Peter Lynch, the legendary fund manager, guided Fidelity's Magellan fund to some spectacular returns from 1977 to 1990 - 29.2% per year. He also is well known for his advice to investors "Invest in what you know." Many SiriusXM (SIRI) investors appear to have taken that advice, first getting to know the service and then investing in the company.
Is knowing the service a good reason to buy the stock? Is this service a must-have for the consumer? More importantly, is the stock a must have for one's portfolio? The answer to all three of these questions should be a resounding "No!"
Satellite radio is clearly a discretionary service. SiriusXM markets the service by working with vehicle manufacturers to give new car buyers (and, more recently, used car buyers) a free trial, giving the new owners a chance to experience a wide selection of news, sports and talk programming, as well many channels of commercial-free music. The premise is that once the listener experiences the service for a period of 3-12 months, they would be hooked and willing to pay for it. And, there are certainly many customers that are willing to pay to listen to radio. Millions of them. At the end of the first quarter, SiriusXM had more than 18.2 million customers that decided to pay for the service.
Investors should also consider how many choose not to pay and whether or not the SiriusXM subscribers are loyal. Clearly many choose not to pay and many of those that do are not particularly loyal. We know this by looking at the number of subscribers that decide to cancel the service each year.
By the numbers
The number of potential customers that choose not to pay can be found in the number of de-activated subscribers, which came in at 1,757,097 during the first quarter. This figure, along with the New Vehicle Consumer Conversion Rate and the Self-pay Monthly Churn, is a part of the subscriber metrics that SiriusXM reports each quarter. While each of these figures provides some insight into the business, they also have flaws.
The New Vehicle Consumer Conversion Rate lets one derive one component of de-activated subscribers. The conversion rate "is defined as the percentage of owners and lessees of new vehicles that receive our service and convert to become self-paying subscribers after the initial promotion period." During the first quarter the figure was reported at 45%. It also means that 55% of the new car purchasers or lessees chose not to take the service.
The other component of de-activated subscribers is self-pay monthly churn. During the first quarter SiriusXM reported the self-pay monthly churn at 1.9%. Based on the number of self-pay subscribers at the beginning of the quarter (17,908,742) and the end of the quarter (18,208,090), we have an approximate monthly average of 18,050,416. Using the monthly churn rate of 1.9%, the approximate number of self-pay subscribers that terminated the service during the first quarter was just over 1 million. (The numbers are approximate because Sirius does not reveal the actual weighted average number of self-pay subscribers during the quarter and the churn rate is rounded to the nearest tenth.) And, if approximately 1 million of the 1.76 million de-activated subscribers came from churn, that means three quarters of a million de-activations came from recipients of new vehicle free trials that chose not to convert, and gives total de-activations that are trending towards more than 7 million for the year. That's a lot of potential subscribers that made a choice not to pay for the service.
While these metrics are important, they do not tell the entire subscriber story. If churn is considered a measure of subscriber dissatisfaction, it is overstated from the inclusion of former/current subscribers that deactivated simply because they bought a new car that came with a free trial. And, if conversion is considered a measure of new subscriber satisfaction, it is overstated by the inclusion of former subscribers that bought a new car with a free trial. Regardless, both churn and trials that don't convert contribute to a high number of de-activated subscribers.
Another component that isn't captured is the behavior of purchasers of used cars that come with a free trial. SiriusXM management has informed investors that approximately 1 million gross subscriber additions will come from the used car program (where the purchaser gets a free three month trial) in 2012, and that these are expected to experience a conversion rate in the mid-30's. That indicates that nearly two thirds of those that have the opportunity to experience the service will choose not to convert.
Is knowing the service a reason to invest in the company?
Despite the statement by Peter Lynch to invest in what you know, knowing the service is not enough of a reason to invest in SiriusXM. Perhaps it is a starting point to look at the company as a potential investment opportunity, but it should, at best, be only the first step in a process. It is far more important to consider the company's financial strength, market position and growth prospects. Those are much more important criteria for choosing an investment than the fact that one likes to listen to commercial-free Howard Stern.
Is the service a "must have" for the consumer?
Clearly the service is not a "must have" for most consumers. Many find the aggregation of content that is easily accessible from the dashboard of their car a convenience they are willing to pay for. Others find listening to commercial-free music or some of the unique content worth the monthly payment. And, still others find the availability of diverse content, especially outside major metropolitan areas, well worth the monthly payment. Most, however, do not think the service is worth the price, or simply refuse to pay for radio.
While more than 18.2 million have chosen to subscribe, far more than that have chosen not to do so. The high number of de-activations is the proof. Unofficial de-activations this year alone will total approximately 8 million.
Is the stock a "must have" for one's portfolio?
No stock should ever be considered a "must have" for one's portfolio, and only those stocks that meet an investor's individual criteria should ever seriously be considered, whether one "knows" the product or not. SiriusXM is a holding in my portfolio. It meets my criteria for a long term investment.
The company is expected to generate a reasonable amount of free cash flow (FCF) per share and that FCF can be expected grow at rates well above the general market. The growth in FCF will be accomplished by a combination of lower interest expense through reducing and refinancing debt at more attractive rates, price increases, a growing subscriber base and more rational expense control when renewing current content agreements.
The current 2012 projection of $700 million FCF is more than ten cents per diluted share. At a current share price below $2, that's a cash yield of more than 5%, and as noted, it is expected to rise. Are there risks? Absolutely. The company has a major negotiation with SoundExchange over music royalty costs. SoundExchange is looking for 20% of certain revenues in 2013 and beyond, up from the current rate of 8% in 2012. SiriusXM is looking for a reduction from the current rate. I expect an increase from the current 8% rate, and think that the new agreement will probably move up in small steps to a low double digit percentage. The prior agreement moved up in one half percent per year increments to its current level.
There is also uncertainty about Liberty Media's (LMCA) short and long term plans with respect to its 46.2% stake in SiriusXM, and uncertainty is never good for the share price of a stock. While it appears Liberty will go to majority ownership before the end of the year, it is not clear whether they plan to retain control or spin it out to Liberty shareholders. I expect Liberty will continue to retain control for a period of time in order to use its FCF and leverage its borrowing capacity.
SiriusXM is heavily dependent on new vehicle sales for increasing its subscriber base. Mike Ward, an auto analyst at Sterne Agee & Leach Inc., during a June 5th interview on Bloomberg's Taking Stock said he expects new vehicle sales to come in at the low end of trend - about 14 million units - down from the higher pace set during the first quarter. This reduction is based on the recent weakness in the overall US economy.
These SiriusXM specific risks are in addition to any overall macroeconomic factors. Weak employment data, sovereign debt issues in Europe, and the fiscal cliff a divided US government refuses to address could all directly impact the overall market and drag the price of SiriusXM lower.
Summary
Lynch suggested that investors should invest in what they know. Based on some of the comments made on this site, there are SiriusXM investors that followed this advice. Some of these investors claim they will cancel their subscriptions if Liberty does not treat them fairly in the event of a takeover. It is indicative of an investor unable to separate an investment from the service. It's an unusual criterion on which to base one's consumption. It is also an unusual way to make an investment decision.
And, I suspect if Lynch made decisions on this basis, he would not have achieved an annual return of 29.2%on .
Disclosure: I am long SIRI.
Additional disclosure: I have $3 January 2013 covered calls against most of my Sirius position, as well as some $2 and $2.50 January 2013 covered calls. I may initiate (or close) a buy stock/sell option position in Sirius, discussed in another article, at any time. I have no positions, or any plans to open positions in the next 72 hours, in Liberty Media.
