As an investor from Europe, sometimes you overlook companies that focus on the U.S. market. Recently, I came across one of these companies: Sirius XM Holdings (SIRI) as one of my clients gave an interview and performed live at Sirius XM's The Coffee House. With a market cap of over $21 billion and a very strong presence in the market radio business, I probably should have noticed this stock much earlier. Unfortunately I did not. Considering the fact that Sirius XM trades only 3% below its 52-week high, I assumed to have missed an attractive entry point. However, this article by Brian Nicholas pointed out that Sirius XM is still an attractive stock to buy, even at its current valuation. This made me curious and I decided to determine Sirius XM's fair value using a DCF valuation model. I find that Sirius XM is quite undervalued indeed.
As Mr. Nicholas' article perfectly points out, Sirius XM has a very solid business model in an competitive (online) radio environment. One of the company's biggest competitive advantages is its long-term contracts with car manufacturers. Car owners are probably still the most important client base for radio broadcasters. This enabled Sirius XM to add over 400k subscribers in the first quarter of this year, even considering fierce competition from Pandora (NYSE:P), Apple (NASDAQ:AAPL) and others. Accordingly, Sirius XM expects revenue to grow 7% to $4.47 billion this year. In the period 2011-2015, Sirius XM's revenue is expected to grow 10.4% on average per year. Income from operations will even grow 15.5% on average per year (see table 1 below).
Free cash flow analyses
Another interesting aspect from Mr. Nicholas' article is his focus on Sirius XM's free cash flow rather than revenue or earnings per share. I completely share his opinion to use free cash flow instead of net income to determine whether a stock is over- or undervalued. From 2011, the first historical year in my analyses, Sirius XM did great in this area as well. The company grew free cash flow to $1,156 million in 2014 up from $406 million in 2011. The average free cash flow growth rate in the period 2011-2014 was an astonishing 42.9%. For this year, the company expect free cash flow to be around $1,250 million or 8.1% higher compared to 2014 (see table 1 below).
Table 1: Historical financial information 2011-2015
Sirius XM's free cash flow growth rate might not be as large as it was in the period 2011-2013, it is still very likely that the company will grow free cash flow with high single digits in the next five to ten years. My assumption is supported by the strong performance in the first quarter (free cash flow was up 24%), strong long-term relations with car manufacturers and Sirius XM's ability to grow the number of subscribers in a competitive market environment. For my DCF valuation model, I assume free cash flow growth for the years one through five to be 9.5% on average per year. I moderate free cash flow growth for the years six through ten to 8% on average per year. Terminal free cash flow growth (after ten years) is set to be 1.75% on average per year.
My model exists of the determination of the weighted cost of capital (also referred to as WACC) and a DCF calculation of Sirius XM's fair value. As interest rates are very low from a historic point of view, I used a normalized risk free rate of 3.50% to determine the weighted cost of capital. The calculation of Sirius XM's weighted cost of capital is shown in table 2 below:
Table 2: Determination of the WACC
Based on my calculation above, I determined Sirius XM's WACC to be 8.54%. For this calculation, I made the following assumptions:
- Total long-term debt to market capitalization of 24%;
- Normalized Risk Free Rate of 3.50%;
- Company Beta of 1.17;
- Company Debt Risk Premium of 1.50%;
- Effective tax rate of 40%.
Now I determined the company's WACC and made several argued assumptions regarding its future cash flow growth, I am able to draft a DCF valuation model based on the following assumptions:
- Initial free cash flow of $1.25 billion;
- Growth rates of 9.5% (1-5), 8% (6-10) and 1.75% (terminal);
- 5,640 million diluted shares outstanding;
- Balance sheet impact of $4.6 billion;
- Margin of safety of 5%.
The DCF model (source: focusinvestor.com) of Sirius XM is shown in table 3 below. I find that the company's fair value is $4.60 per share or 17.6% below its current share price. Based on the outcome of my DCF model, it is fair the say that Sirius XM is seriously undervalued. This confirms the conclusion of Mr. Nicholas as well. In his article, he concluded that Sirius XM has significant upside potential in the years ahead. Given a fair value of $4.60 per share, there might even be significant upside potential in the short-term as this stock trades at quite a bargain. Investors who are looking for quality stocks with sustainable business models and attractive valuations should consider buying Sirius XM Holdings. I certainly did.
Table 3: DCF valuation model of Sirius XM Holdings
Another important argument to own Sirius XM is the company's large share buyback program. The company repurchased its own stock for the amount of $2.5 billion in 2014 and $1.75 billion in 2013. In the first quarter of this year, Sirius XM repurchased another $0.5 billion. Over the past nine quarters, share repurchased totaled $4.75 billion or 22% of the company's current market capitalization. As I wrote in this article, share repurchases could deliver great additional value for shareholders. I find that Sirius XM's share buyback program meets my two criteria and is very profitable for its shareholders.
First of all, Sirius XM finances some of the share repurchases with long-term debt. Total long-term debt increased to $5.1 billion by the end of the first quarter of 2015 compared to $4.6 billion by the end of the first quarter of last year. Interest on long-term debt is a deductible expense. Therefore, the total tax bill is lower as well. So, the tax authority compensates a significant part of the additional interest expenses. This creates value for the shareholders. Second, Sirius XM repurchased shares at an average price that is much lower than the company's fair value. Therefore, Sirius XM's opportunistic share repurchases make perfect sense. Third, the company's board sends out a very strong signal to the market buying back shares so aggressive. Apparently, the board also believes Sirius XM's share price to be undervalued.
What is not to like about Sirius XM Holdings? Based on my research and DCF valuation model, I cannot come up with an argument not to own this stock. First of all, Sirius XM has a quality business model which proved to be sustainable despite fierce competition. Moreover, the company's stock trades at a significant discount to its fair value. Based on the outcome of my DCF valuation model, I find that Sirius XM is 17.6% undervalued and that a further increase of its share price is likely in the short-term. Finally, I find that Sirius XM's recent aggressive share repurchases created tremendous value for its shareholders. The company will create even more value with its share buyback program as long as its share price trades below the fair value of $4.60 per share.
Disclosure: The author is long AAPL, SIRI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.