Within the past week, Sirius XM Holdings (NASDAQ:SIRI) made news that some investors thought would propel the share price higher. Not only was a merger offer from majority owner Liberty Media (NASDAQ:LMCA) withdrawn, but the company also reiterated its guidance and received upgrades from two analysts with price targets ranging from $4.50 to $5. And, despite an up day for the market on St. Patrick's Day where most stocks finished in the green, shares of Sirius XM finished in the red. Who's right - the analysts or the market's tepid reaction?
In a recent article on Seeking Alpha, Stephen Faulkner predicted that the shares of Liberty would rise and the shares of Sirius XM would fall following the withdrawal of the merger offer from Liberty:
With the deal removed, the equities are now free to trade in decoupled fashion, and the holders of those positions are backed into a corner and likely looking to exit post haste.
What does this mean in the short term? Since Liberty is shorted or sold, covering creates buying pressure. It is highly likely that Liberty Media's share price receives a rapid upward bump on Friday at the very least. After-market prices in Liberty support this with the equity up by roughly $4.
Sirius XM? Because this would have been the long side of the play, an unwinding should result in significant selling. Downward pressure? After-market trading Thursday has shown that Sirius XM shaved 8 cents from its closing price, or a little over 2% on the news.
Well, Faulkner was half right, with the reaction on Friday showing a move up by more than 7% for Liberty, but also up more than 2% by Sirius XM. The moves were also accompanied by massive volume, with both stocks trading at more than four times the average volume of the last three months. The last time the volumes approached those levels was the first full day of trading following the announcement of the merger offer. Both stocks traded slightly lower on Monday.
Sirius XM should have been helped by upgrades on Friday and Monday, and perhaps that was the reason there were gains on Friday. Merrill Lynch upgraded the stock to buy with a $5 price target, while Evercore Partners upgraded the stock to Outperform on Monday with a target of $4.50.
It wasn't just the upgrades and the merger proposal that should have lifted Sirius XM. When the merger was called off, the company announced that:
...it intends to resume its common stock repurchase program. ...Sirius XM had previously suspended its stock repurchase program in connection with Liberty Media's proposal.
Shares of common stock may be purchased from time to time on the open market and in privately negotiated transactions, including in transactions with Liberty Media and its affiliates. The company will fund the repurchases through cash on hand, future cash flow from operations and future borrowings.
When the buyback was suspended, Sirius XM was in the process of buying back 136,600,825 shares for $500 million from Liberty. There are still 92,888,560 shares to be purchased for $340 million under that agreement. I suspect that the Sirius XM purchase of non-Liberty owned shares will not resume in any significant volume until the company issues more debt.
At the same time that Sirius XM announced that buybacks would resume, it re-affirmed 2014 guidance:
- Net subscriber additions of 1.25 million,
- Revenue of over $4.0 billion,
- Adjusted EBITDA of approximately $1.38 billion, and
- Free cash flow approaching $1.1 billion.
When the guidance is compared to 2013 full year results, it shows some fairly attractive growth. Subscribers are projected to grow by 4.9% and self-pay subscribers are projected to grow by 5.9%. The other growth rates are:
- Revenue by more than 5.2%
- Adjusted EBITDA by approximately 18%, and
- Free cash flow should grow by almost 19%.
Perhaps that's one of the bigger drags on the share price. All of the above numbers indicate a slowdown in growth. It's not just the rate of growth that has been slowing, but also the year-over-year increases. While free cash flow grew by $294 million in 2012, that growth slowed to $218 million last year and is forecasted to grow by less than $173 million in 2014. Similar slowdowns occurred with:
- Revenue, which grew by $388 million in 2012, by $397 million last year and is forecasted to grow by "more than" $201 million in 2014,
- Adjusted EBITDA, which grew by $189 million in 2012, and by $246 million last year, is forecasted to grow by "approximately" $214 million in 2014, and
- Subscribers, which grew by 2,007,512 in 2012, and by 1,658,974 last year, is forecasted to grow by 1.25 million in 2014.
