Sirius XM has a monopoly on satellite radio, a growing subscriber base, and loads of free cash

SATURDAY, NOVEMBER 23, 2013

Sirius XM’s Sweet Sound of Success

By ALEXANDER EULE | MORE ARTICLES BY AUTHOR

Sirius XM has a monopoly on satellite radio, a growing subscriber base, and loads of free cash. Why the stock could rise 50%.

By the end of its first decade, Sirius XM had blanketed the country with satellite radio coverage, but on Wall Street the signal was growing faint. On Feb. 11, 2009, Sirius XM shares fell as low as five cents. Years of big spending had finally caught up with the firm, and the credit crisis would be the finishing touch. Hours before filing for bankruptcy, Sirius got a lifeline from cable pioneer John Malone’s Liberty Media (ticker: LMCA).“We thought the market had overreacted,” says Greg Maffei, Liberty’s CEO, looking back on those panicked days. “And that Sirius was in a bind not of its own making.” • Liberty provided a $400 million loan to Sirius, which granted Liberty the right to acquire 40% of Sirius’ equity for a nominal sum. It was a sweetheart deal for Liberty, which now owns a controlling stake in the company. But it allowed Sirius to live another day, and as the economy improved, the company gradually found its rhythm.

Today, Sirius XM Holdings (SIRI) has nearly 26 million subscribers and annual sales approaching $4 billion. At a recent $3.68, its shares are up nearly 74 times since hitting rock-bottom. The rebound gives Sirius XM a market value of $23 billion, in line with satellite-TV providerDish (DISH) and topping Internet-TV sensation Netflix (NFLX). Yet investors still underestimate the company’s potential and its effective monopoly in satellite radio. Sirius is using its now-ample free cash flow—more than $900 million this year—to buy back a big chunk of its stock. And the company, once a favorite of day traders, is getting more attention from professional money managers, like Seattle-based Rainier Investment Management. Rainier has bought $100 million worth of Sirius shares since April. Portfolio manager Sam Console thinks the stock is worth $5.50 to $6—50% above current levels.

“It’s been more of a retail stock,” Console says, discussing Sirius’ volatile past. Now, “more institutional people are thinking about this company as a viable holding. From a fundamental perspective, there are a lot of reasons to like it.”

Sirius is adding subscribers at a formidable clip, even as pay-TV companies struggle to maintain them. Last quarter, it added 513,000 customers, bringing its total paid base to 25.6 million—larger than any cable or satellite-TV company, including Comcast(CMCSA) and DirecTV (DTV), and right on the heels of HBO, which has 30 million customers through its cable partners. Sirius CEO Jim Meyer thinks his company will easily get to 30 million subs, and he talks about the possibility of reaching 40 million in the coming years. At that size, Sirius could become more profitable than any of its subscription-based peers.

IT HAS BEEN A LONG and winding path for Sirius. XM Radio debuted its satellite-radio service in 2001, followed a year later by Sirius. They merged in 2008, after six years of battling for subscribers and bidding up programming costs. “They put each other out of business in a lot of ways,” Console says, “because they overbid for content that the market wasn’t quite ready for. It was just too early, too fast.” The company has spent the past five years weaning itself from oppressive contracts.

Sirius’ business model is bearing fruit, pushing costs down and profits up. “Before we merged, our programming cost was $450 million for everything but music,” Meyer toldBarron’s recently at Sirius’ headquarters in midtown Manhattan. “Now, it’s under $300 million. And that’s not going to change a lot.” Contrast that with the cost of TV content, which has been rising 9% a year, thanks to a hypercompetitive environment.

Most of Sirius’ content, including Major League Baseball games and Fox News, is signed through the end of the decade. Howard Stern and the National Football League—admittedly costly programming—are up for renewal at the end of 2015. Music channels, which make up about half of Sirius XM’s content, generate an estimated 60% of the costs. To cover royalties, Sirius pays a flat percentage of revenue, at a rate set by the Library of Congress. It’s 9% now, rising to 11% by 2017.

