Sirius XM (NASDAQ:SIRI) has been covered and debated extensively on Seeking Alpha, so the business needs no introduction. I would like to discuss what I believe are the company's competitive strengths and follow that up with a model for its valuation.
I believe that Sirius XM has one of the best, most sustainable competitive moats in US business today. At its heart, I think this comes from its broad selection of content - you cannot come close to Sirius XM's selection of music, sports, and talk. People enjoy the ability to listen to whatever they want when they are in their cars, and they are willing to pay a relatively small fee for it (~$150 / year).
When looking at a company's competitive position, I always try to think of how I would compete against it. In the case of Sirius XM, I see four different groups of competitors: terrestrial radio, streaming, satellite radio, and large tech firms. I see two overarching themes for any competitor:
1. Discerning between Sirius XM subscribers and their potential customers - It's going to be very difficult to pry listeners away directly from Sirius XM: listeners have just about all of the content that they want, the service always works (even without internet access), they don't have to use their data plan, and they pay about $12 per month (very little for their average, higher income customer). People don't usually switch away from relatively inexpensive things that they like and always work. Instead, if I was competing against them, I would really focus on the lower income consumer who hasn't been exposed to Sirius XM, but who will be exposed in the near future when they start enabling used cars. While it will be hard to win their current customers, it will be much easier to provide a good product that will slow their growth in the future (i.e. reduce their conversion rate).
2. You need to compete on content, and startup costs are huge - the failure of Spotify, Pandora (NYSE:P), and other streaming platforms to put a dent in Sirius XM's subscriber base (churn has remained very low and conversions high) tells me that people want more than just music, so you're going to need to deliver a lot of content. I see this competition as similar to that of a TV antenna versus cable - the antenna is very inexpensive and provides some of what you want, but people still overwhelmingly choose cable and its expanded choice, even though it costs a lot more. If you're going to try to compete head on with Sirius XM, you need content upfront (people won't buy your service hoping that it'll magically appear in the future), and it's expensive: Sirius XM spent almost $1 billion on content last year.
Another Satellite Radio Provider - No one would do this. You would probably go bankrupt faster than if you try to start your own railroad.
Terrestrial Radio - If I was a terrestrial radio operator, I would want to own as many stations per area as possible, subject to antitrust concerns. That way I could specifically tailor my offering to that area - maybe some areas would have mostly music stations and others would have a balance of music, talk, and sports. At the end of the day, I won't have nearly the same selection as Sirius XM, and I will have commercials, but it will be free. This is largely what terrestrial radio operators are doing now, and I don't expect much to change over time.
Streaming - If I ran Pandora (or pick your own streaming operator), I would be worried about continuing to win more customers. I would be worried about becoming profitable. I would be worried about Apple. I would be worried about a lot of things. One thing I wouldn't be worried about is Sirius XM. Lots of consumers have both Pandora or Spotify and Sirius XM, so right now they aren't huge competitors. There's plenty of room for growth for Pandora even before you think about increasing the amount of content that you provide. You might like to add content, but it's an expensive bet that more content will actually lure more subscribers, and it's especially expensive since the company isn't even profitable. And also, since your company isn't profitable, you have more pressing problems.
I would say that terrestrial radio and streaming compete more with Sirius XM at the initial point of sale (when someone is deciding whether or not to activate a subscription), and I see this as influencing the conversion rate: without terrestrial radio or streaming, people would obviously make the decision to use Sirius XM much more often, and the conversion rate would therefore be much higher. Alternatively, if streaming or terrestrial had a much stronger, broader service for free, people obviously would choose Sirius XM much less. Terrestrial radio can't offer what Sirius XM can because of antitrust concerns, and streaming services don't have nearly enough capital to make that investment. Since customers have already decided that they are willing to pay for the service over those alternatives, they have no reason to change their minds.