There are those who will argue that the subscribers were impacted by the movement of one large OEM customer from paid promotional trials to unpaid trials, and that is partially true. However, the company is experiencing a slowdown in the growth of self-pay subscribers. On the recent conference call, CFO David Frear stated:
For now, we don't see much of a difference between the self-pay growth and the total, including the paid trials.
The self-pay subscribers grew by 1,661,532 in 2012, by 1,511,543 in 2013 and is only forecasted to grow by 1.25 million in 2014. Frear further explained the "conservative view" of self-pay sub growth:
So right now we don't see a growth in the inventory of paid trial subscribers. We do expect the total funnel to grow a little bit, but we won't see the same kind of growth that we've seen in past years.
In terms of the change from 1.5 million self-pay (inaudible) to 1.25, you know, honestly, we got surprised last year with the amount of vehicle migrations that went on. And so we've taken a pretty cautious view towards that this year.
As (Sirius XM CEO Jim Meyer) mentioned, as we get to a more price sensitive subscriber, it makes sense to us that you might see conversion rates coming down a little bit. We are up at roughly 70% penetration now as opposed to being at 60% a couple of years ago. Throughout the history of satellite radio, you've seen as production penetration rises, conversion rates fall a little bit, but generally that's been good news, right? You'd rather have 44% of 70% than have 46% of 60%.
So all in all, we've taken a cautious outlook towards next year, and that's what we see.
Meyer subsequently added that the price increase could also contribute to a slowdown in subscriber growth. Regardless of the reasons, the company expects self-pay subscriber growth to slow down, and it's the growth in subscribers that drives much of the growth in revenue, EBITDA and free cash flow.
The company has been able to grow the subscriber base in recent years through a combination of factors. First, the sales of new vehicles has increased dramatically over the past five years. Second, during that same time period, the percentage of new vehicles equipped with satellite radios and new free trials rose from 55% to 70%. Third, the company began to aggressively pursue programs to turn the installed base of inactive radios into self-pay subscribers through programs like Service Lane and 90-day free trials offered through more than 11000 used car dealers.
Despite all of these efforts, the company is expecting it to be difficult to grow subscribers. It even went so far as to offer an extended free trial of up to five months targeted at the Hispanic market. That trial ended February 28th, and was to be followed by a $5.99 per month package of programs targeted at this market segment. The results of that trial could be reported when first quarter results are released in a few weeks. However, since guidance was re-affirmed at 1.25 million net adds, I am not looking forward to much in the way of a positive surprise.
The shares of Sirius XM are currently trading at $3.40. Those who expected the withdrawal of the merger offer to allow the price of the shares to immediately recover and move towards the $4.18 price reached last October are probably disappointed. Even the two very recent upgrades, with their target prices of $4.50 and $5 have not been enough to push the price higher. (There was also a third upgrade by Macquarie to Outperform with a target of $4 in the first week of March.)
It's possible that Faulkner was correct that the arb position at Sirius is still being unwound and the recent price falling back below $3.40 supports that view, although the nearly 300 million shares traded on Friday should have provided much of the liquidity needed for that to occur. It's also possible that the market is coming to the realization that the growth at Sirius XM is slowing significantly and the growth premium factored into the share price needed to be ratcheted down.
Let me be very clear. While I expect the growth in subscribers to continue to decline, I also expect the company to be able to continue to grow earnings and free cash flow through price increases in both the subscriptions fees and the Music Royalty Fee, as well as growth from advertising and new services. Most importantly, I expect the growth to continue to slow and the share price to continue to reflect that lower growth.
The market prices stocks based on expected future performance and management has given a lot of reasons to expect lower growth going forward. Meyer observed:
The mix of our vehicle, owner and subscription base will continue to move toward the demographics of the average driver in this country. I don't think it will surprise any of you that over the years, we have seen higher income households convert at higher rates and churn at lower rates than lower income households, but lower income subscribers remain a very profitable segment for us, because of our high contribution margin and low variable cost per acquisition.
The opposite must also be true - lower income households convert at lower rates and churn at higher rates. Those would support a view of lower growth, and that's something that investors will need to carefully follow.
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.
Additional disclosure: I actively trade SIRI. In addition to my long positions in SIRI, I have January 2015 $4 covered calls written against some of these positions. I may initiate new covered call positions or close out or open new positions in SIRI at any time.