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Summary

  • Sirius, despite beating revenue forecasts, experienced a sequential revenue decline.
  • Resulting share price declines potentially increases effectiveness of buyback program.
  • Company will need to raise new debt if it is to fulfill current buyback authorization in 2014.

It was surprising to see the share price react favorably right after the first quarter results were reported by Sirius XM Holdings (NASDAQ:SIRI). Headlines in the earnings release highlighted the positive:

  • Revenue of $998 Million, Up 11% From First Quarter of 2013
  • Net Income of $94 Million
  • Adjusted EBITDA Grows 28% to a Record $335 Million
  • Free Cash Flow Increases 56% to a First Quarter Record of $223 Million
  • Company Reiterates 2014 Guidance

Sounds pretty good. When one also sees comments that,

  • Subscribers set a record of 25.8 million, up 6% from Q1 2013
  • Self-pay net subscribers also set a record high of 21.3 million, up 7% from Q1 2013
  • Total trials in the funnel came in at 6.9 million at the end of the quarter (a number that had been omitted in Q4 and was the same as the total in Q3 2014)
  • Adjusted EBITDA set a Q1 record of $335 million (up 28% from Q1 2013) and Adjusted EBITDA margin reached a record of 33.5%

it sounds even better. In addition, the company added a new data point to the quarterly report - free cash flow per share - which came in at "3.6 cents in the first quarter of 2014, up 64% from 2.2 cents in the first quarter of 2013." The growth was due to fewer number of shares outstanding and a 56% increase in free cash flow from $142 million in Q1 2013 to $223 million.

With all those records, why was it a surprise that the share price initially reacted favorably, and why have the share prices weakened considerably since then? From my perspective it is all about the lack of growth in revenue, despite a beat in the consensus estimate.

Zack's had a consensus estimate of $991 million for the quarter while an article at Forbes had a figure of $994.6 million. The puzzle for me is why there had been a sequential decline in projected quarterly revenue. I clearly would have expected the revenue to grow, so despite the 11% growth from Q1 2013, the revenue that beat estimates was sequentially down from Q4. That's correct - it was down from just over $1.0 billion the previous quarter. This is not what an investor should expect from a subscription oriented company that is growing subscriber figures, acquiring businesses and raising prices.

Total revenue in the fourth quarter was boosted by advertising revenue of $25.4 million (which declined to $22.4 million in Q1) and could have been expected to seasonally decline as political and holiday related advertising slowed down. And holiday sales of radios could be expected to experience a similar seasonal decline as the sales fell from $26 million to $24 million. But these two declines total only $5 million and were fully offset by an increase in other revenue (mostly the Music Royalty Fee) of $5 million. It's the subscription revenue declines that are a concern.

Consider the following factors that should have driven subscription revenue increases higher from Q4 of 2013:

  1. The company instituted a price increase, effective January 1st. Granted, it was a relatively small increase of $0.50 per month, it applied only to those with the basic monthly subscription rate plan, and it takes time for price changes to roll through the subscriber population, but it was an increase and there were millions of new or returning subscribers entering the population. Even if only 10% of self-pay subscribers were subject to the increase, that would have driven subscriber revenue higher by $3.1 million.
  2. There was a net increase of 173,480 self-pay subscribers during the quarter. Even assuming they were in the population for only half the time and generate just $10 per month that would be an extra $2.6 million.
  3. In addition to the self-pay growth, total growth of subscribers was 266,799, or an additional 93,319 paid trials. Using the same assumption that these were in the population an average of 1.5 months, and at a paltry average rate of $5 per month, that would be another $0.3 million.
  4. Q1 represented a full quarter of revenue from the connected vehicle services division acquired from Agero that closed on November 4, 2013. We know that the acquired unit generated $18.6 million of subscription revenue during Q1 of 2014, and can reasonably assume that the unit generated less than two thirds of that amount in Q4 of 2013, or less than $12 million. (We can assume that the number was less than $12 million because it was part of Sirius for less than two months in Q4 2013 and because the unit is supposed to grow rapidly to $100 million of revenue in 2014.)
  5. The above four items should have contributed growth of more than $12.5 million. ($3.0 + $2.6 + $0.3 + $6.6)

So, if subscriber revenue should have grown by at least $12.5 million based on these very conservative assumptions, why should investors bid up the share price when subscriber revenue declined by more than $1 million from the prior quarter?

Why should the share prices have risen at all based on the earnings report if there is a revenue decline? The only thing that should drive the share price at a company like Sirius should be the anticipated free cash flow per share. Ignore the high multiple on the Sirius EPS of more than 50x. Look at the free cash flow projected at $1.1 billion for 2014 and the 6,058,791,343 shares outstanding at the end of Q1. What follows is an adjusted total of the shares projected to be outstanding at the end of 2014.

As of April 24th, based on statements in the 10Q that 25,247,342 shares had been purchased after the close of the quarter and another 92,888,561 were purchased from Liberty Media (NASDAQ:LMCA), there were 5,940,655,440 shares outstanding. Following these purchases (which totaled $421,310,000) there was $1,687,640,000 remaining under the company's share repurchase authorization.

We also know that Sirius has $502,370,000 of convertible debt maturing in December. With the conversion price per share of just over $1.841, it is almost certain that these notes will become shares. When each $1000 note converts into 543.1372 shares there will be an additional 272,855,000 shares outstanding at year end.

