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Fundamental analysis of Sirius XM (part 1)

|Includes:Sirius XM Holdings Inc. (SIRI)

Note: I decided to post this as an instablog as the editorial team found this coverage "to naive for their sophisticated audience".

My initial interest in Sirius XM (NASDAQ:SIRI) awoke, when I read about its coverage of sports and the recent contract with the NFL. I subsequently discovered the magnitude of coverage Sirius XM has received recently, as Seeking Alpha has literally been flooded with articles and comments. As there seems to be quite an amount of SIRI experts out there, much of the discussion here on SA has been centered on highly detailed topics, such as the ownership arrangement of Liberty Media’s a preferred shares and its effect on a possible buy back program or possible synergies between SIRI and Barnes and Noble.

This article will provide a more general discussion of the company and will be followed up with a couple of valuation proposals for SIRI stock. My main objective is to cast a better light on the company’s business model and the key drivers of value for its common shares.  

The basics

Satellite radio is an analogue or digital radio signal that is relayed through one or more satellites giving it a significantly wider geographical reach over the conventional terrestrial FM radio. The main benefits of satellite radio over terrestrial or IP radio is mobility and quality of receivership. Content also plays an important role as customers face a trade-off between free listening with commercials and paying a fee for no-commercials. And last but not least the exclusivity of the content plays a fundamental role.

Competitive landscape

The radio market can be split into three separate categories, namely terrestrial, IP and satellite radio. According to a recent Sirius XM presentation, the total radio market growth in terms of revenue has been stagnant in the last decade (see figure 1). At the same time satellite radio’s market share has gone from nil to 15%.

Figure 1: Radio market
Radio Market per Revenue

There have been some write-ups on to which extent Sirius XM and Pandora compete (see I, II, III, IV and V). Although both offer the same core product (radio programming), it is my impression that they cater to a totally different target group. At Sirius XM mobility is a key competence, hence the benefit for drivers. According to Sirius XM, Pandora generated $1.68 of revenue per user in 2010, Clear Channel $13.61 per listener and SIRI $141 per subscriber giving SIRI a 90% market share in terms of US based subscription revenue (see table below).


A comparison of the competitive landscape for internet radio vs. satellite radio is interesting. There are countless ways to listen to music online, but there’s only one way to listen to satellite radio as Sirius XM (originally two competing companies) is the only provider of satellite radio in the US and Canada. Satellite radio's chief asset is the fact that it is not localized: drivers can receive the same programming anywhere in the footprint of the service. Additionally, the company sees its content as a competitive advantage (in commercial free radio, sports coverage and news, talk & entertainment).

Competitive advantage

For subscription-based businesses churn rates are an important indicator of competitive advantage (i.e. in terms of customer lock-in or relative product quality). Small reductions in churn can have a huge impact on enterprise value. It should be noted though, that indicators indicate, they don’t answer questions of why and how. Also, it is difficult to compare churn ratios of different companies as they often apply different definitions to churn (i.e. should you include trial subscription etc). Churn reductions occur when the quality of a customer’s experience falls below a certain threshold either relative to competition (comparison churn) or relative to her own expectations (frustration churn). SIRI has shown a consistently low churn ratio, compared to its peers (nota bene: according to SIRI) of about 2% (1Q2011). Netflix (), that has a similar base (+20m) in comparison had a 3.9% churn rate in the same quarter. In his letter to shareholders from 2010, Mel Karmazin said: "In the last year, our conversion rate moving consumers on trials to self-pay subscribers continued to improve and our self-pay churn declined. We grew our self-pay subscriber base alone by nearly 1 million subscribers in 2010. Six times as many new customers chose to pay for our service in 2010 than in 2009."

Another indicator of competitive advantage is pricing. As Sirius XM is operating (a monopoly) within a regulated industry, pricing will always be under the influence of regulation. Sirius XM has never in its history increased its base subscription rate and it is currently on 36 month price freeze until august of 2011 (base subscription stands at $12.95 per month). Under normal conditions, I would view this as a negative indication on competitive advantage. However, once you factor in the leveraged structure of the business model (further discussion follows), you would have to take into account that unit costs decrease rapidly with subscription growth. So, once they have the scale, Sirius XM is in a position (in terms of unit costs) that any new entrant would be unable to replicate. 

A third indicator of competitive advantage is the penetration of OEM agreements. As it stands now about 60% of new car sales in the US come equipped with satellite radio receivers. The conversion rate of those sales into subscription is about 45% (source: Sirius XM). 

There are negative points to be made as well. Consider the following table from the 2010 10Q (see figure 2). Although net additions came in at 1.4 million in 2010, 37% of the beginning subscriber base deactivated their subscription. To me, this indicates that the customer lock in is perhaps not as strong as I had initially thought. Also, the number of retail clients has been diminishing steadily in recent years.

