Landenburg Thalmann Initiates coverage for Sirius
March 31, 2006
Landenburg Thalmann initiates coverage on Sirius satellite Radio with a BUY rating and a target of $6.00.
We at SSG feel that the report by William Kidd of Landenburg Thalmann was very well thought out, and highlights the import areas that investors need to condsider in the SDARS sector.
Highlights> Clear momentum: We don’t expect Sirius to give back its retail gains so easily. After strong net adds growth in 4Q05 and what appears to be an impressive 1Q06 follow-up performance, there has been considerable conjecture over the “Howard effect” and how long it may last. Although we’re forecasting a significant sequential drop in 2Q06 gross adds, we still expect Howard Stern to be extremely relevant at the point of sale. When a potential subscriber runs through their mental checklist, even if they’re not fans of Howard or the NFL, both packages speak well of the overall quality of Sirius’ programming line-up, which is why we believe Howard is going to be a factor for a long time.
> Sometimes perception becomes reality. We believe investor perception could increasingly favor Sirius in 2006. With the technology gap between Sirius and XM quickly waning, Sirius’ mix of high profile management, vis-à-vis Mel Karmazin, dramatic market share gains, and proven content could prove to be an intoxicating cocktail.
> Isn’t terrestrial radio the enemy? At some point, Sirius and XM need to eat someone else’s lunch. We are concerned by Sirius’ increasingly competitive stance, in what should be a more cooperative duopoly, and its willingness to write large checks payable in company equity. For instance, we suspect that the company’s recent acquisition of Volkswagen may have carried higher incentives than what XM was paying. If both Sirius and XM management continue to contest every piece of content and every OEM partner, the positive economic model that we envision in 2010 and thereafter could be in jeopardy.
> We see upside from current price levels. We are initiating coverage of Sirius with a Buy recommendation and $6.00 year-end target based on our DCF. We would be opportunistic with Sirius shares given the combination of
ThemesWhat’s Good News for One is Good for the Other? Take Advantage of the Market’s Constant Indecisiveness.
In recent months, even when positive news has surfaced for one, which was negative for the other, the market has tended to almost equally reward both Sirius and XM shares. It sometimes seems as if market participants are arbitraging valuation discrepancies between the two, believing that both should be valued similarly on an enterprise value or some other basis. The market seems as if it is having difficulty deciding on what is better: XM’s larger subscriber base or Sirius’ momentum and content. At these prices, we think the answer is relatively easy. XM’s past and future GM subs (at least through 2013, when we expect the GM agreement to terminate) are worth less than the typical sub, in our opinion, giving Sirius an advantage in some key areas. That difference alone impacts millions of past and projected XM subscribers, making it important to consider.
We think that the costly GM agreement reduces XM’s willingness to spend heavily on other agreements, affording Sirius some comparative, operational flexibility. That said, Sirius’ new penchant to spend might not always be the smartest move, given they are operating in a duopoly, and if programming costs continue to be bid up over time, both companies will ultimately lose.
Addicted to DilutionSirius has been heavily reliant on using equity to cover operating costs and wages. In 2004 and 2005, Sirius recorded an expense for “equity granted to third parties and employees” of $126.7mn and $163.1mn, respectively.
Besides the dilution, the payment choice is creating significant distortion in the company’s P&L. For instance, if these expenses were paid in cash as opposed to equity, Sirius’ reported SAC line item would have been $49.7mn (14%) higher, sales and marketing $42.1mn (25%); and content costs $19.5mn (20%).
The adoption of SFAS No. 123R, which the company will reflect as of January 1, 2006, does not help matters. Sirius’ 2005 expense would have been roughly $50mn higher, totally about $212mn, under 123R.
We do not think the solution is as simple as Sirius simply paying in cash instead of stock and options. Rather, we think Sirius management needs to get considerably more cost conscious. Even before the equity is factored into the company’s expense analysis, adjusting for scale (e.g., subs), Sirius’ spending is above XM in many areas, such as SAC, content and customer care. Thus, we think the company’s eagerness to spend is a concern, particularly at this early stage. Keep in mind, Sirius is not spending a war chest. Sirius is planning to nurse its business on prepayments from customers for years, as opposed to sustained profitability, which is almost a form of borrowing in and of itself. In the end, perhaps debt is another alternative for management, since it at least holds management more accountable for the magnitude of the spending.
