One of the reasons - perhaps the only reason - to invest in Sirius XM Holdings (NASDAQ:SIRI) is the free cash flow [or FCF] the company generates. It is a number that has grown dramatically over the past several years:
Tap to see the table
Source: Company press releases
A number of factors were instrumental in the growth of the FCF, including the growth in revenue and reductions in a variety of costs.
Revenue
On the revenue side, the company has benefited from a pair of price increases with apparently no negative impact from two rate increases as well as increases in the Music Royalty Fee (or MRF). It has also reaped the benefit of rising auto sales driving increases in subscribers. Sirius has increased its penetration rate into the dashboards of new cars at the same time that new car sales have been rapidly rising:
Tap to see the table
Data Source: The Detroit News, Conference calls, interviews, presentations and company 10Ks and 10Q.
The subscriber growth attributable to new car sales is unlikely to continue. Among the factors impacting the future growth are the expected slowdowns in the rate of increase in both new car sales and the penetration rate. More importantly, the subscriber conversion rate has suffered as that penetration rate increased from 62% to 71% over the past five years.
In addition to the new car sales activity, the company has rapidly expanded its used car re-activation program, growing from 100 participating dealers in 2010 to more than 15,000 earlier this year. The future success of that program remains to be seen.
Costs
While the increasing revenue has helped drive increases in the FCF, the company has also had the benefit of costs that were contained or even declining. For instance, interest expense had dropped from more than $315 million in 2009 to $204.7 million in 2013 before rising sharply in 2014 to $269 million. Programming and content slowly declined from more than $308 million in 2009 to just under $279 million in 2012 before beginning to rise, reaching $297.3 million in 2014.
The more important issue is what will happen to FCF going forward. As far as interest expense, we know that $269 million expense will again see a significant increase in 2015 and beyond. First, the $500.5 million of 7% Notes that were redeemed in December of 2014 for 272 million shares was "replaced" with $1 billion of 5.375% ten year notes. So, the $35 million of annual interest expense on those 7% Notes has been replaced by $54 million of interest on the new 5.375% notes, or a $19 million difference in annual interest expense. However, because of the timing of the redemption of the 7% Notes and the new issue, the company will see an increase of only $13 million on those transactions in 2015, with the full impact to be felt in 2016. Then, there is the $1.5 billion of debt issued in early May of 2014. The interest rate on those notes was 6%, or $90 million per year. However, since those notes were only outstanding for 8 months in 2014, the company incurred just under $60 million of expense last year, indicating an increase of $30 million in 2015.
The interest expense can be expected to exceed $300 million in 2015 and increase to record levels in 2016 and beyond as the company continues to borrow to fuel share buybacks. But it's not just the interest expenses that will continue to rise. The revenue share and royalty expenses will continue to rise, although the rate of increase for the past few years should begin to taper. These expenses were $551 million in 2012 (up 17%), $678 million in 2013 (up 23%) and $810 million in 2014 (up 20%). The performance royalty rate for sound recordings component will rise from 9.5% of certain revenues in 2014 to 10% in 2015 and increase by 0.5 percentage point for both 2016 and 2017. The revenue share component could grow more slowly as a result of a new agreement with a large OEM in late 2013.
Programming and content costs, according to company management, will
...fluctuate as we offer additional programming, and renew or replace expiring agreements.
The single largest programming expense will come up for renewal at the end of this year - Howard Stern. Stern has been with Sirius for a decade, with an original 5-year contract that reportedly paid $500 million for his show. The show was subsequently renewed for an additional five years at an estimated $80 million per year. Will Sirius want to renew Stern? And, if so, at what price? Bloomberg had a lengthy discussion and article about Stern, CEO Jim Meyer and Sirius earlier this month. Meyer had this to say about Stern:
...he "loves" Stern, is a "huge Howard fan," thinks "his interviews are the best," and the "show has never been better." If he had his druthers, he says, he wouldn't wait until December. He'd renew Stern's deal right now-that is, if they could agree on the right price. "I want Howard Stern for as long as Howard Stern wants to work," Meyer says while a public-relations person records the interview. "I'm only willing to pay so much. I know what that number is. But even if I was in an al-Qaeda death camp, no one is going to know what that number is but me."
The article also included some interesting numbers for those wondering what might happen if Stern were to leave. A Maquarie survey found that:
...while SiriusXM is available on the go for premium subscribers via Web and mobile apps, 84 percent of listening takes place in cars. Of the respondents, 12 percent said they listen to Stern-the equivalent of about 3.2 million listeners. Five percent said they'd consider leaving SiriusXM if Stern departed. A rough estimate suggests it could cost the company about $240 million in lost revenue annually if he left.
