Sirius XM's Improving Fundamentals

| About: Sirius XM (SIRI)

By Relmor Demitrius

Mel Karmazin, CEO of Sirius XM (NASDAQ:SIRI), has been attempting for years through conference calls and various interviews to focus investors' attention not on the company’s troubled past, but on its promising future. Perceptions are hard to change. Analysts have gone from hot to cold to hot again on the company and, looking at a five-year chart, one can see why.

The chart, as do most, tells the story of a company that had high expectations, emerging during the technological and internet boom of the late 1990s. The boom was in full swing and technology companies, as Sirius XM was considered at the time, were priced for success. Analysts' expectations were later tempered only to return again with news of Howard Stern signing, Karmazin coming aboard, and the possibility of a huge cost-saving merger. Synergies in the billions were proven on paper and analysts and investors jumped back in at the prospects that a successful merger would finally lead to long promised profits.

We all know what happened next. The bond market crumbled, long-standing financial institutions fell, and just when Sirius XM needed a loose credit market, it entered during its worst time in decades. All that aside, and a Liberty Media (LINTA) bailout later, Karmazin and Sirius are now poised to deliver the kind of synergies and profit-making potential that have kept long-term investors stubborn and correct to hang in there, average down, and come out smelling like a rose.

They guessed correctly that a rebound in autos would hold the model, and new revenue streams would finally break a once close model that almost was profitable, into a cash-making machine that could now fund its large debt load, repay that debt, and begin actually making direct promises to stockholders of a return of capital value. Karmazin posited that a buyback of shares would be the most likely alternative.

Consider that just two years ago the company’s future was in doubt, not by lack of customers or revenue, but by a crippling debt load that was required to fund its business into the cash-generating model it is today. With billions in combined costs in start-up satellites, repeater networks, and an infrastructure never attempted before, it was not a cheap cost to entry into this business model.

This was no Pandora (NYSE:P). This is real state-of-the-art technology that had never been attempted before to cover an area that had never before been tasked. Give one commercial-free, content-driven radio service to the entire country, no matter where you lived ... and do it all for under 13 bucks a month. Unbelievable? That’s what many shorts thought from day one. Until the merger, they might have been right.

What did the merger allow? It allowed cutting satellite costs in half. It combined customer service aspects, bandwidth, and other costs that both companies used to fund, but now no longer are forced to. It allowed contracts for talent and business partners to be one negotiator, not two, keeping costs down and fair practices in play. With XM and Sirius in direct competition for OEM partners, each OEM partner at the time got a much better deal for themselves than would have otherwise been possible. As these contracts expire, Sirius XM can renegotiate these deals at more favorable conditions.

It also can raise prices, as now it's no longer two companies competing against each other. For 10 years, Sirius and XM were struggling to differentiate themselves from the other service, so that an increase in price on one side could tip the balance of what service the retail purchaser pursued. Now that is no longer a hindrance. Sure enough, Best of Packages increases to family plan, and adding an internet charge increased revenue flows. Once the FCC allowed the company to pass along its royalty charges (past and present) to its customers, the final revenue steam that makes it a solid cash generator was now in place.

These were expensive costs associated with running a radio company that terrestrial radio does not have to deal with. Even with these costs, Sirius XM has gained overall radio revenue since 10 years ago against a comparison with terrestrial radio. An Arbitron study indicated that over 35 million people listen to Sirius XM and are a desired consumer base. This means that they are people more likely to purchase products they hear on ads. This gives Sirius XM additional leverage when negotiating advertising charges from its advertisers.

With around $20 million a quarter coming now from advertising revenue, this is no small amount. I believe by the end of 2011, this will come close to generating $100 million in revenue. That is all over costs, too, so almost 100% of that is pure profit. It doesn’t cost much to generate that $100 million. As its base increases, expect to see more ad dollars from its online service as well. One hope is that it could geographically target advertisers through this end, since they are unable at this time to run local ads through the satellite service, due to FCC restrictions upon being sold the spectrum licenses. Some investors feel this is illegal and one day may be corrected.

Sirius XM, like all companies, has certain expenses that come up from time to time, as well as charges to earnings. I want to focus on just two items: Total revenue and total costs. This doesn’t represent earnings or EBTIDA, but it gives a great trend analysis opportunity without all the noise of minor fluctuations or hits to earnings due to non-cash related reasons.

Basically if your revenue is over costs, you should be in good shape long term. Barring some charges for refinancing debt or capital expenditures that are unforeseen; Sirius XM will spend around $30 million a quarter consistently now that there will be no satellite-related expenditures after 2011 until the year 2017. So as it is a now consistently incorporated cost, it is no longer a cost concern for the next six years. The estimated yearly savings is around $200 million that it had been spending since even before the merger. I have plotted revenue, costs, and differential below.

Quarter and Year Total Revenue Total Costs Net Difference
Q 4 2008 644 689 -45
Q1 2009 605 570 35
Q2 2009 607 579 28
Q3 2009 629 592 37
Q4 2009 684 636 48
Q1 2010 670 583 87
Q2 2010 700 574 126
Q3 2010 722 575 147
Q4 2010 736 595 141
Q1 2011 723 559 164
Click to enlarge

The trend is clear. Costs are flat, if not dropping, and revenue is rising almost every quarter now. Of course there will be normal fluctuations from Q to Q, but the trends here are clear. Since its self-pay base is increasing at about 200,000 every quarter, there is only going to be more revenue going forward. Keep in mind, this is a base total revenue minus total costs analysis. This does not reflect earnings, free cash flow, or EBITDA.

Future growth to EBITDA at around 25-30% will provide even more cash to its coffers going forward. As its subscriber totals increase and it's able to successfully execute a new price structure after 2011, revenue will continue to grow as costs remain relatively flat. If it adds new talent, one would hope new revenue would pay for it.

I’m sure Karmazin and company monitor the effect adding higher-priced talent has on retention and would not spend money wastefully. Recent additions to SIRI's line-up has proven that it's adding talent that is desirable to the general public. Karmazin has stated it takes only 30 cents to add an additional $1 to revenue now, once flat consistent costs are covered. As costs to acquire subscribers is related to auto sales and is increasing at an acceptable pace, there is no need to adjust cost structure greatly to account for huge shifts in increased OEM car sales. Consistent and steady growth in auto sales is perfect for this model.

This company is only an infant since the merger and even overall if you consider how long it took cable and satellite TV to get going. This turning point of profitability could still be the ground floor of a long-term play on the radio space. Are these trends during the worst economic downturn in our modern history a fluke? What would actually happen when the economy is healthy again? Definitely an exciting time for the company.

Disclosure: Long SIRI