Note: In 1Q06, Sirius will recognize a charge $225 million (34,375,000 shares) for the equity granted to Howard Stern and his agent, which was supposed to vest when Stern contributed 1 million subs. Sirius apparently amended its agreement with Stern. The net result was that it allowed Stern to receive this stock award immediately and for Sirius to put the large share expense in its past. Even after this award, Stern is still eligible to receive additional shares from Sirius. We believe sometime around year-end 2006 or shortly thereafter, the company will compare its subscriber levels to what was projected prior to Stern’s arrival, and award him a share per subscriber for some portion of the difference. Given the strong 4Q05 and our projections for 2006, we believe Stern will be eligible for an award, perhaps in the ballpark of 1 to 2 million shares. We believe this process will be repeated at the end of each year of Stern’s five-year agreement.
Investment ThesisFor most of the past few years, Sirius has struggled to overcome delays in launching its service and less than favorable comparisons with its rival, XM Satellite Radio. In 4Q05, Sirius was able to sign 1.1 million net adds due in large part to Howard Stern’s pending arrival as well as the Holiday Season. The quarter was a watershed event in Sirius’ history, since it was the first time it was able to surpass its rival in net adds growth. The accomplishment is even more significant when one considers Sirius surpassed XM’s overall growth without much of an OEM effort.
On a go forward basis, we expect Sirius to continue to show its strength in the retail channel. But on an absolute/total basis, XM should be able to regain some of its lost thunder in the second-half 2006, and more likely 4Q06, as a result of continued growth in OEM sales. Even so, if XM does not regain retail dominance in 2006, Sirius’ gains will serve as an important harbinger to the market. Since the result would suggest that when consumers have a choice, they prefer Sirius. At least for now, we do not see the OEM market as necessarily the best long-term demand indicator since the sales are captive, based on the aggressiveness of one’s auto partners. At this relatively early stage in satellite radio’s life cycle, the aggressiveness still varies widely between automakers. In time, we think the efforts will normalize and be fairly consistent across the board. With more time, consumers may ultimately get more of a say in the OEM market as well, if some automakers become un-exclusive and/or radios become interoperable between the Sirius and XM systems. If that were to occur, it would place even more importance on the immediate retail market share numbers, which we think will be consistently favorable to Sirius. The potential wildcard in 2006 being the strength of Oprah with XM, which we presently do not think will lead to a material retail market share shift.
Longer-term, our projections reflect the belief that Sirius, much like XM, will see a considerable shift in its business from retail to OEM, as Sirius’ auto partners become more involved. We believe it’s the natural progress of satellite radio for the bulk of its business to come from new car sales, versus the retail channel.
Our two biggest concerns long-term relate to churn and programming costs. We assume both worsen considerably over time. We believe Sirius’ churn will trend higher as it moves into OEM sales much like what XM has experienced with its OEM subscribers. In addition, Sirius recognizes OEM subscribers at shipment to the lot, in order to match SAC with gross adds. While we don’t disagree with the accounting practice, the process naturally creates higher churn, since some new car purchasers will elect not to activate or continue on with Sirius. In terms of specifics, we are forecasting churn to rise to 2.3% per month in time, above the 1.8% average of 2005.
Of our two concerns, programming is a bigger theoretical risk in our opinion, given the power that we perceive programmers have in other comparable subscription businesses, like pay television. Satellite radio has avoided some of the pitfalls of content costs because it is able to produce so many channels inhouse and music royalties are relatively cheap. That said, the risks of overpaying for or of high priced programming is clearly evident in agreements from Howard Stern to the NFL. At this stage of the company’s life cycle, we still see Sirius having considerable power over programmers, since so much of the growth is still ahead of the company. For now, programmers do not want to risk losing a spot on the platform at such an early stage. However, as the business matures in the out years, we believe the power could shift considerably towards content producers, as the loss of a key channel or two could lead to subscriber
Sirius Satellite Radio (SIRI) disruption. Programmers tend to use such fears to negotiate favorable rate adjustments.
Valuation The net result of our thesis is what we believe to be a fairly balanced outlook for Sirius. Within the parameters of our DCF, which extends through 2015, we value Sirius at $6.00 as of year-end 2006, incorporating a 11.0% WACC and a 7.0% terminal growth rate. Given that in 2015, our EBITDA and unlevered free cash flow increase at 15.5% and 22.0%, respectively, we do not feel that our terminal growth is unrealistic.
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