Sirius XM (NASDAQ:SIRI) is a satellite radio operator currently going through a consolidation with its parent entity Liberty SiriusXM (NASDAQ:LSXMK). The integration is expected to make this stable and cash-generative business more accessible to yield-seeking investment funds, potentially increasing the valuation multiples at which it trades. On top of this, LSXM currently sells at a discount to the value of the SIRI shares it holds, and the transaction will close this gap.
We are holders of LSXM, as we intend to benefit from the rather low-risk returns attainable from corporate action, on the other hand, we are not convinced that SIRI would be an attractive long-term holding. We believe that the core business of SIRI is weakening while it tries to branch out to different content markets, where competition is a lot more intense. Even the potential benefits of increased liquidity on the valuation of the stock are elusive due to the lack of industry peers to compare SIRI against.
We have previously covered both Sirius XM and LSXM:
Sirius XM: Penetrating Through Difficult Times: In this article, we have emphasised the strength of SIRI’s content offering, though outlined the challenging industry trends. The stock is down 25% since the article was published.
Liberty SiriusXM: The Discount Being Closed: We were bullish and had a price target of $28 on LSXM, based on a SIRI price of $3.6. SIRI is now down to $3. Thus, the return estimate has contracted.
The moat is being eroded
Sirius XM is a distributor of original talk, licensed sports and music content. The competitive strength of the business stems from content ownership as well as its control of the exclusive distribution pipe via in-car satellite radios. Increasing mobile network coverage as well as the continuing evolution of in-vehicle infotainment systems is gradually reducing SIRI’s advantage in distribution and could potentially erode some of its pricing power. Over the long term, the core business of SIRI is likely to start declining in value.
To counteract these future developments, SIRI is broadening its content distribution through acquisitions in the digital media space. The company’s monumental acquisition of Pandora in 2019 was largely motivated by the desire to acquire a technology stack which was later utilised in the development of the SiriusXM streaming app. The streaming-only offering, first introduced in 2019 considerably expanded the addressable market for the original content owned by Sirius. It is expected that the new modernised app launched in late 2023 will further the company’s efforts to address the virgin market. On the other hand, the market for original audio content is quite competitive and has been attracting the attention of tech industry players such as Apple, Spotify and Amazon. The company’s core property is the exclusive live sports broadcasting rights, but so far, the streaming-only offering has failed to make a tangible difference.
It remains to be seen if Sirius can carve itself a niche in this hotly contested market, with the launch of the much anticipated new app. It is probably too early to tell, but initial signs indicate listeners are not rushing to subscribe, we will see how this plays out over this year. However, it is quite obvious that the upcoming decade will be a lot more difficult than the previous, as the ability to deliver high-quality audio content in-car was a significant differentiator of the business, now SIRI will have to compete on content quality. They will now have to invest a lot more to acquire the content and the pricing power will be capped due to competition with tech companies that have significant resources to build a scale in this market.
Satellite radio is likely to remain a viable business for many years to come as the exclusive sports broadcasting rights as well as universal coverage, even in the most remote areas, will continue attracting a core audience. For a share of their customers, SIRI service is irreplaceable, this statement is backed by the low rates of churn that Sirius XM delivers. Unfortunately, customer loyalty and pricing power might go separate ways on this one. The higher age cohorts will eventually churn, and gradually the share of tech-savvy customers will increase. If the pricing of the streaming-only product continues to be significantly cheaper than the satellite service, over time SIRI will likely face ARPU headwinds, which could erode some of its margins even as customer loyalty stays strong.
The best-case scenario for the business would be to run down the core customer base gradually, while retaining a small base for which satellite content delivery is essential. At the same time, SIRI could grow considerably the addressable market for its content by developing compelling and differentiated streaming-only offerings. Under this scenario, overall customer numbers would grow considerably, and even as ARPU declines, the overall revenues of the business would grow. The problem is that, so far, the traction of the streaming-only offering has been limited, and subscriber numbers are in decline.
