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Edited By Adam Isaac

Sirius XM Radio (NASDAQ:SIRI) provides satellite radio services for customers in the United States and Canada. The company broadcasts approximately 135 channels, including music, sports, entertainment, comedy, talk, news, traffic, and weather channels on subscription fee basis through two satellite radio systems. It also offers music stations in a variety of genres, including rock, pop, and hip-hop, as well as dance, jazz, Latin, and classical music.

Sirius XM is one of the most controversial stocks in the market. During the peak of the financial crisis, the stock was treated as a penny stock and was dumped by investors. Since its dip to $0.1, it has shown remarkable performance. In the last four years, Sirius XM stock has seen a steady increase in its price and the stock is currently trading at about $2.5. I think the stock is still undervalued, and my valuation model supports this thesis.

Valuation Model

For the purposes of this model, I evaluated the firm on its future growth and business potential in order to determine a fair value price. At the moment, revenue is growing at an impressive rate, with earnings expected to show an increase of 24 percent. The company has increased its full-year revenue guidance to $3.4 billion, since recovering auto sales are expected to contribute significantly toward revenue growth. The Sirius price increase seems to have been well received and revenue growth has not yet slowed.

In my model, I have assumed a revenue growth rate of 20 percent for 2012, as I believe the firm will be able to achieve revenue this year well above that of the previous year. However, for the next four years, I have assumed a constant growth rate of only seven percent for revenues, and a terminal growth rate of four percent in the year 2017. I have made this choice because the market is saturating, and I am not confident that the company will be able to maintain this rate over the long term. I have therefore assumed a declining growth rate. On the other hand, I have assumed a growth rate of between one and four percent for different components of the cost. Sirius expects an increase in depreciation expenses in the coming years.

However, it is believed that other operational and marketing expenses will come down as a percentage of the total expenses once Sirius expands its operations. During the second quarter of 2012, the firm recorded a one-time tax benefit of $3 billion. However, I have ignored this tax benefit for the purposes of this valuation since, in its earnings report, the company disclosed that it cannot guarantee how much of the tax benefit will actually be recovered. Sometimes, one-time benefits can be pitfalls for company valuations and prove nothing more than an attempt to improve operating results. Therefore, in this model, I have ignored the one-time tax benefit in order to value the firm based entirely on its operations and regular earnings.

ProForma Earnings

Reported Earnings

Projected Earnings

2010

2011

2012

2013

2014

2015

2016

2017

Revenue:

Subscriber Revenue

$2,414,174

$2,595,414

$3,114,497

$3,332,512

$3,565,787

$3,815,393

$4,082,470

$4,245,769

Advertising Revenue, net of agency fee

$64,517

$73,672

$88,406

$94,595

$101,216

$108,302

$115,883

$123,995

Equipment Revenue

$71,355

$71,051

$85,261

$87,819

$90,454

$93,167

$95,962

$98,841

Other Revenue

$266,946

$274,387

$279,875

$285,472

$291,182

$297,005

$302,945

$309,004

Total Revenue

$2,816,992

$3,014,524

$3,568,039

$3,800,398

$4,048,639

$4,313,867

$4,597,260

$4,777,609

Operating Expenses:

Revenue share and Royalties

$435,410

$471,149

$489,995

$509,595

$529,979

$551,178

$573,225

$596,154

Programming and content

$305,914

$281,234

$289,671

$298,361

$307,312

$316,531

$326,027

$335,808

Customer Service and billing

$241,680

$259,719

$267,511

$275,536

$283,802

$292,316

$301,086

$310,118

Satellite and transmission

$80,947

$75,902

$77,420

$78,968

$80,548

$82,159

$83,802

$85,478

Cost of Equipment

$35,281

$33,095

$33,426

$33,760

$34,098

$34,439

$34,783

$35,131

Subscriber acquisition costs

$413,041

$434,482

$447,516

$460,942

$474,770

$489,013

$503,684

$518,794

Sales and marketing

$215,454

$222,773

$229,456

$245,518

$262,704

$281,094

$300,770

$321,824

Engineering, design and development

$45,390

$53,435

$55,038

$56,689

$58,390

$60,142

$61,946

$63,804

General and Administrative

$240,970

$238,738

$243,513

$248,383

$253,351

$258,418

$263,586

$268,858

Depreciation and amortization

$273,691

$267,880

$262,522

$275,649

$278,405

$281,189

$284,001

$286,841

Restructuring and impairment costs

$63,800

$0

$0

$0

$0

$0

$0

$0

Total Operating Expenses

$2,351,578

$2,338,407

$2,396,068

$2,483,401

$2,563,358

$2,646,478

$2,732,909

$2,822,810

Income from operations

$465,414

$676,117

$1,171,971

$1,316,996

$1,485,281

$1,667,389

$1,864,351

$1,954,798

Other Income (Expense)