In the second quarter, Sirius’ profit margins exceeded 30% for the first time, using Ebitda, or earnings before interest, taxes, depreciation, and amortization, the media industry’s earnings standard. Margins will climb as the company spreads out more of its fixed costs, from programming to satellite maintenance, over a bigger listener base. Says Meyer: “We are going to continue to improve every quarter as our model scales, and we believe we can get to 40% margins.”

In contrast, Comcast and DirecTV are mature businesses with Ebitda margins that have topped out at about 33% and 25%, respectively, according to analyst projections. Margins for Netflix, 8% today, are expected to reach 21% by 2016.

ISI Group estimates Sirius’ monthly programming costs will come to 96 cents per subscriber this year, falling to 76 cents by 2016. When Sirius and XM merged in 2008, it was about $2 per sub.

Mel Karmazin, the longtime radio executive who ran Sirius from 2004 until last year, deserves a lot of credit for Sirius’ recent success, and plenty of blame for its earlier struggles. For years, he campaigned for the Sirius-XM merger. He eventually got regulators’ consent, closing the deal in July 2008. But by then the credit markets were falling apart and much of the company’s heavy debt load was coming due.

Karmazin’s days were numbered from the time Liberty got involved. “I loved working for Mel,” says new CEO Meyer, who’s been at Sirius since before Karmazin arrived. “But Mel had a difference of philosophy with Liberty that I just don’t have.”

THE AUTOMOTIVE RECOVERY has been a major boon to Sirius’ business. Some 70% of new cars now roll off assembly lines with Sirius pre-installed, thanks to long-term deals with every major car maker. The company pays vehicle manufacturers to include its equipment, and today 57 million cars have Sirius receivers in the dashboard. That installed base will hit 100 million in 2017, assuming the auto industry continues its post-recession recovery.

The new cars come with a free trial, which typically lasts three months. It’s a powerful hook, and unlike the new-car smell, the Sirius soundtrack tends to stick around. Nearly half of new owners pay to continue their subscription, at a monthly cost of $14.50. And it’s predictable. Indeed, since the merger, the conversion rate has barely changed, hovering between 44% and 46% of new-car buyers, according to the company. Even recent price increases from Sirius haven’t done much to change consumer demand. The pricing power speaks to the unique nature of Sirius XM content.

By traditional metrics, Sirius has never been a cheap stock. On an enterprise-value-to-Ebitda basis, it trades at 19 times 2014 estimates. But this is no traditional story. Thanks to a decade in the red, Sirius has $7 billion worth of net operating losses to apply against future earnings. Net income is slated to hit $468 million this year, or seven cents a share, rising to 11 cents in 2014.

Analysts expect Sirius to generate $930 million of free cash this year, growing to $1.9 billion by 2016. Most of that will be used to repurchase stock. “They could retire 40% of their equity over the next five years, if not sooner,” says Rainier’s Console.

ISI Group analyst Vijay Jayant estimates free cash flow, on a per-share basis, will rise 35% a year, from 16 cents in 2013 to 30 cents in 2015. At roughly 15 times the 2015 figure, Jayant gets to a price target of $4.40, 20% above Sirius’ recent close.

Console is considerably more bullish; he thinks sell-side analysts are underestimating Sirius’ subscriber gains.

Bulls believe Sirius’ installed base is about to snowball. Auto makers are on pace to sell more than 15 million new vehicles this year, a strong number, but one that pales in comparison with the 40 million vehicles sold in the used-car market. Those vehicles increasingly are hitting the road again with Sirius XM radios installed, effectively giving the company a second bite of the apple, with none of the hardware costs it has for new models.

Meyer is excited about the used-car opportunity, which the CEO says never even factored into the company’s early strategy. The challenge will be how to appeal to less-affluent used-car buyers. Sirius, he says, is exploring every option to expand the used-car channel without endangering its new-car base. This year, Sirius believes, it will add 1.5 million used-car subscribers. By 2017, annual used-car activations could grow to 2.6 million, according to estimates from Barclays Capital.