One of the reasons why we like SIRI in the first place is the core customer loyalty, growing satellite radio penetration, subscription-based model as well as somewhat differentiated content offering. We are not convinced about the ability of SIRI to grow, but we are quite certain that it will not fall off a cliff like the newspaper or FM radio operators. We were therefore considering SIRI as a potentially generous dividend payer.
Sirius XM as a dividend stock
The future growth trends of SIRI are far from straightforward, and the business faces a significant risk of gradual value erosion. Even with this in mind, we could still consider buying and holding SIRI long-term, in theory at least. One of the reasons we cover the mature media content companies that control their distribution pipe is the flexibility on the cost side. Mature media companies can often leverage their pricing power with core customer cohorts while also gradually reducing content spending. This can often produce significant quantities of free cash flows and dividends while they are in decline. Yield-seeking investors can, in theory, realise quite attractive returns if the company in question is purchased at a reasonable price.
We have looked at multiple situations like this, and to be honest, our success rate has not been great. The main reason preventing these situations from providing attractive returns is usually leverage. As EBITDA declines, companies with significant leverage positions have to allocate a share of their free cash flows for debt pay-downs to maintain or even reduce the leverage ratios. Periods of inflation or intensified customer churn often increase the need for restructuring, which adds another source of cash drain just as the EBITDA decline intensifies, and this can often lead to a death spiral.
We do not know if Sirius is a value trap and if the scenario described above applies to the company. But we have learned our lessons the hard way and would advise anybody to stay away from highly leveraged companies that are facing structural decline trends. The valuation multiples might be attractive initially, but the maximum potential returns are very much capped and the pain of holding on to these is significant, and often losses result. We do not think it is worth investing in highly leveraged companies.
The leverage of Sirius XM
Sirius XM is a leveraged, but cash-generating business. To assess the risks of indebtedness, we need to evaluate the capacity of the business to pay down debts.
At the end of Q1 2024, SIRI had a Net Debt of $9.5 billion, though, after the merger with LSXM, the leverage is expected to rise as the holding company's net debt of $1.2 billion gets absorbed by the group. Overall, the merged SIRI is likely to have a net debt of ~$11 billion.
During the Q1 conference call, SIRI management provided FY2024 guidance:
The company reiterated its full-year 2024 guidance for revenue, adjusted EBITDA, and free cash flow:
• Total revenue of approximately $8.75 billion,
• Adjusted EBITDA of approximately $2.70 billion, and
- Free cash flow of approximately $1.20 billion.
Based on this guidance, SIRI will have leverage of close to 4x EBITDA and Net Debt which is almost 9x the Free Cash Flow for the year. This leverage level is considerable and will restrict the company’s ability to pay out dividends and buy back shares.
After the transaction is complete, SIRI is expected to enter a deleveraging mode and has planned on returning only $0.66 per share next year. Assuming that EBITDA stays at the same level, SIRI will likely attempt to reduce the Net Debt level to about $8.5 billion, meaning that shareholder returns will be rather shy over the next 2-3 years. This is not great news for yield-hungry holders.
It has to be pointed out that the current FCF generation is depressed due to satellite replacement investments, and once these are complete, cash conversion of the business should improve providing some additional headroom for shareholder returns, assuming that EBITDA remains at the same level and does not start declining.
Overall, SIRI is quite leveraged. If we assume that it is a utility-like company with strong customer loyalty and the ability to pass on inflation, such levels of leverage would not be an issue. Unfortunately, the latest industry development trends indicate that this business is considerably more risky than a utility. The balance sheet leverage should be of concern to SIRI holders.
The corporate action update
As we have pointed out, SIRI is going through a process of merging with its parent entity LSXM. We have no interest in holding Sirius long-term, though the corporate action has caught our attention. We believe there is still a way to make rather low-risk returns over a short holding period.
The transaction is pending and should be finalised within the next two months (“early in the third quarter”). Exchange ratios have been finalised and LSXM has been streamlined. Therefore, the see-through value is easy to estimate now. Having said that, a discount of LSXM still prevails.
