VIC Write-up: Sirius XM Radio (Long)

Disclaimer: We and our affiliates are long Sirius (SIRI) and may purchase additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of ASCMA. This is not a recommendation to buy or sell shares.  Our research should not be taken for certainty.  Please conduct your own research and reach your own conclusion

Business description:

Sirius XM Radio (SIRI) is a provider of satellite radio services in the US and Canada; its product offering consists of music and talk content distributed to a base of 23.9M subscribers, most of whom listen in the car.  SIRI has a monopoly in satellite radio (after merging with XM in 2008), and Liberty Media has recently taken majority control of the company.      

Thesis:

Sirius XM Radio is a long – the company has a monopoly over a sustainably valuable product category and is set to experience enormous growth in free cash flow per share, driven by strong secular volume growth, operating margin expansion (pricing power + cost leverage), and favorable capital allocation (share buybacks + debt refinancing) spearheaded by John Malone.

Investment merits:

• Monopoly with a sustainably excellent product and solid pricing power: the superiority of SIRI’s product over alternatives has resulted in high customer conversion, low churn, and significant pricing power that is likely to  continue, unthreatened by technological advances such as Pandora’s integration into cars, especially over the next few years.
• Strong secular volume tailwinds driving top-line growth: Strong sales of new cars, winbacks of former customers, and rapid penetration of the used car market are likely to drive ~10% growth in SIRI’s subscribers for the next five years.
• Significant operating margin expansion magnifies earnings growth: High operating leverage (35% of SIRI’s cost structure is fixed or even falling in absolute terms) + variable costs falling as a % of sales from favorable subscriber mix shift (mainly used car customers) 
• High medium-term cash flow conversion: Satellite radio is a negative working capital business (prepaid subscriptions), and the company has $7.6B in NOL tax assets and zero new satellite capex until 2017, leaving ample capital to be deployed.
• Excellent co-investor and capital allocation partner: John Malone (through Liberty Media) is currently taking control of the company in order to engage in enormous levered share repurchases and could end up repurchasing over $10B of stock over the next four years (vs. $22B current market cap).

Sirius offers a compelling value proposition unlikely to be threatened by internet radio

It’s easy for New Yorkers to forget that the average American spends over 1.5 hours driving each day and that individuals with long commutes (typically higher income) spend even more time in their cars. It comes as no surprise then that SIRI subscribers (who spend 1.7 hours per day driving) find Sirius XM’s music/talk content, user interface, excellent reception (in any location), and lack of commercials to be a compelling value proposition.

These Sirius XM users are highly loyal and have allowed the company to achieve impressive operating metrics and pricing power.  ~45% of free trial users become paid subscribers, and monthly churn of paid subscribers has been consistent at only ~2% over time, low relative to other subscription services (Netflix  & HBO/Showtime/Starz average 4-5%).  Sirius recently passed through a ~5% subscription price increase, which has been put into effect for three fourths of the subscriber base with no effect on customer churn or trial user conversion. Our work suggests the ability for further price hikes.

The debate over whether the integration of Pandora and other internet music services into cars will threaten SIRI’s value proposition is the central controversy surrounding any investment in the company. The debate over the threat of smartphone connectivity is interesting, and our work suggests that Pandora does not threaten SIRI’s value proposition to its actual subscribers, even over the long term.  Even if it did, though, we still believe the threat gets inordinate attention from the Street, who may be making mountains out of molehills on both the scale and timing of the threat:  Pandora-in-car is totally irrelevant to the 65-70% of SIRI’s 2016 customers whose cars will never have it because they’re too old, and furthermore, internet radio options are already prevalent in many new cars and are having no effect on churn, while the ability of a car to stream Pandora (without a phone) are too far away to be a threat over the investment horizon and will cost money to the consumer when they do arrive.

We also believe that internet radio services do not pose a long-term threat to Sirius’s value proposition:

1. Many Sirius listeners are low-effort music listeners uninterested in the pre-programming required for Pandora or Spotify playlists and unwilling even to take the small amount of time to configure their phone to stream into the car.
2. No service so far has the breadth of content that Sirius offers – subscribers are willing to pay up for Sirius’s bundling of music + news + sports + talk radio, but have shown no interest in paying simply for music, and no service so far offers anything other than music.

Strong volume growth (fueled by used car market) and margin expansion will drive cash flow growth

SIRI is likely to see ~10% subscriber growth over the next five years as a result of strong secular tailwinds.  A strong continued recovery in U.S. new car sales will allow the company to increase its penetration of the new OEM car base, currently its largest category of customers.  The most exciting prospect, however, is SIRI’s rapid penetration of the used car market, which we believe is an opportunity for massive growth.  SIRI already was able to add ~1M used car subscribers in 2012, and that number should grow explosively in the coming years:

• Rapid growth in franchise car dealership partners: out of the ~18,000 US franchise dealerships, SIRI signed up 4,000 in 2011 and 4,000 more in 2012; this pace implies roughly 63% growth in weighted-average number of dealerships in 2013 alone.
• Growth in SIRI-installed cars per dealership: at each lot, the car mix is shifting toward newer models with higher SIRI prevalence

The result is that the used car customer segment is likely grow into an enormous source of profit for Sirius over the next several years.  These customers are particularly profitable and will boost Sirius’s margins because of their low variable costs. Currently, most new cars sold with SIRI equipment require Sirius to pay the OEM manufacturer an equipment installation subsidy; these arrangements are likely to continue for the most part in new cars. Used car customers are higher-margin because they generate the same revenue without this equipment subsidy. 

SIRI’s margins will also expand because of the company’s high fixed costs.  Roughly 35% of SIRI’s cost structure can be considered genuinely fixed and will fall from 24% of sales to 16% of sales by 2016:

• G&A, R&D, satellite and equipment costs, and 70% of sales & marketing likely to grow no more than inflation. 
• SIRI’s expenditures on talk content (think Howard Stern) are 9% of the company’s cost structure and are likely to fall in absolute terms by 2016, as a third of SIRI’s pre-merger content budget remains to be renegotiated.

Cash generation will outpace earnings growth and fund enormous share repurchases led by excellent co-investor John Malone

The growth in SIRI earnings actually understates the massive amount of cash the company will generate for several reasons:

• Negative working capital business: prepaid subscriptions mean SIRI will always gain cash as the business grows
• Significant financial leverage, with interest rates falling as high-cost pre-merger debt is refinanced at lower rates
• No taxes until 2018: $7.6B in NOL tax assets from pre-merger losses, unlikely to be used up until late in the decade
• Lower-than-normalized capex until 2017: no need to buy new satellites until 2017 because SIRI got them in the merger

The ~$6.7B in cash SIRI will generate through 2016 will have to be deployed somewhere. As Liberty Media has maneuvered to take control of the company, SIRI has authorized a two-year plan to purchase $2B of its own stock, and we believe this plan is only the tip of the iceberg.  SIRI management has informed us that the company is likely to re-lever to 3.5x gross leverage to fund buybacks, adding significantly to SIRI’s growth in FCF per share.  We also gain conviction in our thesis simply from Malone’s very large bet that now is still a good time to buy the stock.

Risks

• We could be wrong on our Pandora assessment if a) spotty streaming service is really the problem with Pandora now, and the 4G revolution fixes it or b) the spread of Pandora-in-car into lower-end vehicles finds price-sensitive SIRI customers who stop converting
• At 25x 2013 normalized free cash flow per share (after accounting for NOL tax assets & low short-term capex), there is little room for error