Description

Summary:

Liberty Sirius XM (Liberty) creates Sirius XM Holdings (SIRI) at a discount that will almost certainly close in the next couple of years.  SIRI is a highly attractive business with good unit growth,  improving margins, relatively low capital requirements and opportunities to redeploy valuable spectrum over the next several years.  Furthermore, SIRI is aggressively reducing its equity base, thus magnifying returns to shareholders.

Background:

Both Liberty and Sirius are well-known to most VIC members, so I will not go into a lot of historic detail in this report but am happy to respond to questions. Additionally, there are 3 VIC Liberty reports over the last 30 months and a SIRI report from early 2013 that are certainly worth reading for context. At the height of the financial crisis in early 2009, Liberty received a 40% equity stake for $530MM (as can be imagined with a Malone deal, it was a little more complicated, but that was the outcome).  Fast forward, Liberty owns approximately 65% of SIRI--a percentage that is climbing steadily given the SIRI buyback program.  

In the fall of 2015, Liberty Media announced that it would divide itself into 3 tracking stocks, of which Liberty Sirius XM is the largest.  On April 19, trading began in new Liberty and the other two entities.  Whereas before SIRI made up the lion’s share of Liberty Media’s value, some of the other holdings could only be valued subjectively.  Now, computing the asset value could not be easier.  New Liberty owns 3.162 billion shares of SIRI, has a $250MM margin loan, and $50MM of attributed corporate cash.  Or on a per share basis:

9.443 shares SIRI, or $39.28, against which there is $0.60 of net debt=$38.68

Liberty now trades at a 14.5% discount, so another way to look at it is that through it one can create SIRI at $3.56/share. The primary goal articulated by Liberty management in the recent division of the company was to narrow the discounts of each to its asset value. At least for LSXMK, this has not worked yet. 

Liberty bid for SIRI in early 2014, only to abandon its quest soon after as it turned its attention to cable acquisitions.  But senior management, which of course already controls SIRI,  has been anything but coy about its desire to merge the two companies.  I believe that a deal is likely between now and the end of 2018, when SIRI should have used up its NOLs.  

Key Investment Risks and Opportunities:

 Let’s start with a big perceived negative: Competition from streaming services, most notably Pandora and Spotify, and potential longer-term competition from Apple, Google, and perhaps others.  It would be crazy to just dismiss this out of hand as a non-issue.  But SIRI has grown its user base faster, and without an uptick in churn, than any projections I have seen in recent years despite the ubiquity of Bluetooth connections in cars and smartphones.  Over 80% of US teen and adult cell phone users now have smartphones.  Given the demographics of the SIRI installed base, I would bet that 90-95% have smartphones.  Hence, almost all of its customers can use the streaming services now, and customer surveys show that, in fact, a significant percentage do use them, but regard them as different (more like a playlist or personal music collection) than the Sirius XM experience which is far more than just 70 music channels.

Connected cars (modem enabled) potentially raise the competitive stakes for SIRI but also provide it with new opportunities. Having two-way communications will give SIRI both new customer service opportunities--probably most important is the ability to renew a subscription, or convert from a trial to a subscriber, with the touch of a button on the radio--and gain much more knowledge about whether or not users are listening and what they are listening to. Users will benefit as well, with features like on-line program guides and the ability to do some customization.  Since early 2015 management has discussed, without a lot of detail, SXM17, essentially a new operating platform which should be available by late next year.  On the Q1 call it was noted that “almost every OEM is engaged on this product.”  

Because of the merger between Sirius and XM Radio in 2008, SIRI currently broadcasts over two parallel networks.  But as CEO Jim Meyer observed at a recent investment conference, “Sometime in the early part of the next decade we will have a choice to make about what we do with the low band spectrum” [as only one network will be necessary for the current SIRI channels.]  The options include expanding the number of channels, petitioning for licensing changes to offer regional networks and offering video channels to self-driving cars.  Though SIRI management has focused in their public remarks on using the excess spectrum, Greg Maffei from LIberty has said that it “could end up being very valuable to someone else.  Note that Jessica Reif Cohen at Merrill Lynch has estimated value of the extra spectrum at $4 billion.  

The market of SIRI enabled cars on the road continues to grow and should grow for over 10 years.  SIRI provides the chipsets to the auto OEMs, who have chosen to place them in an increasing number of models.  Today, about 75% of new cars sold in the US have a factory-installed satellite radio, and there are over 82MM cars on the road (1/3 of the total) in the US with one installed.  This installed base should more than double over the next 10 years.  What this means for SIRI is that the used car market has become a major opportunity:  Around 30% of used cars sold now have radios installed.  While the demographics of used car buyers are obviously not as attractive as new car buyers, the size of the market is much bigger (40MM+ vehicles/year) and the costs to SIRI are much less, as the radio is already installed.  SIRI is pursuing a number of interesting channels to create trial with used car buyers and demonstrating solid results.  So while short term fluctuations in new car sales will undoubtedly continue to move the stock, it is far from the whole story in looking at the company.   

Financials and Investment Returns:

In recent years SIRI has mostly delivered “beat and raise” results.  This pattern came to an end on the release of the year-end 2015 results, which were excellent, but the margin guidance for 2016, which disappointed the Street.  Major new contracts with Howard Stern and the NFL along with technology spending will keep margins roughly flat this year.  Given the importance of both, and the fact that SIRI has its major programming costs locked in for several years (which will prove to be a source of positive leverage), this strikes me as smart.  Management still believes that EBITDA margins, which are now in the 36-37% range, should trend above 40% over time given high (70%) contribution margins and I don’t see why they shouldn’t. 

The single most important financial measure for the company is free cash flow/share.  I have this at $0.26 in 2016 and rising, in large measure due to aggressive share buybacks, to $0.40/share in 2018.  As noted above, SIRI should become a cash tax payer in 2019, so I wouldn’t value it off of that number.  Liberty, of course, is a master at employing clever tax strategies; but I don’t think one should assume that SIRI will continue to have a tax shield beyond 2018.  I have created a simple model going out to 2020, which shows SIRI producing $0.36 in FCF/share then even as a full taxpayer.  To me, a 6-7% forward free cash flow yield on a company with these attributes makes sense and might be a little conservative.  So my target range looking out three years is $5.15-$6.00.  That’s not so great using the current SIRI price as a starting point, but it becomes quite attractive (13-19%/year return) if one creates it through Liberty.

Catalyst

1.  Liberty-SIRI merger

2.  Continued strong operating performance and aggressive share repurchases.