There are a couple of key factors that have driven Sirius XM’s (NASDAQ:SIRI) growth this year – an improving vehicle mix and continued strength in the U.S. automotive market. The company’s stock has gained roughly 35% this year and more than 100% since mid 2012, thanks to its robust business model, market growth, appealing content and cost control despite pressure from intermediary bodies to raise royalty rates. Although the overall outlook is good, we believe that the market may not be aptly accounting for the risk posed by the possibility of higher royalty rates in the future. In this analysis, we’ll take a look at what’s working for Sirius XM and the reason for caution.
The U.S. Automotive Market Showing Strength
U.S. car buyers purchased roughly 1.4 million cars and light trucks in June bringing the half year new vehicle sales to about 7.8 million.  This implies growth of roughly 7.7% over the first half of 2012 which suggests that the U.S. automotive industry could see another record year as sales continue to climb since the recession of 2008-2009. Vehicle sales for Q1 2013 reached about 3.7 million, implying growth of roughly 7% over the first quarter of 2012. However, this growth accelerated slightly in the second quarter with June sales increasing by more than 9% over the same period last year.  Sirius XM stated during its Q2 2013 earnings announcement that vehicle sales in the U.S. could reach 15.5 million this year thanks to the gradual improvement in the economy and better financing deals.
As of August 2012, Sirius XM’s satellite radios were installed in 50 million cars. However, only a fraction of these are active. The company expects that over 100 million cars will have factory-installed Sirius XM radios by 2018, and about 150 million will have them in the next 10 years. However, we don’t expect Sirius XM’s subscriber base to triple in this manner over the next decade as that would imply no changes in the market scenario and the level of competition. Nevertheless, an expectation that the subscriber base doubles over the next decade suggests upside of about 25% to our current price estimate.
Favorable Vehicle Mix Is Helping
Sirius XM’s new car penetration rate has increased substantially over the past few years. Although it appeared that the figure had stabilized in 2012, the second quarter of 2013 saw another jump. Sirius XM saw its new car penetration rate growing to 69%, the highest in the company’s history.  This can be attributed to a favorable vehicle mix, implying that automakers with strong relationship with Sirius XM gained market share in the second quarter.
The new car penetration rate essentially refers to the number of new vehicles sold in the U.S. that come fitted with the company’s radio equipment. Needless to say, the figure depends on the extent of Sirius XM’s relationship with automotive companies and partnerships with dealer networks throughout the country. Every year Sirius XM pays a large sum to its OEM (original equipment manufacturers) partners to keep its radio equipment flowing into the new car market. The company has entered into long-term contracts with car makers such as General Motors, Ford, Toyota, Kia, Bentley, BMW, Volkswagen, Nissan, Hyundai, and Mitsubishi. Several trucks, boats and recreational vehicles also include Sirius XM radios as standard installation. Currently, more than two-thirds of new vehicles sold in the U.S. have Sirius XM’s radio installed.
Risk From The Possibility Of Jump In Royalty Rates
Last year, Sirius XM filed a complaint against SoundExchange Inc. and the American Association of Independent Music with the intention of cutting out mediating organizations in order to secure audio licenses directly from the labels and artists. This will give the company greater flexibility, a price advantage and ensure faster processing. Sirius XM argues that SoundExchange currently deducts its administrative fee from the royalties that the companies pay. Sirius XM can eliminate this which will benefit the artists. Furthermore, it may also be looking at personalizing its radio service as direct access to record labels could help it personalize and improve its service.
On the other hand, SoundExchange believes that it is protecting the artists and copyright owners who might not get favorable terms if Sirius XM is allowed to directly negotiate with them. The organization believes that the current royalty rates are below market standards and plans to raise them for Sirius XM. SoundExchange was looking to raise the royalty rate from 7.5% of the gross revenue in 2011 to 13% in 2013. According to royalty rates set by the Copyright Royalty Board, Sirius XM has to pay 9% of gross revenues as royalty payment in 2013, but argues that the market rate is around 5% to 7% of the defined revenue.
The relevant cost driver in our model that gets affected as a result of this legal battle is Sirius XM’s revenue share and royalty cost. Given the subscription and advertising revenues of close to $3.05 billion in 2012 and 8% royalty rate, we estimate that Sirius XM paid close to $245 million in royalty fee while total royalty & revenue share cost stood at $551 million. If the royalty rate rises to 13%, Sirius XM will be paying close to $450 million in royalty fee alone, which can result in downside of about 10-15% to our current price estimate.
Risk From The Possibility Of Increased Competition
Apple has ambitions to seamlessly integrate its devices with in-car entertainment systems. The company has announced its Internet radio service that will directly compete with Pandora. Under the name iTunes Radio, Apple will offer many features similar to that of Pandora, including personalized radio stations, free ad-supported service as well as the ad-free subscription option. While Pandora has over 1 million songs in its library, Apple’s service will give users access to its entire iTunes catalog which boasts of over 26 million songs. In addition, the subscription fee for iTunes Radio (at $24.99 per year) is lower than that for Pandora, which charges $36 per year for its Pandora One service.
As of June 25, 2013, Pandora was present in 100 car models from 23 different automakers. More than 2.5 million car owners had already activated the company’s service. However, that’s just the tip of the iceberg and there exists a huge opportunity to expand given the total number of vehicles in the U.S. and Pandora’s active listener base. Additionally, the company has made meaningful progress in the pre-owned vehicle market, which has been critical to Sirius XM’s (NASDAQ:SIRI) growth. Pandora has partnerships with eight after-market manufacturers who have introduced more than 200 devices that feature its service
Our price estimate for Sirius XM stands $3.20, implying a discount of about 20% to the market price.Notes: