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Did you hear about the lawyer on vacation whose sailboat capsized in dangerous, shark-infested waters?

He surprised his traveling companions by volunteering to swim to the far-off shore for help. As he swam, his companions were startled by the appearance of two dorsal fins -- great white sharks, heading straight toward the lawyer.

To their surprise, the sharks allowed the lawyer to take hold of their fins, and escorted him safely to shore.

When the lawyer returned with help, his companions asked him how he had managed such an incredible feat. The lawyer answered, "Professional courtesy."

I'm sure everyone has heard numerous lawyer jokes, including some version of the above joke. The version was taken from ExpertLaw's Collection of Lawyer Jokes, and it is certainly applicable to the recent takeover offer for Sirius XM Holdings (SIRI) by its majority shareholder, Liberty Media (LMCA). Like sharks, the lawyers apparently smell blood and they are circling Liberty and the Sirius Board of Directors hoping to get a bite from a class action lawsuit. Frequently cited in these potential legal actions is the $4.18 share price of Sirius from last October vs. the offer valued at $3.68. Here's a partial list of headlines and the firms sniffing around the proposed offer:

  • Levi & Korsinsky, LLP Announces Investigation of SIRIUS XM HOLDINGS, INC. and Its Board of Directors In Connection With the Proposed Sale of the Company to Liberty Media Corp.
  • Ryan & Maniskas, LLP Announces Investigation of Sirius XM Holdings Inc.
  • Former SEC Attorney Willie Briscoe and Powers Taylor LLP Investigate Proposed Acquisition by Liberty Media Corp
  • Law Office of Brodsky & Smith, LLC Announces Investigation of Sirius XM Holdings, Inc.
  • Bernstein Liebhard LLP Announces Investigation of Proposed Acquisition by Liberty Media Corporation
  • Block & Leviton LLP Investigates Sirius XM Holdings Inc. for Possible Breaches of Fiduciary Duty in Connection with Its Potential Acquisition by Liberty Media Corporation
  • Rigrodsky & Long, P.A. Announces Investigation Of Buyout Proposal

All of the indignant Sirius XM shareholders clamoring for an SEC investigation and a shareholder lawsuit have plenty of lawyers to contact for additional information. They are sure to find a sympathetic ear, and if they are among the "lucky" shareholders who happened to buy at the $4.18 high, they might even stand a decent chance to become a lead plaintiff in a class action suit. Perhaps a few of the firms may even be able to recoup some damages for their clients while they line their own pockets with multi-million dollar fees.

While the headlines have been about the proposed takeover and potential lawsuits, share volumes have spiked. Investors and traders appear to be far more interested in the drama around the Liberty proposal than the performance of Sirius XM:

Date

Open

High

Low

Close

Volume

Adj Close*

Jan 8, 2014

3.86

3.89

3.76

3.77

152,056,000

3.77

Jan 7, 2014

3.86

3.87

3.81

3.86

194,397,000

3.86

Jan 6, 2014

3.84

3.86

3.75

3.83

405,676,500

3.83

Jan 3, 2014

3.59

3.64

3.54

3.57

56,268,200

3.57

This recent focus has overshadowed the 2013 subscriber figures and the more detailed guidance issued by Sirius XM earlier this week. All of the investor indignation has apparently allowed some poor subscriber projections and some revelations by Sirius XM CEO Jim Meyer at the Citi Internet, Media and Telecommunications Conference to almost go unnoticed.

Sirius XM and Fundamentals

Sirius XM has often traded at prices well above and well below what I consider an appropriate value based on its fundamentals. The wild swings in share price are particularly unusual because the company's subscription model is highly predictable. I consider the company's free cash flow one of these accurately predictable fundamentals. How predictable?

In 2012 the company issued initial free cash flow guidance of "approximately $700 million," and it came in at $709 million. For 2013, the company issued guidance "approaching $900 million" and subsequently increased the guidance to "approximately $915 million." Earlier this week, Sirius XM announced that it will meet or exceed its revenue, adjusted EBITDA and free cash flow guidance for 2013.

When the company issued its 2014 free cash flow guidance this week, it projected it would be "approaching $1.1 billion." It is a solid number, and if it exceeds that figure, there is little reason to expect that it will do so by any significant amount.

An article written last month discussed looking at free cash flow per share as a method for determining value. The estimate used in that article for 2014 free cash flow was $1.1 billion (remember, this is a highly predictable subscription model). Taking share buybacks and dilution from convertible bonds into consideration, the expected free cash flow per share for 2014 was $0.19, an important metric in the valuation of Sirius XM.

It is also important to consider how that figure will grow. The most obvious methods are increasing revenue, reducing costs and reducing share count. Significant cost reductions seem unlikely for several reasons. The content costs are likely to increase as the music royalty expense will be increasing each of the next several years and because the company has added Hispanic targeted content. In addition, sales and marketing and customer service and billing expenses are likely to rise to support a growing customer base.

Also, interest expense will be rising. That leverage is at 3.5 times, and it won't be stopping there. CFO David Frear was quoted in the press release:

With our leverage at year end under 3.5x adjusted EBITDA and our interest coverage at more than 5x, the company is very conservatively capitalized. Our stable subscriber base and growing profitability allows us to raise our target leverage ratio to 4x adjusted EBITDA, providing increased flexibility for capital returns to stockholders and acquisition opportunities.

This leaves revenue. Revenue will grow based on four factors:

  1. Increases in subscribers
  2. Increases in subscription fees
  3. Increases in advertising revenue
  4. Revenue from new products and services

The most important of these would appear to be the organic growth from increasing subscribers.

