Value Investors Club / Sirius Satellite Radio (short) (SIRI)

Description

Sirius Satellite Radio is a story that has been long on hype and short on profits. After years of management painting pictures of parabolic subscriber growth, I think we're finally reaching the tipping point when reality will start to set in.

Sirius recently lowered its year-end subscriber estimate from 6.3 million to a range of 5.9-6.1. To achieve its initial guidance, it would have needed to add more subscribers than it did in the same quarter last year -- when the fervor around the arrival of Howard Stern was at its peak. Even with satellite radio's greater exposure and higher OEM penetration, it was not in the cards for Sirius to add more subscribers than it did in such a (justifiably) frenzied period.

One estimate revision isn't the end of the world, but if it is a hint at future growth rates, it will drastically change the outlook for satellite radio. Management would like you to believe growth is healthy, but the numbers show that it is decelerating quickly -- in the same manner XM's growth did. With 1.4-1.8% of subscribers churning off each month, as XM's base grew it naturally began churning off more subscribers. At this point growth stopped accelerating and started decelerating, and XM is in the latter part of this decelerating (but still positive) growth. Sirius is following a very similar trend. And with the shares priced as a hyper-growth stock, the realization that it will follow a similar path to XM should put significant pressure on the shares.

          SIRI   y/y    XMSR     y/y
    Net Adds change Net Adds change

2003 Q1   38    136
2003 Q2     37          209
2003 Q3     44    237
2003 Q4    111    272%    431    196%
2004 Q1     91    138%    322    137%
2004 Q2    129    247%    418    100%
2004 Q3    182    310%    416    75%
2004 Q4    481    332%    713 66%
2005 Q1    305    237%    541    68%
2005 Q2    366    184%    647   55%
2005 Q3    359     97%    617     48%
2005 Q4   1143    138%    898 26%
2006 Q1    761    149%    569 5%
2006 Q2    600 64%    398    (39%)
2006 Q3    441    23% 268    (57%)
2006 Q4E   973 (15%) 656    (27%)

This will be Sirius' first quarter with year over year declines in net adds. Following a similar path to XM, the acceleration is gone from these businesses. It's now a matter of figuring out where steady state falls out and if it justifies the valuation.

Outlook

There are a number of upcoming events which will challenge the value proposition of satellite radio. A large number of automakers are adding Ipod jacks to their stereos. This should pressure Sirius & XM, as some percentage of people who would otherwise pay $8-15 a month will now pass on satellite radio in favor of the large collections of music already stored on their Ipods. The second major pressure will be Wimax, or in-car internet. When this innovation hits, which some manufacturers will start to install next year, consumers' options for getting content will expand dramatically. Internet radio, whether free sites like Pandora or $3.99 per month sites like Yahoo Music, will all of a sudden be in direct competition with satellite radio's bread and butter, in-car audio content. It is not clear what effect Ipod jacks and Wimax will have on satellite radio, but there is no doubt each of them will challenge satellite radio's value proposition.

Traditional radio will continue to offer the local content which makes broadcast radio work. If there is a saving grace for Sirius, it must be content. That will be one of the only ways it can really differentiate itself in such a fragmenting marketplace. Howard Stern is a good example.

By my estimate, Howard Stern brought 1.5M incremental subscribers (and counting) to Sirius. At $11 per month each, that's $200M in incremental annual revenue. But this growth has come at a steep price. Howard's contract was an enormous $500M over five years. Unfortunately, at its current churn rate it will have effectively cycled through all 1.5 million subscribers in about 4 years. (In Sirius' defense, Howard's subscribers may be slightly stickier than a typical Sirius sub.) But with the $500M (plus overhead & other) in content costs, together with subscriber acquisition costs, it's questionable whether this was a good deal. And even though the majority of his compensation is in shares, it costs shareholders the same either way, whether via cash or dilution. On the plus side, the shares have declined from where the deal was signed, and furthermore the deal with Howard amounted to an equity raise without having to dip into the capital markets again.