While it is not clear how Maquarie arrived at $240 million, we know that the Sirius average revenue per user (or ARPU) was $12.49 per month (a $150 annual rate) in the most recent quarter. It would be reasonable to assume that the listeners to Stern are paying more than the average since his show is only available as part of certain premium packages, but in the interests of being somewhat conservative, the average will be used for this particular exercise.
$240 million divided by $150 per year would translate to 1.6 million subscribers. Would that many subscribers cancel their subscriptions if Stern left? It's certainly possible. As part of a lawsuit that Stern brought against Sirius, information about his contract indicated that he received stock option bonuses based on the number of subscribers he brought to Sirius. That number appeared to be in excess of 1.6 million subscribers.
More importantly, if one considers that the cost of the Stern show is $80 million per year, than it appears as though less than 600,000 subscribers cover that cost:
600,000 subscibers x $150/subscriber = $90 million
While losing Stern's show would save the company $80 million in programming costs, there is the possibility that the FCF would actually decline if there are significant subscriber losses. If the Maquarie estimates are correct, that loss in FCF could be substantial.
Some of these and other costs will rise as the revenue grows. More important than these expenses and independent of the growth in revenue, the large FCF that Sirius currently enjoys is due to two very significant factors:
1. The company is currently spending minimal amounts on capital expenditures.
2. The company pays minimal cash taxes as it burns through billions of dollars of losses from prior years.
Satellite Capital Expenditures
The overwhelming majority of Sirius subscribers receive content from its network of satellites. These satellites have a limited life span and the company is in a lull in the replacement cycle. The build cycle to replace the network is now beginning as the company has already begun to purchase certain parts with long lead times. In a discussion on the 2013 FCF, the 10K reports:
The increase was primarily driven by higher net cash provided by operating activities from improved operating performance, lower interest payments, and higher collections from subscribers and distributors, partially offset by payments related to the launch of our FM-6 satellite and the purchase of certain long-lead parts for a future satellite.
At a recent analyst conference, Sirius management added this about the future capital expenditures on satellites.
We require kind of five discrete satellite projects every 15 years. So two active satellites on the XM side, two active on the Sirius side and one spare, that can really go in between or kind of step in, in case of any issues with either or any of those four satellites. Those projects are really roughly speaking about $300 million a piece. So about $1.5 billion in total satellite CapEx spending over a cycle.
And I think, we'll start that spending probably late '16. So it would be done approximately over a 12-year period.
Since this does not start until late 2016, the full impact won't be felt until 2017 at which time it would be an average of $125 million per year for more than a decade.
CashTaxes
Looking at the Income Statement for the company shows that it incurred an income tax expense of $337.5 million in 2014, up 30% from the $259.9 million in 2013. However, that income tax liability is not currently a significant drain on the company's cash. The Consolidated Statement of Cash Flows shows those tax liabilities required far less cash for payments - approximately $10 million in 2014 and $100,000 in 2013. The 10K also notes that the company has an effective tax rate of 41%.
On the first quarter conference call, Meyer said:
I think based on current outlook, we will become a tax payer in '19, I think. So we'll have the benefit of full tax yield through the end of '18, anyway.
Company management frequently likes to point out how much of its EBITDA is converted into FCF. On the most recent call, Meyer again pointed to this particular statistic:
Combining revenue growth, high variable margins and tight expense management, we grew our adjusted EBITDA by 26% to nearly $1.5 billion. And we converted more than $1.15 billion of this into free cash flow, up 25%.
...We believe growing our free cash flow and even more specifically our free cash flow per share will enhance value for our shareholders.
I agree with Meyer that increasing FCF per share will enhance value for the shareholders. That said, it is important that investors remember that taxes will begin to consume a large portion of FCF before the end of the decade. More importantly, the market will be looking ahead to that tax impact before it actually occurs and price it into the value of the shares.
Summary
Sirius is currently enjoying a host of favorable conditions that boost FCF. It has had rising revenues that can be attributed to subscriber growth from both an increase in new vehicle sales and increasing penetration rates. It has had two subscription rate increases and increases in the MRF with no noticeable impact on churn. It has been able to refinance debt in an interest rate environment that many economists believe is artificially low. It has been able to negotiate lower programming costs on the renewal of several of its sports content agreements. It is in a lull on the cap-ex spending cycle and enjoys a cash income tax rate that is essentially zero.
The favorable conditions are not going to evaporate overnight, but several of them will be going away. The market prices stocks on where it thinks the FCF will be in the future. In the case of Sirius, it is clear that the FCF will decline in the future, and that decline will be significant.
The question investors should considering is "How much of that decline is currently priced into the stock?"
Disclosure: The author is long SIRI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to my long positions, I have January 2016 $4 covered calls written against a small portion of my long positions and January 2016 $4.50 covered calls written against a majority of my long positions in Sirius XM. I also continue to make short term trades on large blocks of Sirius XM on a regular basis. I may close the current call positions, open new call positions or buy or sell large blocks of Sirius at any time.