Subscribers

Subscriber metrics have always been an important part of the Sirius XM story. Its business model has been dependent on deals with OEMs, where the partners offer free trials to car buyers with the expectation that a certain percentage will decide to become paying subscribers at the end of that trial. Currently, about 70% of all vehicles sold in the US come with a free trial, and about 44% convert to self-pay subscribers.

Vehicle sales have increased steadily since 2009, and over that same period, the percentage of new vehicles equipped with satellite radios also increased. And, although the new car trial conversion rate drifted lower over this period, these two factors helped drive increases in self-pay subscribers until this past year.

Year

2009

2010

2011

2012

Est. 2013

Conversion

Percent

45.4%

46.2%

45%

45%

44%

Self-Pay

Net Adds

154,275

982,867

1,221,943

1,661,532

<1,500,000

The self-pay subscriber growth from new car trials has essentially ended. That growth has been replaced by efforts to activate idle radios in used cars. The company has been increasing efforts in this area as it moved from offering free three month trials in certain Certified Pre-Owned [CPO] vehicles sold through participating dealers, to any used vehicle with an OEM-installed radio sold by participating dealers, to offering two month trials to certain owners that brought their cars in for servicing.

As the trial programs and participating dealers in the programs increased, so did the activations from used cars. The growth went from approximately 1 million net adds in 2012, to more than 1.5 million in 2013 to 2 million anticipated for 2014. And, it is not just the used car trial program that is being targeted for growth. The company has also introduced a new, low-cost subscription ($5.99/month) package targeted at the Hispanic market demographic.

So, with all these efforts, why has the company guided to only 1.25 million net adds in 2014? And, why has the company not even issued guidance on self-pay net adds? The self-pay net add guidance for 2013 was 1.6 million, and when Q3 earnings were reported, it was reduced to 1.5 million. Based on the language in the press release, I expect the number to be slightly less than the 1.5 million. Consider the following statement from that release:

SiriusXM today announced that it ended 2013 with 25.56 million subscribers, reporting 1.66 million net subscriber additions in the year, exceeding the company's recently raised guidance of 1.6 million net additions. Self-pay net additions in 2013 were 1.5 million for the full year, bringing self-pay subscriptions to over 21 million.

Note that the total subscriber figures have two decimal places while the self-pay figures have either zero or one decimal place. Also note that the company stated over 21 million self pay subs and did not use the same adjective for the 1.5 million.

So, why is 2014 guidance for only 1.25 million total net adds and why is there no self-pay guidance? Part of the answer can be found by listening to Meyer at the Citi conference. He discussed being surprised at the reaction to what he considered a minor tweaking (reducing the self-pay guidance from 1.6 million to 1.5 million net adds) of the numbers and said, "I won't make that mistake again." He also added:

You have our subscriber guidance for 2014. Read into that what you'd like.

The only thing I can read into that is that the subscriber number is a conservative estimate, and that investors will have to wait until the Q4 earnings call in early February to get any more details on self-pay net adds.

Meyer also discussed two other significant factors. The first was a discussion about how the more affluent new car buyers from 6 years ago were turning over their vehicles sooner than anticipated. This was first discussed on the Q3 call when he said:

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...

That turnover from self-pay subscriber to free trial is, according to Meyer, expected to "be with us for a while."

The second issue has to do with the effect of both greater penetration in new cars and increased focus on used cars. These two efforts are bringing in more subscribers from lower income demographics. Meyer said:

We are definitely seeing more customers enter our system with incomes under $75,000. And, I can tell you, in the nine years I've been here, the one thing that correlates, that I can prove, is income level and churn. Customers below $75,000 have a higher churn profile to them than customers over $75,000.

Investors need to decide if the increased turnover from self-pay to new car free trial, and the increased churn profiles from penetrating lower-income demographics is reason for the low subscriber figure, or is it Meyer being cautious and unwilling to "make that mistake again."

Revenue

The 2013 revenue guidance of "approximately $3.77 billion" grows to "over $4 billion". This is growth of about 6.1% and looks rather paltry when one considers that (A) the company spent $530 million to acquire the Connected Vehicle Services Division from Agero in November of last year, and (B) the company instituted a $0.50/month increase to the basic monthly subscription rate.

The most likely reason for a revenue increase that is less than expected is the loss of one major OEM's paid promotional trial revenue. Its changeover from paid promotional trials to unpaid trials that occurred during the 4th quarter of 2013 was well known by analysts and investors. This changeover affected total net adds in Q4, which actually declined by 22,000 units, and impacted Q4 revenue. It will also represent a permanent reduction in paid promotional trial revenue, and clearly impacts the year over year revenue comparisons for the first three quarters of 2014 as well as the full year figure.

Summary

Liberty's proposal to offer the non-Liberty shareholders of Sirius XM a 39% stake in Liberty has drawn the wrath of many Sirius XM investors. The market has deemed the offer inadequate and has bid the share price higher since that offer was made. And, that offer, like pouring blood on the water to attract sharks, has attracted the interest of a large number of lawyers hoping to sue Liberty. With the fairness of that offer being questioned, investors should not be looking at the past prices of the stock, but should consider the value of Sirius based on recently issued guidance and its future growth prospects.

As noted above, investors will need to wrestle with the implications of the low guidance figure for 2014 net adds. Is it an over-reaction by Meyer, or a more permanent phenomenon indicating that subscriber growth will be much more difficult going forward? Why did Frear use the term "Our stable subscriber base" rather than our growing subscriber base?

And, if 2 million used car net adds, a forecast for rising new car sales in 2014 and targeted low priced subscription offers can only bring in 1.25 million net adds, a 25% drop from 2013, what is the fair value of the stock of Sirius XM?

Source: Sirius XM: A Closer Look At Fundamentals And Guidance