Description

SHORT (24-month Target Price: $2.50): 

Sirius XM (“SIRI” or the “Company”) is a satellite radio company that delivers music, sports, and entertainment for a subscription fee to automobiles in the US equipped with their satellite receivers.  It’s a ~$25bn market cap company that trades $100mm+ per day.  The Company had a virtual monopoly on premium content in the car with alternatives historically being terrestrial radio and CDs, but this business is in the midst of becoming commoditized:  1) connected cars sold today offer downloadable apps that put a myriad of content options directly in the dash from the likes of Apple, Google, Spotify, Pandora, and Amazon, 2) wireless data networks across the US from all major carriers are now fully equipped to offer high-quality streams without drops in coverage, 3) wireless data plans are no longer cost prohibitive to the point of discouraging usage, and 4) SIRI’s ‘exclusive’ content is now offered by competing apps (Howard is available on YouTube/SoundCloud and premium sports are available on TuneIn).  SIRI’s moat as defined by controlling board member Greg Maffei is “ease of use and unique content”, and the new accessibility of high quality streaming offerings at lower price points will increase SIRI’s churn and pressure ARPU in the coming years.  Given the operating leverage at ~70% and the financial leverage north of ~3.0x, any hiccup in the fundamentals could have a dramatic impact on the equity.  The key risk to the short is stable fundamentals near-term + a large buyback.

Differentiated View: 

The Street is modeling consistent net adds over the next few years and ARPU growing w/ CPI.  This appears aggressive with virtually all the new vehicles sold coming with competitive app offerings in the dashboard via Apple Carplay and Android Auto at price points 50%+ lower with arguably better non-linear, personalized content.  At the same time that the Company could be facing topline pressure, the cost side of the business is likely to see content royalty payments increase in their upcoming CRB negotiations late this year.  Notwithstanding the evolving landscape, the Company is taking on debt and buying back expensive stock for Liberty’s tax agenda instead of investing in the future.  Lastly, SIRI is being valued on a FCF basis which optically looks high given they have not been a tax-payer historically (NOLs) and the Company is entering a new satellite capex cycle this year. 

Asymmetric Opportunity:

Taking a multi-year view which assumes SIRI can manage to hover near their ~30mm sub base through subscription price discounting, the equity would be worth less than $2.50 utilizing a range of valuation techniques (7% FCF yield on ’19 fully-taxed FCF per share of $0.15 or ~10x ’19 EBITDA of ~$1.5bn) for 50%+ upside compared to ~$6.00 or ~15% downside if the Company continues to grow revenue and subscribers per the extrapolated consensus projections (~$0.30 ’19 fully-taxed FCF per share at a sub 5% yield or ~$2.4bn of ’19 EBITDA @ 11-12x still toward the top of the group). 

Background:

Sirius XM is the result of a 2007 merger between the only two previously competing satellite radio companies Sirius and XM.  They gained popularity in the early 2000’s by offering premium content including Howard Stern, Oprah, and live sporting events, but despite accumulating a collective 14mm subs at ~$13 per month pricing, the two companies were still unprofitable.  On that basis, and despite criticism from traditional radio that a merger would create a monopoly, the FCC approved the transaction in 2008 with the rationale that the combined Company would be competing with internet services as well.  As it turns out, both arguments had merit and it was just a matter of timing.  The mobile internet was still in its infancy back in 2008 and robust product offerings with similar convenience compared to a button on the dashboard were still years away.  So over the next eight years, SIRI went on to more than double revenue from ~$2.2bn with ~14mm subs in 2008 to ~$5bn and ~30mm subs in 2016.  Moreover, given the fixed cost nature of the business, EBITDA grew dramatically from less than break-even to what will be ~$1.8bn today representing a 35%+ margin.  The prospects going forward seem less promising and the FCC’s ruling in 2008 that viable competition from the internet was legitimate may be coming to bear. 

Liberty Situation:

Despite winning approval to consummate a merger in 2008, the combined Company was on the verge of bankruptcy shortly after with the impending recession.  Liberty Media stepped in with a $530mm rescue financing in 2009 that gave them preferred stock convertible to 40% of the Company.  The newly combined and recapitalized business rebounded strongly with rising auto sales on the back of the recovering economy, and by early 2013 Liberty had purchased another 10% of the Company to formally take control.  Liberty’s stake today, which has accrued to 65% via share buybacks, is valued in the market place at ~11bn and trades publicly as a tracking stock under the ticker LSXMK.  The ‘problem’ Liberty has today with making so much money is that the resulting ~$9bn gain from their heroic mid-recession recap would leave a sizeable tax burden (potentially as much as ~$3.5bn) if it were simply sold.  Therefore, Liberty’s chairman John Malone, known for his tax-efficient maneuvering, has directed management to lever-up SIRI and aggressively buy stock (at a rate of ~100+% of FCF).  While buybacks are typically applauded by all shareholders when fundamentals are improving and the stock is undervalued, Liberty is advocating this buyback strategy at elevated prices in the face of oncoming headwinds to protect their tax position.  To the extent they reach the 80% ownership threshold, they would be able to effectuate a 355 tax-free separation and consolidate the entities in a Reverse Morris Trust.    