Getting back to the content discussion, it is clear Howard is not happy that so far only 1.5 million people (give or take) have opened their wallets and followed him to Sirius. The numbers he was hoping for were many times that, and recent news has hinted to the notion of a return to terrestrial. Such a move would be devastating for Sirius, even if only half of the incremental subscribers he brought canceled. Sirius has other valuable content, such as the NFL. But Wimax could put pressure on some of these arrangements, too. With in-car internet, content owners will have an interesting opportunity to bring content directly to consumers. The media industry is already undergoing a shake-up. I am not a media strategist, so I am not trying to say content owners will start bringing everything directly to consumers, but it will certainly be explored. It is just one more potential pressure on Sirius' value proposition.

Another saving grace for Sirius would be a merger with XM. While this is a risk for shorts, as I would guess SIRI shares would initially appreciate (even as the acquirer), I think the market would overestimate the benefits. One recent piece of sell-side research put an absurd $10B+ incremental value to a transaction, more than the current combined market cap of the two. Assuming it received regulatory approval, which is no guarantee, the efficiencies from a merger would take a very long time to be realized. The technical hurdles would be quite large, to the extent where, from my understanding, one group of satellites would simply have to be trashed. As for cost savings, several of the two companies' contracts are through 2012-2013. Absent re-negotiation, it would be several years before the bargaining power of the merged entity would be fully realized. So even if a merger did get regulatory approval, I think it would be a very long time before the combined entity could realize the major positive synergies.

Other saving graces would be the Ipod-like Stiletto and deferred revenue. The Stiletto is Sirius' bid to go portable. While I don't think there is a large market for portable satellite radio, it is a risk. As for deferred revenue, collecting money in advance provides for very cheap financing. While this is a positive, it doesn't change the economics of the business substantially.

Previous VIC post / Expenses

It is both sobering and instructive to look at previous post.   On the one hand, you gotta hand it to Sirius for topping its prior growth targets. On the other hand, it has done this only by ballooning expenses to the degree that its operating loss is over $600M per year. And while expense growth has helped it to top subscriber estimates, Sirius has continually pushed back its forecast for when it will turn a profit ... or just break even for that matter. After targeting cash flow breakeven by the end of 2005, then by the end of 2006, it now is hoping for cash flow breakeven by the end of 2007.

Income Statement (pre-ESO*)
($ millions)    Q3
Revenue    167.1
COGS          64.8
Gross Profit   102.3
OpEx       204.1
EBIT          (101.8)
Interest    (8.1)
Other    (0.9)
Net Income   (110.8)

*ESO Expense   43.4

Expenses have been out of control. The business has shown much less operating leverage than the original assumption of the model, due to expensive content deals, more satellites, and higher SG&A. In one sense I think they are doing the right thing as the content is the only thing that will make this business work, but on the other hand they've paid an awful lot for it, and therefore have seen much less operating leverage than the market had originally expected. And in order to break into the OEM market, almost every one of the deals they've cut involve significant revenue shares.

Valuation / Per-subscriber EV

Market Cap   $5.0B
Debt          1.0B
Excess cash   0.0B
EV           $6.0B

With approximately 6 million subscribers, that's $1,000 in enterprise value per subscriber. Even if they were to reach 10 million subscribers, that's still $670 per sub. Even then, at 10x EBITDA, Sirius would have to have $67 in EBITDA per sub, or about $5.50 per month. That is an incredible margin -- Especially when it appears that with its expense profile, Sirius probably won't turn a profit until it hits 12 million subscribers, which in all likelihood will be beyond 2010. In the meantime, they are still burning through cash, and will probably need to raise capital in late 2007.

Conclusion

Growth is slowing, Sirius has not demonstrated the operating leverage necessary to reach profitability or positive free cash flow anytime soon, and competitive forces ahead will pressure its value proposition. Even after a 45% decline in 2006, I think shorting SIRI still offers an attractive risk-reward.

Catalyst

- subscriber guidance for 2007 & lower analyst estimates.
- failure to achieve positive cash from operations in 2007.
- Even with deferred revenue, it looks as though Sirius will have to return to the capital markets for another financing in the second half of 2007.

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			2006	2007
Price:	3.54	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	4,980	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT
Borrow Cost:	NA