That leads to the calculation of share buybacks and where will Sirius get the funds to cover the $1,687,640,000 remaining under its current authorization. At the end of Q1, Sirius had an undrawn balance on the revolver of $940 million and cash of $121.2 million. We also know that in addition to the $421.3 million of purchases that took place after the close of the quarter, there was an additional payment due of $47,613,000 for treasury stock purchased at the end of the quarter that had not yet been paid. And, finally, if the company is to generate its guidance of $1.1 billion of free cash flow for the year and has already generated $222,789,000 in Q1, it will generate $777,211,000 over the remainder final three quarters of the year.

Putting this information together, we find that the company has a total of $940 million under its revolver plus $777.2 million of free cash flow for the remainder of 2014 and $121.2 million of cash on hand at the end of the quarter for a total of $1,838.4 million. It also has payments due of $421.3 million for share purchases made after the close of the quarter and another $47.6 million for share purchases not yet settled at the end of the quarter for a total of $468.9 million. This would give the company a net total of $1,369.5 million cash available (the $1,838.4 million - $468.9 million = $1,369.5 million) through the end of 2014. If we further assume that Sirius will carry a minimum cash balance at year end of $100 million, it could spend up to $1,269.5 million on additional share purchases over the remainder of 2014, assuming it does not spend anything for capital investments and acquisitions or decides to raise new debt.

Note that although the company has $1,687.6 million remaining under its authorization, it won't be able to fulfill that authorization in 2014 unless it raises more than $400 million of new debt. Furthermore, it will be limited in its share buybacks throughout the year as more than half the amount is dependent on free cash flow that has not yet been generated.

Potential Share Reduction

The questions facing investors and analysts is how many shares will Sirius repurchase this year, how much new debt will it raise and will it authorize additional share buybacks. On the recent conference call, CFO David Frear discussed raising debt and mentioned higher leverage:

This week, consistent with our recently raised target leverage of four times, we also raised the restricted payment limitation in our revolving credit facility to allow unlimited restricted payments as long as leverage is under 4.5 times. ...

...Our leverage at the end of quarter stands at [2.8] times including nearly half a turn related to our deep in the money 7% exchangeable notes. We are likely to tap periods of opportunity in the bond market to issue new debt and to replace the 7% notes that will convert into equity in December of this year. As Jim mentioned we are confident of achieving our guidance for the year

When analyst Barton Crockett pushed the issue of raising debt later in the call, asking:

...if you guys were to move to your leverage target of 4x by the end of this year, you could free up between free cash flow and borrowing capacity over $3 billion to do share repurchase or other capital returns to shareholders. Could you talk about your appetite to do something at that level of magnitude, which could require looking at your repurchase authorization and adjusting that?

the response by CEO Jim Meyer was:

I don't disagree with your math, that if we chose to use all of the leverage and all of the cash flow in that way, then it is certainly mathematically possible that we would do 3 billion. We have 1.7 billion remaining on our existing authorization. We care about how we use the shareholders' money. We think we'll be smart with how we do that once we get through that authorization, we'll have a discussion with the board and consider what we might want to do in the future.

Although the company intends to raise new debt, the timing is unclear and it is also not clear how much debt the company will wish to carry under the revolver. However, if the company raises $500 million to replace the 7% notes and draws the revolver to the maximum, the total debt at year end would be $4.4 billion. At four times the $1.38 billion of EBITDA, the borrowing capacity would increase to $5.5 billion, and the company could borrow another billion dollars by the end of 2014.

The additional $1 billion plus the $500 million to replace the 7% notes would bring the available total up to $2.8 billion for the remainder of the year (the $1,269.5 million previously calculated plus the $1 billion plus the $500 million). If the company was able to purchase shares at an average price of $3.25, the total would be $862 million additional shares, at averages of $3.50 and $3.75, the purchases would decline to 800 million and 746 million shares. And, obviously, if the company does not push those levels to the maximum, the purchases would be less.

Using the previously calculated shares outstanding figure of 5,940,655,440, and adjusting for the anticipated conversion of the notes adding 272,855,000, the year end total would be 6,213,510,440. Picking a $3.50 average price for repurchases and an incremental reduction of 800 million shares, the balance would be reduced to 5,413,510,440.

Free Cash Flow per Share

Raising that much debt is probably not in the current plans for Sirius. It pushes the limits quite high, and would result in significant increases in interest expense. And, even if the debt is to climb that high, because the 7% notes won't come off the books until December, the replacement would probably not be available for share repurchases in 2014. However, ignoring these factors, the free cash flow of $1.1 billion and the reduced shares outstanding would drive free cash flow per share to 20.3 cents.

Summary

I believe the sequential revenue decline has greatly contributed to the current reduced share price. It happened to a company where both total and self-pay subscribers increased, subscription rates increased and a new revenue stream had a full quarter impact. It has to raise concerns.

Despite this, for a company intent on increasing leverage and aggressively buying back shares, it presents an opportunity to acquire its own shares at a lower price than would otherwise have been achieved. Whether those lower prices represent a good value for investors is another matter, and will be more fully explored in a future article.

Source: First Quarter Weakness Exposed At Sirius

Additional disclosure: In addition to my long positions in SIRI, I have June 2014 and January 2015 $4 covered calls written against several of these positions. I also actively trade SIRI. I may initiate new covered call positions or close out or open new positions in SIRI at any time. I have no plans to trade any of the other stocks discussed in this article within the next 72 hours.