When satellite radio provider Sirius XM (Nasdaq: SIRI) delivered first-quarter results in late April, it was business as usual.
An 11% gain in revenue led to a sharper 28% surge in earnings before interest, taxes, depreciation and amortization (EBITDA), as the company reaps the benefit of incremental new revenues across its largely fixed cost base. That operating leverage has been in place for quite a while, as EBITDA margins expanded from 23% in 2009 to 34% at the end of 2013.
Equally impressive, Sirius has become a free cash flow machine and appears on track to generate nearly $1 billion in free cash flow for the second straight year. Such robust free cash flow has enabled Sirius to restructure its debt (at lower interest rates) while also buying back a large chunk of stock from investor John Malone. (In fact, the total share buyback plan is an impressive $2 billion.)
Also, the fact that Sirius now has 26 million paying subscribers is a feat that few would have expected the company to accomplish a half decade ago. Sirius' service is resold by 70% of the major automakers and 25% of all cars (new and used) on the road today have the option: Management hopes to boost that figure in coming years as more new cars come pre-installed with it as an option, replacing aging cars that are nearing retirement and were built before the service took off. Second-hand cars are also increasingly coming with satellite radios as well, as dealers retro-fit them to boost resale values.
So why is this stock hated so much?
With more than 300 million shares held by short sellers, Sirius XM is now the most heavily shorted stock in recent memory. To be sure, Sirius has almost always had its detractors, as the short interest has routinely exceeded 100 million shares each year. But 300 million shares held short is a very different story.
Why are so many investors betting against this stock? The short answer is competition.
When Sirius launched its service more than a decade ago, there was no such thing as streaming audio. Now, services such as Spotify and Pandora Media (NYSE: P), giving consumers the ability to request only the artists they like, are starting to take major market share. While Sirius' revenue has grown in the 7% to 13% range in each of the past three years, Pandora's sales have grown at least 40% each year. Sirius' sales growth is expected to remain in the high single digits in 2014 and 2015, while Pandora's sales are expected to grow at least 30% in 2014 and 2015.
Sirius' management insists that investors' fears about competition are misplaced. During a call with analysts in April, CEO David Frear said: "The majority of the churn (customer cancellations) we see are going back to FM radio or going back to terrestrial radio. Obviously when you look at the Pandora listening numbers, they are currently increasing, and that listenership has to be coming from somewhere. I think it's coming from terrestrial radio. We're not seeing a meaningful impact that I can see on our business today from streaming."
Is the question about competition truly moot? After all, Sirius offers a very wide array of unique programming, and holds a different sort of appeal than a streaming music service. Some people like radio shows (Sirius), and some just want to request their songs (streaming services). And right now, Sirius is the industry's best business model. It owns much of its own content and, as a result, has much firmer gross margins than streaming audio companies.
Here's why the question is not moot. A rising tide of automakers are casting their lot with Google (Nasdaq: GOOG), Apple (Nasdaq: AAPL) and Microsoft (Nasdaq: MSFT) as those firms develop the next-generation auto entertainment systems. In a few years, new cars will likely have a stereo that looks and feels just like a mobile phone interface, replete with apps for iTunes, Spotify, Pandora and other streamers. And so far, none of the automakers -- or the technology giants -- have said anything about how Sirius will fit into that ecosystem. Sirius thrived by gaining important real estate on the dashboard and simply can't afford to lose that space.
Management hopes that the issue of dashboard real estate won't become a problem. "I believe automakers will be deploying built-in satellite broadcast technology for many, many, many, many years to come," Frear said, adding that, if necessary, Sirius can adopt a streaming business model as well. But such a move makes the expense of maintaining costly satellites seem pretty foolish.
Here's the unusual thing about shorting a stock that has these kinds of threats to its business model. Sirius is not in any sort of imminent danger. The company is generating excellent free cash flow and buying back lots of stock. But the company is under great pressure to at least maintain its quarterly subscriber trends. It simply can't afford to show any cracks in the armor.
The fact that the short interest rose from under 200 million in the middle of May to more than 300 million at the end of May (where it stood as of last week) suggests that short sellers think that such cracks will appear sooner rather than later. Long or short, one of these groups will likely soon get burned when earnings season rolls around.
Risks to Consider: As an upside risk, Sirius still may become acquisition fodder, even if John Malone recently signaled that he is losing interest in pursuing the company. As a downside risk, Sirius is boosting its levels of debt to pay for its buybacks, which may seem risky in hindsight if free cash flow eventually weakens.
Action to Take --> The short sellers are likely correct in theorizing that Sirius faces a very bumpy future. The radio ecosystem is moving away from satellite and toward wireless, and if automakers start to delist Sirius as a dashboard end, the company may start to be looking at a slow and steady demise.