Description

Thesis

Sirius XM Canada (XSR) is a Toronto-based seller of satellite & internet radio subscriptions to end customers mainly through the automotive channel.  It is in the same business as its American brother, Sirius XM (SIRI), with a few minor differences that I will describe below.  SIRI owns 38% of XSR, with voting rights limited to 25% due to foreign ownership restrictions.

I think this is a high quality business with a huge moat trading at a reasonable multiple.  FYE 8/31/13.  On 2014 & 2015 numbers, I estimate the company is trading at 9.2x Adj EBITA and 7.0x Adj EBITA.  I think Adj EBITA will grow at decent rates for many years.  In addition, the company produces a large amount of FCF, and inferring from management comments on target leverage and capital allocation, they will soon start paying very large dividends.  They annouced an quarterly dividend at annual rate of $0.33 in December 2012 and paid another $0.0825/share special dividend in January 2013.  The stock price is $6.60/share and I think fair value is well north of $10/share a few years out.

The company is closely held.  Ownership structure is as follows: Liberty Media 38%, Canadian Broadcasing Corp 15%, Canadian Satellite Radio Investments 14%, Slaight Communications 13%.   That leaves 20% of float outstanding, or 25m shares.

Background

XSR is a few years behind SIRI.  In the United States, Sirius Satellite Radio was launched in 2002 and XM Satellite Radio in 2001.  The two companies merged in late 2008.  The company was distracted by the merger and FTC approval process and neglected to address its liquidity situation until the financial crisis was at its peak.  John Malone and Liberty Capital (now Liberty Media) swooped in during February 2009 and lent the company $530m at ~15% interest rate, plus 40% of the company as a kicker.  That 40% stake is now worth almost $8b.  An aside, this is my nominee for best deal of the past decade.

In Canada, Canadian Sirius was launched in late 2005 as a private company partially owned by American Sirius.  Canadian XM was also launched in late 2005, partially owned by American XM, and IPO’d that same year.  The two Canadian companies merged in late 2010.  Like in the U.S., this has been a tremendously beneficial merger to the companies.  This is a business that benefits tremendously from scale and going from two players to one has also had a huge impact on the competitive dynamics on all sides.

Business Description

XSR sells satellite radio subscriptions.  The company has 2.2m subscribers, 1.6m self-paying, 0.5m paid promotional, and 0.1m non-paid promotional.  Customers pay $16-20/month for access to 120+ channels, and an additional $4/month for access to the same package via the internet (The U.S. service does not have this additional internet charge).  The company recently increased its base rate by $1/month and added the internet charge.  XSR is installed in 55% of autos sold in Canada (“penetration rate”), it converts 40% of those to paying subscribers (“conversion rate”), and ARPU is $11.60/month.  In the U.S., penetration rate is 67%, conversion rate is 45%, and ARPU is $12.00.  ARPU is below the stated service price due to a variety of paid promotions and discounts for long-term subscriptions.

XSR is an attractive offering, like SIRI, because it offers a compelling content bundle at a reasonable price.  The company has long-term contracts with Oprah, Howard Stern, Opie & Anthony, and all major sports leagues (NHL, NFL, CFL, MLB, NASCAR), in addition to a wide selection of curated music.  While there are many competing free and paid internet offerings, they all have much lower revenue and content spend and thus have a much weaker offering.  It is a chicken-and-egg problem that is hard to crack if you are a much smaller competitor.  In addition, satellite radio has the benefit of very high quality, high coverage distribution with no usage-based consumption fees.  Even if internet offerings improve over time, it will be years before they make a significant dent in XSR’s lock on the valuable OEM auto distribution channel.

The business has very high marginal contribution margins.  I estimate additional sales contribute 40%+ EBITDA margin over time.  Depreciation is maybe 3% of sales, as XSR piggybacks off SIRI for most of its satellites and pays them back through their revenue share.  EBITDA margins have gone from 7% in 2011 to 17% in 2012 to estimated 24% in 2013.  In the U.S., SIRI had 25% EBITDA margins in 2012, up from negative several years earlier, and management is guiding to 40%+ EBITDA margins at maturity.  XSR management has not given guidance on EBITDA margins at maturity, but I don’t see why they would not be in the same zip code.

The cost structure of SIRI and XSR differ a bit, with the two companies paying slightly different rates on variable costs for programming revenue share to OEM’s.  When you line up the two, though, they look pretty similar, and I think the two should have roughly similar financial trajectories going ahead.  The chief area of concern for XSR is that they have operating agreements with their respective U.S. partners wherein they pay 10-15% of revenues for access to programming and branding.  The fear would be that SIRI would try and jack up this rate when the contracts expire in 2017 (legacy SIRI) and 2020 (legacy XM).  I do not think this is a big risk for XSR stock, and I think a likely scenario is that the rate gets bumped up a few hundred basis points, which the company should easily be able to absorb.  It is in the interests of both companies to get along, SIRI owns 38% of XSR, and the financial benefit to SIRI would be swamped by the bad publicity.  Also, the business is heavily regulated and partially owned by the government, and I do not think the Canadian government would view it kindly if the American parent tried to jam its little brother.  (Hands off our money, you hosers.)  If the two companies cannot agree to terms, they will submit to binding arbitration.

Big picture, Canada has 26m cars on the road and sells 1.7m new cars annually.  There are currently about 4m cars on the road in Canada with satellite radios installed, and that number is going up by almost 1m per year.  By 2018, that number is projected to be 10m.  Aside from the sales from converting new auto OEM customers, there is a huge opportunity for XSR in activating dormant satellite radios in used cars.  The company has already paid the $54/car to install the satellite radio and there is little marginal cost to switching that radio on.  The company is working aggressively with the used car sales channel in Canada to drive sales here.

Valuation

XSR trades at $6.60/share, has 124m shares outstanding, $816m market cap, $94m net debt, and a tax asset worth NPV $100m (at 8/31/12, the company had $465m NOLS and a 27% tax rate).

RBC estimates for EBITDA less Capex for the next 3 years are as follows.  Fiscal year ends 8/31.  I think it is more likely than not that these estimates are low, as is often the case in growing companies with large operating leverage.

2013: Revenue $286m, EBITDA, $68m, 25% EBITDA margin

2014: Revenue $315m, EBITDA  $81m, 26% EBITDA margin

2015: Revenue $345m, EBITDA $94m, 27% EBITDA margin

Capex will be mid-to-high single digits in 2013 & 2014 and drop from there.  Sustainable capex/depreciation is maybe 3% of sales.  The company piggybacks on SIRI’s satellites and pays for this through its operating costs.  Tax rate is 27%.  FCF is higher than net income or NOPAT due to negative working capital along with NOLS for the next few years.

I think a reasonable NOPAT multiple is 18x for this business.  I get $0.53 NOPAT/share in 2015.  There will be another ~$157m FCF between now and then ($1.27/share).  Add that up and you get $9.47/share + $1.27/share = $10.73/share.  In addition, the company has indicated it wants to maintain 2-2.5x net leverage.  Share repurchases will be difficult given liquidity, so I think this company will start paying massive dividends.  If you assume company paid out all its FCF and was valued at a 5% dividend yield in 2015, you could get a much higher stock price.

It is worth noting that SIRI trades at multiple far higher than XSR or my target multiples above.  There are a number of ways to slice it, but I have SIRI trading at ~ 6x revenue, ~21x EBITDA, and ~30x EBITA on 2013 numbers (at 27% EBITDA margin).  The growth profile is not radically different, and XSR benefits from lower tax rate.

Catalyst