Another opportunity comes in the form of a connected car, which, in some ways, is the last frontier for wireless coverage. Today’s dashboard looks prehistoric, compared with smartphones. Over time, 4G modems will be integrated into cars, creating traveling hot spots and allowing dealers to diagnose problems remotely and track maintenance needs. Consumers, meanwhile, will be able to instantly upgrade the software on radios and other equipment, just as they pull down apps to their smartphones.

Sirius believes it’s in prime position to benefit; its satellites can provide the download link, easing congestion that already faces wireless networks. And its existing relationship with auto companies makes Sirius a prime candidate to handle hardware, billing, and customer service. “We believe we can drive this cheaper than anybody else,” Meyer says. “Because of what we’ve learned over the last 10 years, we believe we can take a new technology and drive it down the cost curve faster than someone just bringing a modem.”

LAST MONTH, Sirius launched its 10th satellite. The “bird” completes Sirius’ network upgrades, and the company says it won’t need another launch until the end of the decade. The satellites, which all told cost $300 million each, create a private network that covers North America, transmitting 140 channels filled with high-fidelity music, talk shows, and sports.

Much of the content starts in midtown Manhattan, where studios fill a floor at Sirius’ headquarters. As Barron’s visited, a nun walked through the door on the way to host her show on Sirius XM’s Catholic Channel. Four days earlier, Lady Gaga took the same path. A Sirius spokesman describes the office as the “Times Square of pop culture.”

The diversity of original content seems to keep subscribers happy. And it’s a competitive advantage for Sirius, as it faces challenges from the likes of Apple (AAPL), Pandora Media (P), Spotify, and other Internet-based music streams.

Five years ago, that emerging competition was a key argument in favor of the Sirius-XM tie-up. Now, it’s the main threat cited by Sirius detractors. Pandora, after all, offers free ad-sponsored music streams. Others, like Spotify, bring increased personalization to music via the smartphone, which can be connected to in-car radios wirelessly over Bluetooth technology.

The threat implies that Sirius is basically a music distributor, when, in fact, much of its unique content is talk and sports. “There are a lot of places to get music,” says Maffei, who is now the chairman of the Sirius board. “There are not a lot of places to get Howard Stern, the NFL, Major League Baseball, ESPN, CNBC, Fox News.”

Ultimately, the difference in the services shows up in revenue. Pandora made $6.50 per user in 2012, mostly from ads. Sirius made $142, almost all from subscriptions.

Consumers will eventually realize that free streaming services are anything but, since they require pricey wireless data plans. Last year, Jayant at ISI Group analyzed the wireless cost of streaming music. He estimated that a typical commuter spends 16.5 hours a month in the car. Streaming music during that time consumes roughly one gigabyte of data, which equates to $12 on a typical data plan.

Sirius, meanwhile, has embraced the long-term attitude of car makers. “The conversations ongoing with the original-equipment manufacturers today are for 2018,” says Meyer. “We’re not talking to these guys about what they’re going to do next year. That’s done.” The deliberate pace insulates Sirius from the tech world’s constant upheavals.

LIBERTY MEDIA is a happy parent these days. Maffei points out that Sirius has easily exceeded his firm’s projections. “Every year, they’ve really outgrown what we would have thought they would do.” Over the past 18 months, Liberty bought another $1.7 billion worth of stock, bringing its stake to 53%. Liberty has since agreed to sell $500 million worth back to Sirius. Maffei says that Liberty isn’t heading toward the exit. Instead, he said, “We needed to clean up our own balance sheet” after purchasing a big stake in cable provider Charter Communications (CHTR). Liberty still owns $12 billion in Sirius shares. (Late last week, The Wall Street Journal reported Charter andTime Warner Cable (TWC) may be moving closer to a merger.)

Maffei and Meyer both now think for the long term. In addition to used and connected cars, they talk about millions of dashboards that contain dormant Sirius radios. The equipment could pick up an ad-supported radio stream, via Sirius satellites. “There are going to be 70 million cars that are not subscribers, to whom we can provide some kind of a service,” Maffei says. “That’s an awful lot of reach into the best cars in the U.S.”