Google (NASDAQ:GOOGL), Apple (NASDAQ:AAPL), etc. - While other competitors haven't taken Sirius XM's existing customers, I believe that Google, Apple, or some other big tech company potentially poses a much bigger risk. If, say, Google bought Pandora, they would have access to a huge amount of users, and they would also have the ability to spend the necessary money on content to compete with Sirius XM. This is the only combination that can truly rival Sirius XM. That being said, I don't think that any company would do that - it would be a very large capital outlay with a very uncertain payoff; however, throughout corporate history, companies have done much stupider things, so I think that it is something to watch out for. I also think that an Apple or a Google would be much more interested in integrating users into its ecosystem to make it easier to sell media in its store than to go after Sirius XM.
Going after Sirius XM would be very non-core for a company like Apple or Google, and large, upfront content costs would make it unrealistic for any other company. So, as I said earlier, I see competition as continuing at the point of sale. I see Sirius XM's advantage as having a lot of great content for a relatively low price, for which more affluent consumers (up to this point, mainly new car buyers) have shown enthusiasm. However, when Sirius XM starts to offer trials for used car buyers who generally make much less than their current customers, I think that the $150 / year will be more significant and people will be more likely to listen to terrestrial radio or streaming music. This should show up in its financials as a lower conversion rate and slower top line growth, but should not lead to a large erosion of its customer base.
What is it Worth?
So I think the story of Sirius XM is that they have their current customers "hooked" and that they are going to steadily increase their subscriber count as they get more cars enabled over time. The hard part about investing in Sirius XM to me is finding a reasonable valuation, since there are a lot of moving parts: on top of all of the normal troubles of valuing a company, margins are expanding rapidly, the company has over $6 billion in net operating losses on its books and isn't paying taxes, it is under its leverage target, the number of enabled cars will grow rapidly until 2018, and it is buying back a ton of stock.
I set up a model to try to make an educated guess as to what the company will be worth at the end of 2018 and back into a valuation. There are a couple of reasons for this. First, the company will be (or will very nearly be) paying taxes. Second, margins should have reached their approximate steady state at around 40%. And last, the number of enabled cars should be growing at a more normal pace (management says that number will double from 2013 to 2018, or at about a 15% compound rate, then increase by about 25% over the next five years), and companies growing at lower rates are relatively easier to value.
I am going to use a target for a free cash flow yield at the end of 2018 of 6-7%. As a multiple, that would range from 14.3-16.7, or generally in line with companies growing at decent, but not quick rates. I could obviously be wrong, but I think that Sirius XM will be growing in the low to mid-single digits after 2018, and that is about where I would value a company growing fairly slowly (you might compare a future Sirius XM to AutoZone (NYSE:AZO) - it is expected to grow EBIT around 4-5% over the next few years and uses its cash flow to repurchase stock, and it usually trades at a P/E ratio of about 15-17).
With management guiding EBITDA margins over time at 40% and free cash flow conversion (as a percentage of EBITDA) around 55% once the company starts paying taxes and deploying satellites, we just need to find 2018's revenues to estimate its free cash flow (FCF = revenue x .4 x .55).
I estimate revenue pretty simply: the company ended 2013 with 60 million enabled cars and $3.8 billion in revenue. At the end of 2018, it will have doubled its enabled car base, so a first guess would be that it will double revenues. To fine-tune that guess, I think of how well they sign up incremental drivers, or the company's conversion rate. Up to 2013, the company averaged a conversion rate of around 45%. If the company has the same conversion rate over the next five years, it should get around the same amount of incremental revenue. If it is lower, as I argued previously (due to lower income consumers having a higher tendency to pick cheaper options), then incremental revenues will be lower.
I think a recent comment by CFO David Frear provides a good range for a guess. He said that management thought that the conversion rate for used cars would be in the low 20% range but that so far it has been in the low 30% range. Low 20's to low 30's seems to be a good guess to me for used cars, and since used cars are going to drive so much growth in the future, I will somewhat conservatively use that range to estimate future revenues. So, I am estimating that revenue will be up roughly 50% to 75% (low 20% range divided by 45% is about 50%, and low 30% range divided by 45% is about 75%) from 2013's $3.8 billion with an extra 10% coming from price increases (on the Q2 CC they commented that pricing should go up over time just like other media companies). That takes revenue to a range of about $6.3-$7.3 billion.
