Wedge Partners: Sirius XM's EBITDA Margin Expanding to Mid-30% Range by 2014-2015

| About: Sirius XM (SIRI)
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By Demian Russian

Wedge PartnersIn a newly issued research report from Wedge Partners Senior Equity Analyst Martin Pyykkonen (formerly of Janco Partners), the veteran analyst lays out his case for why Sirius XM Radio’s (NASDAQ:SIRI) EBITDA margin can reach the mid-30% range by the 2014-2015 time frame. Pyykkonen also estimates that EBITDA-to-FCF conversion will increase to >90% in that same time frame. He sees this performance possible as the company’s capex spending is reduced to maintenance levels of only ~$50 million a year through at least 2017. He also sees “a much improved debt profile that should be serviceable under the current levered FCF outlook.”

We think SIRI has some upside pricing leverage as subscription rates can be increased in mid-summer of this year, after passing a three year period since the merger of Sirius and XM. The combined platforms’ content has increased which could result in favorable price/demand elasticity for SIRI. While music only subscriptions may face streaming services competition, we think SIRI’s comprehensive entertainment packages have some upside pricing leverage.

– Martin Pyykkonen, Wedge Partners Senior Equity Analyst

Noting that SIRI currently trades at ~14x Price/EBITDA and ~12x EV/EBITDA when looking at the 2011 mean EBITDA estimate on the street (fully diluted, including Liberty Media’s (LCAPA) 40% stake), Pyykkonen sees upside potential to the street’s 2011 EBITDA estimate of $738 million, which he points out is relatively flat year-over-year with the street’s present 2010 EBITDA estimate.

Pyykkonen bases his upside estimates on what he sees as “prominent drivers over the next two years.” Those drivers include: higher subscriber growth (with conversion rates hitting 50% or higher and the SAAR returning to its historical average of 15-16 million), subscription price increases beginning this summer (allowed by the FCC after the three year anniversary of the merger), and continued penetration of the used vehicle market (via certified pre-owned dealers and private transactions).

While Pyykkonen currently estimates that Sirius XM’s conversion rate on new vehicles will remain in the 48%-49% range throughout 2011, he sees strong potential for Sirius XM to surpass a 50% conversion rate within the next year. He sees this possible due to the company’s continuing focus on programming, including the rehiring of Howard Stern, combined with an “improving macro outlook with more consumers willing to pay for the service after the initial trial period.”

Calling the used vehicle market “more art than science,” Pyykkonen sees huge potential in the used vehicle market possibly delivering upside beyond his current subscriber estimates. While noting that Sirius XM has been and will continue pushing into more certified pre-owned auto dealers, he sees the real untapped potential in the used auto market being the “private sales between buyers and sellers via craigslist, eBay, AutoTrader, etc.” Pyykkonen expects Sirius XM to offer more transparency on the used vehicle segment over the next year and sees the company reporting reactivations within the retail channel quarterly.

While Pyykkonen sees “upside pricing leverage” as the Satellite Radio provider gains the freedom to raise its base subscription rate on the three year anniversary of the merger, he does see 4G-based smartphone streaming services such as Pandora and in-dash entertainment centers as potentially being an alternative and legitimate competition to Satellite Radio. “The principal risk factor (especially as perceived by investors) for SIRI is 4G streaming services like Pandora,” Pyykkonen said. While also noting that “neither Pandora or any other streaming service has large scale with an established subscription business model like SIRI does,” he did caution that it’s still in the early stages and that “streaming business models may successfully evolve in their own right.”

While noting that advertising based streaming services can target ads based on age, gender and musical taste, which is very appealing to advertisers, Pyykkonen noted that these services are “clearly not free to the consumer” and thinks the key question is “to what extent 2.0 will offer its own enhancements for streaming and possibly in-dash features such as speech-to-text and other voice activated controls.”

Wedge Partners does not publish price targets on covered companies.

Disclosure: Long SIRI