SIRIUS XM Radio Represents Compelling Take-Out Target

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Albert Rosanno.
Firm: Vance Hall Capital Management. Hedge Fund.
Location: New York, NY.

Recommendation: Long Shares of SIRIUS XM Radio (Nasdaq: SIRI)
Timeframe: 6 Months to 1 Year
Recent Price: $1.85
Target Price: $2.50

Strategy: Event/Special Situation

Disclosure: The author of this idea held an active position in this security at the time of posting.

Quick Thesis:
Founded in 1990, SIRI is the surviving entity of the merger between Sirius and XM Radio in 2010. The merger has been a successful one, removing overcapacity from the industry and allowing SIRI to grow, thrive and significantly improve its’ once over-leveraged balance sheet.

Via a convertible preferred stake, Liberty Media (Nasdaq: LMCA) owns about 40% of SIRI equity, and about 45% pro-forma for a forward purchase contract which likely will be physically closed by 3Q’12. SIRI holds a $7.8bn NOL. It appears LMCA has a favorable view of SIRI’s fundamentals and their NOL. Some analysts have suggested LMCA is in a position to move directly to a 80% equity position in SIRI (allowing full consolidation for tax purposes). It appears LMCA has cleared its Section 382 requirements which would hinder any deal.

I believe LMCA will move to acquire all of SIRI, once there is clarity on the result of their SoundStage/CRB/Music Royalty negotiations (“Royalty negotiations”). LMCA’s $3b cash on hand takes it a long way toward completing the deal, and, in any case, the after-tax cost of borrowing money in today’s very low interest rate environment is attractive way to finance additional tax-shielded earnings. Such an acquisition could happen prior to the public announcement of the results of the Royalty negotiations.

I put a 0% chance on a Reverse Morris trust transaction. It simply doesn’t create as much immediate value.

Valuation
The Street values SIRI on a multiple of FCF basis. Looking out to 2014, 2015, and 2016. this method looks favorable as SIRI begins to enter a “CapEx Holiday”, during which replacement of its Satellite fleet will be minimal through 2020.

The questions that need to be answered to value SIRI on a long-term basis include:

What is the “Normalized” CapEx rate.
What is likely rate of subscriber growth, where does it peak and “level off”?
How will the Royalty Negotiations play out?

The Street does a strong job with point #2, but has largely ignored #1 and #3.

Regarding #1, it’s very hard to predict what Satellite and Launch costs will be 8 years from now. We do know this: the Satellite construction industry is highly consolidated, with just a handful of players, and the Launch industry is the same. At a minimum prices will keep up with inflation. Assuming SIRI continues to require 4-5 on-going satellites, at $100mm/bird including launch costs, that would result in a “Normalized” CapEx rate of about $90mm/year ($65 maint. cap ex. + $25mm satellite/launch costs, depreciated over a 15 year life). For now, this calculation only changes most Street 2014 estimates of MV/Levered FCF by about 2% - but that is assuming my estimates of Satellite and Launch costs are correct.

#3 has already been estimated above at about a 2% potential hit to EBITDA if CRB rules in an “adverse way” against SIRI, increasing music royalty costs from the current level of 7% of gross revenues to 10.5% of gross revenues.

Regarding #2, most Street estimates do not include the “Auto bull thesis” where the SAAR rebounds to an above-trend 15mm+ for a multi-year period, a “catch-up” period after a long period of “depressed” sales. This scenario would represent significant upside to valuation, but is not part of the thesis.

Bearing these three points in mind, Street estimates that SIRI can grow to a 14x Levered FCF multiple, or a 7% earnings yield by 2014 seem reasonable. At that multiple, SIRI should trade at $2.85/share in 2014. Discounted back to today, at $1.85/share purchase price, that implies almost a 25% annualized equity appreciation.

With two sources of return: (1) the 25% potential fundamental return and (2) the possible return resulting from an LMCA takeout, SIRI a compelling buy.

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