Short Thesis:

1.      Apple Carplay / Android Auto integration:  The connected car is finally here and apps-based platforms will be embedded in the vast majority of new cars sold during 2017 onward.  Nearly every major manufacturer offers Apple Carplay (or is in process of launching it).  It will be embedded in 200+ models representing ~80% of the ~250 different car models sold in the US.  This will put Pandora, Spotify, and other music/audio apps conveniently in the dashboard right next to traditional/satellite radio.  Why would you pay $16-20 for SIRI which is an inferior linear experience when you will be able to easily access and enjoy interactive/personalized apps like Pandora, Spotify, Apple Music, Tune-in, SoundCloud, among others, at price points that range from free to half the price? 

2.      Unlimited wireless broadband:  The other major barrier SIRI had vs. IP-based apps was the fact that high-speed data required for streaming apps was historically either not available (spotty LTE coverage) or very expensive (restrictive mobile data plans).  However, all four major cellular networks have invested in recent years to create extensive nationwide 4G/LTE coverage, and thanks to T-Mobile, they each now offer very competitive data plans that allow users to stream music and video without worrying much about usage levels.

3.      Competition accelerating:  On-demand streaming services are rapidly increasing adoption (Spotify and Apple are adding millions of users each month) and are either embedded into the dash of new cars or can be streamed seamlessly through wireless phones.

4.      Product commoditization: The content offerings are no longer differentiated (Howard Stern is on Youtube/SoundCloud and live sporting events are available on TuneIn and direct with the leagues) and SIRI’s music offering is linear vs the personalized playlists offered by the lower priced streaming services.

5.      Business over-earning: SIRI charges a retail list price of $16-19 per subscription compared to all other streaming products at $10 or less, SIRI is only paying 10-11% of revenue for music content royalties as dictated per the last CRB ruling which expires at the end of 2017 (SoundExchange is pushing for 23% and will have a better case given recent streaming deals).  The ruling comes out mid-December, and if the industry gets their way, earnings would take a 35% hit.  Even a modest bump to a 15% rate would take earnings down 10%.

6.      Organic growth poised to slow:  US New Car Sales (SAAR) is expected to moderate, SIRI is achieving less trials per car sold (75% vs 90% pre 2015), and conversions to paying subs is trending lower.

7.      FCF artificially high: The Company has utilized NOLs to avoid paying taxes but will ultimately become a tax payer in a couple years and should be valued on a fully-taxed basis.  Capex at the company will also double over the next 3 years as SIRI has to launch two new satellites.

8.      High leverage (operating and financial):  The business has a ~70% contribution margin so churn or price discounting dramatically effects EBITDA and FCF, and the business is over 3.0x levered which will exacerbate the impact on the equity when estimates come down.

9.      Aggressive estimates: Consensus is modeling revenue and EBITDA growth CAGRs of 5% and 7.5% respectively through ~2020.

10.  Unjustifiable valuation:  SIRI trades at an implied ~3.5% yield to fully-taxed ‘17 FCF on consensus numbers or ~15x ‘17 EBITDA giving it the richest valuation amongst cable and satellite peers that arguably have better fundamentals.

Key Risks:

1.      Near-term fundamentals: Fundamentals have remained resilient despite Spotify and Apple Music’s rapid adoption over the past year and could continue for several more quarters, but the same was said initially for linear television while Netflix gained popularity.  Estimates for 2018 onwards are nonetheless too high as a critical mass of vehicles becomes ‘connected’ and ARPU degradation/churn picks up.

2.      Aggressive buyback:  The Company bought ~$2bn of stock in the last year and is authorized for similar amounts going forward as Liberty moves toward its goal for ~80% ownership.  This bid, coupled with limited float, should support the stock until the fundamentals crack.

3.      Used car market: The Company is marketing that even if the new car subscriber ‘funnel’ slows, there is plenty of ‘recycled’ TAM in the used car market (the Company is attempting to add additional selling channels including insurance companies, auto lenders, and mechanics). 

4.      Acquisition target:  Given SIRI’s incumbent position in the car and relationships with OEMs, Apple and others have been rumored acquirers. 

5.      Liberty RMT:  Liberty would like to get to an 80% ownership stake to effectuate a tax-free monetization of their investment which leads to the possibility that they get nervous waiting and strike an ‘expensive’ deal to acquire the remaining 15% needed.  Liberty management has however stated that they will not pay a further premium and any deal would likely not be materially higher than where SIRI currently trades.