Interest Expense, net of amount capitalized

$295,643

$304,938

$317,136

$329,821

$343,014

$356,734

$371,004

$385,844

Loss on extinguishment of debt and credit

$120,120

$7,206

$40,356

$35,698

$25,698

$45,896

$25,893

$56,984

Interest and Investment Income (loss)

-$5,375

$73,970

$2,300

$2,323

$2,346

$2,370

$2,393

$2,417

Other Income

$3,399

$3,252

-$1,458

$2,356

$2,587

$3,254

$1,250

$1,365

Total Other Expense

$417,739

$234,922

$356,650

$360,840

$363,779

$397,007

$393,253

$439,046

Income before Taxes

$47,675

$441,195

$815,321

$956,157

$1,121,502

$1,270,382

$1,471,098

$1,515,753

Tax Expense

$4,620

$14,234

$57,072

$66,931

$78,505

$88,927

$102,977

$106,103

Tax rate

9.69%

3.23%

7.00%

7.00%

7.00%

7.00%

7.00%

7.00%

Net Income

$43,055

$426,961

$758,249

$889,226

$1,042,997

$1,181,455

$1,368,121

$1,409,650

EPS

0.01

0.11

0.20

0.23

0.27

0.30

0.35

0.36

Shares Outstanding

3,693,259

3,744,606

3,830,000

3,849,150

3,868,396

3,887,738

3,907,176

3,926,712

According to my assumptions, the firm should see a gradual increase in its EPS and generate over $1.4 billion in total earnings at the end of 2017. At the moment, Sirius has 3.83 billion outstanding common shares. However, it also has a large number of stock options, which can be exercised as the stock price goes up. At the end of the valuation period, Sirius should generate an EPS of $0.36.

Valuation

For valuation purposes, I have assumed a discount rate of ten percent. Sirius has a strong history of revenue growth, healthy cash reserves, and a fairly strong business model. Taking into account the established position of the company, I believe a discount rate of ten percent is justified.

Valuation

2012

2013

2014

2015

2016

2017

Earnings

$0.20

$0.23

$0.27

$0.30

$0.35

$0.36

Discount rate

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Present Value Factors

0.95

0.91

0.83

0.75

0.68

0.62

Discounted Earnings

$0.19

$0.21

$0.22

$0.23

$0.24

$0.22

Terminal year Value @3% constant growth

$3.67

Discounted Terminal Value

$2.28

Fair Value

$3.59

There are two conventional methods to calculate the terminal year value; multiple of terminal year earnings and a constant growth model. I have used the latter, and assumed a three percent constant growth rate after the high growth period of five years. I believe Sirius will be able to generate impressive growth figures during the next five years.

Furthermore, the terminal year earnings of $0.36 are discounted using the single-stage growth model, where the earnings are first adjusted for constant growth and then discounted by a rate of ten percent. The single-stage growth model also adjusts the discount rate for growth by deducting the terminal growth rate from the discount rate. Once the terminal year value is calculated, it is then discounted to reach the present value. On the other hand, earnings before the terminal year are simply discounted to reach their present value. Finally, the discounted earnings are added to the discounted terminal value to reach the true value/fair value of the stock.

According to my valuation, the stock should trade above $3.5. At a price of about $2.5, the stock is trading at a significant discount to its fair value.

Summary

While Sirius XM had a good year last year, it expected a slowdown when 2012 began. Nevertheless, the company has been able to add to its increasing number of subscribers, and it should be able to carry its momentum over the coming years. Sirius XM is currently a very popular choice for vehicle owners. However, the company faces some future threats from radio services such as Pandora (NYSE:P) and Clear Channel Radio that, with their personalized service, are looking to push further into the automotive market. However, Sirius XM should be able to fend off the competition in order to record healthy growth. The stock is currently trading at a reasonable discount to its fair value and offers a great opportunity to make great returns. Based on my discounted earnings model, Sirius XM has at least 40% upside potential to reach its fair value.

Source: How Much Is Sirius XM Worth?