The 'Connected Car' Is Coming: Get 65% Upside With This Cheap Stock

Marshall Hargrave's picture

Wednesday, May 7, 2014 - 2:15pm

by Marshall Hargrave

Although the car radio was introduced back in 1930, it's still a timeless tradition. While the mechanics of the car radio have changed drastically through the years, radios still come standard in every car. 

One type of radio that continues to gain traction is satellite radio, and Sirius XM (Nasdaq: SIRI) is by far the largest player in the satellite radio market. 

Shares are down nearly 10% over the past two months amid the broad sell-off in momentum stocks. But the pullback could be presenting an enticing buying opportunity. 

Sirius has an agreement with every major automaker, so the continued rebound in U.S. auto sales are only helping the company expand its already impressive subscriber base. And the other major opportunity for Sirius is that it's becoming a bigger player in what's known as the "connected car." This involves bringing together radio, navigation and other electronics within the car. 

Sirius expects the number of new cars sold with satellite radio will reach 11 million this year, up from 10.7 million in 2013. The auto market in the U.S. is strengthening -- auto sales were up 8% year over year in April -- and should only continue to do so as the economy rebounds. 

Powered by this rebound, Sirius projects the number of new cars sold with satellite radio will double in five years. But the long-term opportunity lies in putting Sirius' radios in more used cars. Sirius radios are in about 26% of cars on the road, which is around 62 million cars. The company estimates that total will double to 120 million cars in five years. 

With the help of new-car sales and greater penetration among used cars, Sirius' paid subscriber base is expected to reach 30 million in the next few years, up from just 3 million subscribers in 2005. 

   
  Flickr/tbisaacs  
  Sirius projects the number of new cars sold with satellite radio will double in five years.  

The startup costs in the satellite radio industry are very high, giving Sirius an economic moat. But Sirius contrarians make the case that Internet radio providers, such as Pandora (NYSE: P), will take market share. Pandora already has partnerships with 25 car manufacturers. Pioneer has already developed a radio that supports Internet radio, including Pandora. (My colleague David Sterman made the case for Pandora earlier this week.) 

However, for investors, the beauty of Sirius is that it's a cash flow machine. The majority of its revenues are recurring, with over 85% of its revenue derived from subscription services. 

In contrast, Pandora has yet to figure out the subscription model. It still gets over 85% of its revenues from advertising. Pandora does have over 80 million users in the U.S., but its paid subscriber count is only 3.3 million. Sirius' paid subscriber count is over 25 million. 

Sirius is already looking for ways to decrease its reliance on satellite radio subscriptions, where its recent initiative is part of its strategy for a "connected car." The use of cellular networks is rising, which allows drivers to use Internet radio. That has been good news for Pandora, but it's also good news for Sirius. 

Sirius' acquisition of the connected vehicle services segment of automotive services firm Agero last year for $530 million gave Sirius the ability to provide services via satellite and cellular networks. And Sirius already has a head start on Internet radio providers when it comes to establishing its presence in cars. 

The goal is to provide connected services to drivers, including navigation, traffic info, voice texting, maintenance notifications and various other driver alerts. Sales from connected-vehicle services are expected to hit $100 million this year and double over the next three years. The long-term prospects are also appealing, considering Sirius can expand connected services to the 60 million vehicles in which it already has a presence. 

Sirius' majority owner, Liberty Media (Nasdaq: LMCA), had planned on buying up the other 47% of Sirius that it didn't own. Liberty called that plan off earlier this year -- but since then, Sirius has decided to accelerate its $1.7 billion share buyback program. That's just under 10% of its market cap. This should be a great way for Sirius to boost shareholder value. 

Although it enjoys substantial cash flow, Sirius can also take on more debt to accelerate its share repurchases. Its current leverage ratio (the ratio of its net debt to its earnings before interest, taxes, depreciation and amortization) is 2.8 times, but the company is willing to increase that to 4 times.

Sirius has not only seen its subscriber base grow from 19 million in 2009 to more than 25 million last year, its average revenue per user is also on the rise, while subscriber acquisition costs are going down. That's a very good combination for margins. 

Last quarter, average revenue per user came in at $12.18, up $0.13 from the same period last year. Sirius has already raised the price of its core service by $0.50 this year, which should drive that revenue per user figure even higher. On the costs side, subscriber acquisition costs fell 25% last quarter, to $35. Put another way, it costs Sirius an average $35 to acquire a customer -- from which it makes $146 a year. 

Sirius has a very low churn rate for a subscription-based company. Its self-pay churn rate was less than 2% last quarter, while estimates put Pandora's churn rate as high as 30%. 

Sirius trades at a price-to-earnings (P/E) ratio of 27 based on next year's earnings estimates, which compares favorably with Pandora's forward P/E of 50.

A group of hedge funds are already owners of Sirius. This includes billionaire Leon Cooperman, activist hedge fund Jana Partners, John Griffin's Blue Ridge Capital, and Coatue Management. Collectively, they own about 13% of the company. 

Risks to Consider: The biggest risk is the increasing popularity of other radio services. New radios that support other services, such as Spotify and Pandora, could lead to a higher churn rate and lost revenue for Sirius. The company is also heavily reliant on car sales, thus, any slowdown in the economy would mean a decline in subscriber growth.

Action to Take --> Buy Sirius with a multi-year target of $5. That's over 65% upside. It assumes that Sirius can keep its stronghold in the auto market by moving beyond just satellite radio to the "connected car."

P.S. My colleague Andy Obermueller, the Chief Investment Strategist behind StreetAuthority's Game-Changing Stocks advisory, is keenly interested in the future of American driving. In fact, he just released a report spotlighting technological advances that could allow blind people to drive and make the gasoline engine obsolete. To learn more about these developing technologies -- and the companies behind them -- follow this link.

Marshall Hargrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.