6.      Liberty management:  The Liberty management team is best-in-class with respect to their shareholder-friendly decision making, though there is really only so much they can do about the fundamentals (other potentially secularly challenged Liberty assets like QVC have underperformed).

7.      SIRI management: SIRI’s management team is incentivized to do their best to keep the stock north of $4.00 with healthy options awards in the mid/high $3.00 range.

8.      New revenue opportunities: A new platform called SXM17 that will embed an internet streaming capability side-by-side satellite.  Longer-term, SIRI is hoping to become a meaningful player in connected vehicle services or potentially cooperate with Liberty’s Live Nation asset.

What’s Misunderstood:

1.      Monopoly:  The same Company that argued to the FCC in 2008 that Sirius and XM competed against internet companies is now making the case to investors that they are still “not seeing [competition]”.  Ironically, this argument that won clearance for the Company to go on to earn monopoly rents over the last nine years may finally prove accurate.  SIRI CFO David Frear attempted nonetheless to defend SIRI’s competitive position at the last Goldman Communicopia conference saying, “we used to worry about streaming [back when it was] mostly on desktops, you could see the smartphones coming, everybody got a jack in the car they can plug in to.  But what we’ve seen happen over the last five years is we’ve seen smartphones go from zero to over 200 million and I can’t see the effect.”  He then offers the new theory that it will get more competitive when it’s engrained in the car, but that he’s “not seeing it yet”.  Finally, he concedes that the real connected car platforms like Android Auto (Google) and Carplay (Apple) have yet to scale in the market and “we’ll see how it plays out over the next couple years”.  The pieces are finally in place for competition to attack: 1. high quality streaming apps that have gained popularity, 2. unlimited high-speed data coupled with great network coverage, 3. in-dash accessibility in the connected car.  At the end of the day, what’s likely to take place in-car is the same thing that happened to the TV ecosystem.  The result in the TV landscape was increased competition, cord-cutting, skinny bundles, and churn.   

2.      Content costs: SIRI currently pays ~10% of revenue in royalty fees to SoundExchange for their music content.  Last time the deal was up for negotiation SoundExchange pushed for 20%, but this was in 2012 when SIRI was less profitable.  This time around the industry is pushing for 23%.  The ruling will be announced in the middle of December, setting the rate for the next five years, and based on Pandora’s recent negotiations for their on-demand product (~65% of revenue paid in royalties, albeit for a slightly different product), it is likely that some healthy step-up is in the cards (potentially doubling the cost to 20%+).  A new 23% rate would impact earnings by ~35%, but even a modest bump to a 15% rate would still take earnings down 10%. 

3.      Liberty situation:  Some SIRI bulls may be excited to be investing ‘alongside’ Liberty, known for their shareholder friendly capital allocation and strategic thinking.  But Liberty bought 80% of their SIRI stake at ~20 cents a share; their money has been made (the original ~$500mm investment has turned into a ~$10bn gain).  The reality in this case is Liberty is less focused on upside and more focused on monetizing their gain tax efficiently.  Shareholders buying into any long-term SIRI story would be better off if the Company tempered the buyback (currently 130%+ of FCF) and prepared for the future.  Hoping Liberty throws more capital at SIRI to speed up the RMT process also seems unlikely.  Liberty’s stake trades publicly for an implied ~$4.00 so taking an instant ~20% markdown would not be attractive.  Moreover, Liberty’s theoretical ‘indifference price’ from a tax perspective today is ~$2.80.  It’s kind of a circular argument, but by that I mean the after-tax gains of selling their stake at the prevailing ~$4.00 market price today is equivalent to the completion of a tax-free separation in a couple years where the ultimate stock trades back down to $2.80.  In other words, Liberty has a free option to see if the fundamentals hold up, and they’ve incentivized management to keep pushing onwards, but if it doesn’t work out, at least they’ll monetize their stake tax-free with a similar net result.  Liberty’s tax agenda (aggressive buyback to accrue 80% ownership instead of investing to prepare for the new wave of competition) is at odds with the best interest of an investor buying into the stock today.

Catalyst

Catalysts:  There are a several soft and hard catalysts that should be meaningful going forward including:

1.      Roll-out of Apple Carplay/Android Auto-enabled vehicle sales (majority of new cars sold in 2017).

2.      Uptake of competitive audio alternatives including Spotify, Apple Music, Google Play, Amazon Prime, and recently launched Pandora Premium.

3.      CRB ruling set for mid-December will likely increase content costs (industry pushing to have them double).  

4.      Churn ticks up above 2% on back of competition / ARPU comes down due to forced discounting of the current SIRI offering that is 50% more expensive than competing products.

5.      Slowing US new auto SAAR.

6.      SIRI makes a defensive acquisition (potentially Pandora).