Figure 2: Churn
Figure 2: ChurnClick to enlarge

Business model

My initial thought on the business model was that it resembles cable and telecommunication models as it (1) requires significant capital outlays to establish a platform, (2) is highly scalable and (3) subscription-based. Consider this description of the telecommunications industry in a Deutsche Bank report from 2007: “Telecommunications is a very simple business complicated by regulation and politics. The standard business model relies on a trade off between pricing, penetration and capital intensity. Almost all elements of the telecoms industry follow the standard “S” growth curve in penetration.

With these assumptions, a valuation approach to SIRI could be similar to that of a cable or telecom company. Cable companies, as so often has been noted, have rather meaningless earnings statements, as high initial capital spending translates into high depreciations, consequently lowering earnings. John Malone of Liberty Media explained this in a 2009 interview in the Denver Business Journal (found at manualofideas.com):   

"The concept that cable television looked more like real estate than it did manufacturing was always obvious, … to me, anyway. And I think the financial markets really didn’t have a model for cable, because the industry was a small, startup industry with no real following. Coming out of that period of the ’70s, the industry needed some model, some metric how the market could value us.

We decided out here in Colorado — not just us, but the other companies out here — to go on a cash flow metric very much like real estate. Levered cash flow growth became the mantra out here. A number of our eastern competitors early on were still large industrial companies — Westinghouse, GE, — and they were on an earnings metric. It became obvious to us that if you were going to be measured on earnings, it would be real tough to stay in the cable industry and grow. We needed to be measured much more like real estate as an industry."

Notably, in the last 6 years, Sirius and XM launched 23 satellites which have been capital intensive endeavors. However, the company now has sufficient satellite power for the next 5-6 years, which should translate directly into additional free cash flow.  In his most recent letter to shareholders, Mel Karmazian said: "Our capital expenditures are decreasing and this is a positive for us. We successfully placed a new satellite into orbit at the end of 2010. In the fourth quarter of 2011, we will complete our satellite replacement cycle. We expect our satellite capital expenditures to decline by nearly $90 million in 2011, and by another $100 million in 2012 to nearly zero. We do not expect to begin construction of another satellite before late 2016 or 2017."

As with many other subscription based models, whether it is telecom or cable TV, SIRI’s business model is highly scalable. It demands high initial capital outlays for the platform making profits subject of scaling effects. As an example of this, EBITA margins were 22% in 2010 but according to the company, they could be over 40% at maturity.

Outlook

To conclude this review, I would like to post a quote from the aforementioned interview with John Malone with his answer to a question on his view on the outlook on 4G:

This is a story yet to play out, because, as 4G, or wireless broadband, comes in and becomes more potent in terms of its data-rate capacities and its ubiquitousness, the bundle of 4G services with satellite and DSL or an enhanced DSL starts to become a very competitive service relative to cable. And the ubiquity is its No. 1 advantage — one national offering, one national brand, one national price. Cable suffers, as it always did, from the balkanization that was its birthright from the franchising process.”

"The question really is, now, as the world turns to mobility being important to consumers, will a consumer regard mobility of connectivity as important a phenomenon as speed? In other words, would you sacrifice speed for mobility, or will you buy both? Obviously, in high-income households, folks will buy both. You can afford it; why not? You can have extremely high speed from your terrestrial connection, but when you travel you have reasonably high-speed portability.

That’s the next shoe to drop in the competitive race. How important in that environment is the bundle? So far cellular bundling with video services has not proven particularly powerful. And it may not prove that wireless broadband bundled with video turns out to be a dominant thing.

There are those who believe that we’re entering a national branding and marketing game as much as we are a technology game. The argument the two dominant cellular carriers would make is that, “Hey, we’re national, we’re ubiquitous; our services will be promoted nationally, and that’s cost-effective. We’ll have stores everywhere that you can go in and sign up for it.” It’s one brand, one national offering, and that’s something the cable industry has to worry about, because the cable industry’s fragmented.

The cable industry’s counter-move has been to back the Sprint WiMax deployment, which may or may not technologically be a meaningful competitor to 4G. You can take money on that bet, but for the moment, at least, that’s the cable industry’s counter-play. And Charlie Ergen over here at EchoStar, he went out and bought some frequencies on the theory that he might be able to put something together, and he even went after Sirius radio. Nobody’s really put Charlie on the couch to figure out why, but the theory is that there may be some applications there for mobile video.

They have their terrestrial repeating network, which is 800 sites now, and the frequencies they have. The question is: can you blend that all together? And obviously we’re now deeply involved in the Sirius thing, and we think we’re going to win. We’ll see."

In part two of this coverage I will propose a simple model that would try to replicate the sensitivities in the Sirius XM business model and the corresponding values of its shares.

Contintue to Part 2


 



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Stocks: SIRI