LSXM holders are expected to hold 81% of the combined new SIRI, the latter currently has a market cap of $11.6 billion. The 81% therefore should be worth $9.4 billion, but the market cap of LSXM (after dilution) is $8.5 billion. The holders of LSXM could therefore realise a return of ~10% over 2 months.
This would not be a risk-free trade, as SIRI is too illiquid to be shorted, and has proven to be incredibly volatile as many hedge funds have positions to benefit from this corporate action. We advise against shorting SIRI. On the positive side, SIRI is currently trading at about 10x forward PE, - a valuation which probably already takes into consideration all future risks. There is not much potential downside to the value of SIRI, and therefore hedging is not essential.
The new SIRI will be more liquid as free floats of both SIRI and LSXM will be combined, providing significant improvement in liquidity and potentially getting rid of some tracker discounts. SIRI does not have direct industry comparable stocks, therefore the potential uplift in valuation multiples is hard to assess. To provide us with some indication of potential, we compare SIRI against mature consumer staple companies that also seem to be losing traction with customers. Kraft Heinz, for example, is trading at 9.7x EBITDA, while SIRI is trading at 8.1X EV/EBITDA. Having said it, this is far from a perfect way to assess where SIRI should trade post-merger, as different industries pose different risk factors. For this reason, we are not comfortable in holding on to SIRI post-transaction in anticipation of an increased valuation multiple.
Recent performance
Sirius XM has reported encouraging results in the first quarter of FY2024, as ad revenue was up 7% Y-O-Y while adjusted EBITDA was up 4%. The company has recently launched its rebuilt SiriusXM app and claims to be seeing promising early indicators from new users. We are not as optimistic though.
The company is expecting to attract additional customers, which would help the business leverage its content investment to a greater degree. Increasing the share of streaming-only accounts would reduce the ARPU of the business, but overall subscriber and revenue growth could enable the business to grow its revenues and margins.
So far, SIRI has not disclosed the number of streaming-only Sirius XM subscribers, while the overall SiriusXM self-pay subscribers decreased by 359,000 in Q1 to 33 million, and down from 34 million reported a year ago. In the off-platform segment, self-pay subscribers of Pandora Plus and Pandora Premium decreased by 64,000 in Q1. So far, we have not seen any encouraging results from the new Sirius XM app, as subscriber numbers are in decline.
Advertising revenue in Off-Platform has increased by 8% in the quarter, driving a considerable increase in the profitability of the division. This performance, on the other hand, has been driven mainly by stronger advertising prices, as ad-supported listening hours have declined by 4%.
Overall, income from operations of the group has increased in Q1, though this development has been largely driven by external factors. The business performance continues to be stagnant as the much anticipated new Sirius XM app launch has not, so far, provided tangible results. We are in no position to tally the success rate of the new app, and will therefore only intend to ascribe value to it once subscriber numbers start increasing.
Conclusion
Sirius XM is currently trading at about 10x PE, while LSXM is trading at a discount to the Net Book Value of the SIRI shares that it owns. We are currently long LSXM and will continue holding the stock for another 2-3 months until the transaction closes, to secure the 10% expected return. We have no intention to continue holding on to SIRI post transaction though.
Technological development is reducing the competitive moat protecting the profits of SIRI, as an increasing number of content providers are now able to deliver audio content to drivers on the move. Siri does have some exclusive content, but it has also benefited greatly from being the only premium audio content alternative to FM radio. The company now will have to double down on content and compete directly with much bigger and more resourceful players in an industry where scale matters.
The business might be able to compete successfully with its new Sirius XM app by leveraging its sports portfolio and talk show content that it has, on the other hand, the odds are stacked against them, and we are uncomfortable making a bet on the business until we see some success of their strategy. At this point, we do not see many reasons to hold on to SIRI stock.
We currently hold the shares of LSXM, as they provide a way how to make money from SIRI in the short term. We intend to close our position in LSXM within the next 2-3 months, or earlier if we find alternative attractive investment opportunities.
Curonian Research
Long-Term Focussed In-Depth Fundamental Analysis.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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