50 at the moment, that represents a huge gain.
I have a very good feeling that some investors may find this estimated share price to be an exaggeration, however, I have tried my best to use conservative estimates at all times in this article so as not to sound overly optimistic. The only number that I think might be seen as optimistic is the market cap to free cash flow or EBITDA ratio estimation of about 30 for 2019. For Sirius XM to trade at 30 times FCF or EBITDA would be generous, however the shares have traded at that level many times in the past and it is possible that in the future they will trade at that multiple again, even if only briefly. The main goal of this article is to propose a scenario for the future which seems entirely plausible, given conservative estimates and current trends. Even if investors disagree on the chance of Sirius XM attaining a market cap of 100 billion, the fact that revenue, FCF and EBITDA are set to rise at a considerably higher rate than expenses for the foreseeable future should help define the potential value of the company.
Furthermore, I would like to stress that I am basing these estimates off of the current trend seen in subscriber additions and revenue growth rates. It is possible that these trends will accelerate faster than estimated as OEM installation rates increase and more subscribers come from the used car market. Furthermore, the change in revenue share agreement will result in a noticeable bump in profitability in the short term. However, investors should be cautious that there is also a chance that the trends revert after a few years and growth slows considerably. As a tech company, Sirius XM is highly susceptible to rapid changes in consumer preferences and technological advances. I noted last week that Google (GOOG) was making a strong entrance into the connected car market, and Apple (AAPL) is also rolling out a host of vehicle connectivity options. If the connected car market is really going to grow as fast and as large as I estimate, then Sirius XM can expect an awful lot of competitors to enter the market and nibble away at market share and profits. Costs might increase, rather than stagnate as the company is forced to innovate or buy new content at above market rates. Any of these factors can have a serious adverse effect on the company's valuation.
From a macro perspective, it is impossible to estimate how the overall economy or the stock market will be performing in five years time. Over the last five years, we have experienced unprecedented increases in the stock markets and valuations multiples. Historically these bull market cycles have lasted about 5 to 7 years. We are currently close to the average duration. If, in five years time, we are in the midst of a bear market, and valuations are deeply depressed, it would be unreasonable to expect that Sirius XM would be valued at $100 billion.
The Liberty Media Buyout
The current buyout proposal from Liberty Media values Sirius XM at about $23 billion. From the analysis above, we can see that this is a great undervaluation with respect to the company's future earning power, growth prospects, and cash generation ability. For investors who have been Sirius XM holders for many years, as I have been, and who understand the true value of the company, the only reasonable plan of action is the vote against the current buyout proposal. Even if my future growth expectations are slightly over bullish, Sirius XM is clearly going to be a much larger and profitable company in the near future, and shareholders should be permitted to earn all the capital gains which will come from that future growth, rather than transferring that wealth, at below valuation cost, to Liberty Media.
As always, investors should conduct their own due diligence before making any investment. For a company like Sirius XM, which has seen its share of ups and downs, and is in the technology industry, this will be even more important than regular. Considering the currently available information and the trends in terms of technological adoption both on an industry and consumer level, I doubt that you will be able to draw conclusions which significantly differ from those proposed in this article, but any details and facts which can be used to better evaluate the future prospects of Sirius XM would be well appreciated and can be discussed in the comments section of this article.