Multiplying the revenue range by EBITDA margins of 40% and free cash flow conversion of 55%, free cash flow would be in a range of $1.4-$1.6 billion. Dividing the low end by a 7% cash flow yield and the high end by a 6% cash flow yield (lower growth should have a lower multiple and vice versa), we get a range of value from $20-26.7 billion.
Having an estimate for the value of the equity, the last step in my model is to estimate the number of shares outstanding at the end of the period, since the company will be buying back so much stock. I'm using the amount spent on buybacks as total free cash flow plus additional debt issuance, with the debt to EBITDA ratio at 4x, as per the company's guidance.
For my less optimistic case (revenue at $6.3 billion, EBITDA at $2.52 billion, free cash flow at $1.4 billion), I get $12.6 billion spent on buybacks, with about $7.1 billion coming from free cash flow and $5.5 billion from incremental debt.
For my more optimistic case (revenue at $7.3 billion, EBITDA at $2.92 billion, free cash flow at $1.6 billion), I get $14.7 billion spent on buybacks, with about $7.7 billion coming from free cash flow and $7 billion coming from incremental debt.
Both of these numbers are a tad fuzzy, but I basically get them by taking free cash flow guidance for the rest of this year, then trending revenue to 2018 and multiplying by the 40% EBITDA margin and 55% free cash flow conversion rate. The margin probably overstates free cash a little bit, and the conversion rate probably understates it since the company isn't launching satellites for a while, but if I'm off by 10% or so, it's not catastrophic (that would change the ending value by much less than 10%). Lastly, I added the value for the NOLs - with ~$6.1 billion outstanding and a 35% tax rate (could be closer to 40% but I'm not quite sure where it will end up over time), I get a value of $2.14 billion.
I made a simple excel model to help me calculate the ending shares outstanding due to all of the buybacks. I use this just so I get a ballpark estimate of the average price paid by the company for the shares. Even though that estimate will be wrong, you win both ways: if the actual price paid is below the estimated price, you will own more of the company, and if the price is much above that, you can just sell your shares for a nice gain. (A couple of quick notes for people paying a lot of attention: Shares outstanding are at the end of the second quarter plus shares from the upcoming dilution offset by $500 million in extra debt taken away by the dilution used to buy back shares at an average price of $3.50. Ending shares outstanding are increased by 10% to take account for incentive stock options.) Here are the results:
Less optimistic case
More optimistic case
As you can see, with this model, 5-year compounded returns are quite high with a starting price of $3.46. I consider a price fair when it produces probable returns of about 10%. That comes out to a price right around $4.00 per share (returns range from about 7.7% to 12.3%).
Obviously, this is a model, which means that it will certainly be wrong in many ways, but I think it makes a good estimation of Sirius XM's real value (or at least better than I can do in my head). As a cross check, I'm going to look at its free cash flow yield stripping away a lot of the one time stuff. My method here is just to assume that EBITDA margins are already at 40% (not too far off) and to assume that free cash flow conversion is at 55% then add back the present value of the NOLs (something like $1.5 billion, or $.26 per share). This will get a normalized free cash flow number that we can use to ballpark a valuation. With $4.0 billion in TTM revenue, that gets to $880 million of "trend" free cash flow, and after subtracting out the net present value of the NOLs on the balance sheet, we get a free cash flow multiple of about 21.5, which is fairly inexpensive for a company with such good growth prospects.
Sirius XM is a company with a strong competitive position that should be able to grow quickly over the next 4-5 years. Although there are currently a lot of moving parts, a basic model says that shares are probably undervalued by around 15%, giving a good entry point for a long-term investor.
Disclosure: The author is long SIRI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also long SIRI January 2016 $3 calls. Many of my clients are also long SIRI. I am a registered investment adviser. However, this commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.