Editor's note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on
. He's also a regular contributor to
subscription site. If you'd like to see all of Jon Markman's
commentary, click here for information about a free trial.
One of the real paradoxes of this tech investing season is the concurrent success of two totally different approaches to the acquisition and consumption of music.
On one hand, there is
iPod, a device that lets users completely customize their music experience. On the other hand, there's digital radio from
XM Satellite Radio
, which jams music and talk programmed largely by robots down users' throats.
It shouldn't be a big surprise to anyone that Apple is winning this fight, as freedom is just another word for nothing left to lose. Shares of the music device leader have outperformed those of Sirius and XM by a wide margin this year.
All You Need Is Technology That Works
Why the differential? Consumers don't care much about such things, but on the financial side of the ledger, the gee-whiz quality of commercial-free satellite radio has been obscured by the oh-my quality of its incredibly capital-intensive business model. Buyers of devices just want the technology to work well; buyers of stocks want the income statement to work well too.
For Apple, the coolness of the iPod costs little more than a year's worth of industrial design and testing and a few bucks worth of satin-smooth metal, a handful of transistors per unit and some pixie dust. No big deal. Apple earns a return on capital of 5%. It's not fantastic -- the computer industry overall earns 13.5% -- but it's good enough.
For XM and Sirius, the coolness of their product costs hundreds of millions of dollars' worth of broadcast licenses, satellite construction and launches, the development of vast programming bureaucracies from scratch in high-rent districts of New York and Washington, and breathtakingly expensive contracts to acquire exclusive content. XM and Sirius probably won't be conventionally profitable in our lifetimes -- though, as the old saying goes, they hope to make it up in volume.
The game-breaker for Apple, XM and Sirius is subscriptions. And that is where the two satellite radio companies expect to shine eventually. Apple focuses on selling songs for 99 cents apiece through its online iTunes music store, which integrates beautifully with the iPod. XM and Sirius focus on a bet that consumers will pay $9 to $12 per month for the right to receive radio signals from space that are mostly free of commercials.
Apple's product is essentially a commodity, as any technology outfit with a business-development department can make a deal with recording companies to provide music online. Apple already has several major competitors, including the Napster service from
, Rhapsody from
, Musicmatch from
MSN Music. There is also
online music store, which sells songs for 88 cents each.
The Drive for the Most Compelling Package
But satellite radio is noncommoditized, and the big wager for XM and Sirius is that they will lock up the most compelling package of content for the broadest audience. If you haven't checked out the two systems, you probably don't realize that their program lists are very different -- and proprietary.
Unlike an AM/FM car radio or your home television set, the buyers of one system can't pick up signals broadcast by the other. It's like buying a television that only receives CBS programming. In one context, there is something of a red state/blue state divide between the content of the two.
Sirius aims at urban core and red states.
It has paid staggering amounts of money for the exclusive right to broadcast the National Football League, the National Basketball Association and NCAA college football and basketball. To hike the testosterone level another notch, last month Sirius signed shock jock Howard Stern to a $100 million deal.
It also has a couple of rap channels with explicit, uncensored lyrics. Most of the Sirius music channels are hosted by real human DJs, who provide some context for the songs and chatter just like a good local FM channel. At their best, they're terrific; at their worst, they're fine.
XM aims at the suburbs and blue states.
It signed former National Public Radio host Bob Edwards to host a morning news show. Its big sports bets are on Nascar and baseball, as it recently signed a huge contract to broadcast every single Major League Baseball game over the next eight years.
Most of the XM music channels are programmed from headquarters by clones from minority shareholder
Clear Channel Communications
; they simply play song after song without DJ banter. At their best they are bland, and at their worst, well, they can be frustrating. How many times can you hear the same five Nelly songs over and over before you throw something at the dashboard?
Digital Radio Needs Automakers
While most consumers see the advertising for these two operations on television and see the enticements to sign up for service at retailers like
, the truth of the matter is that there is only one way for the companies to make money. That is by having automakers build their products into cars on the assembly line as standard options.
This becomes clear when you look at the revenue projections that analysts have laid out for the business. Smith Barney forecasts that satellite radio subscribers will grow at an annual compound rate of 29% by the end of 2014 -- from 4.1 million at year-end 2004 to 51.5 million. They expect industry revenue to compound annually at a 37% rate over that span, rising to $7.5 billion by 2014 from $312 million in 2004.
And this is where the differential between the valuations of Sirius and XM gets interesting. When I wrote my first column on satellite radio back in
May 2003, Sirius traded for $1.30 and XM for $10. XM was a much larger company than Sirius, even though each offered a very similar product. I loved the satellite radio story and service, and my thesis was that Sirius was bound to catch up. That has certainly happened, for Sirius has surpassed XM in market capitalization by winning the hype wars with its brilliant deals to acquire content from Stern, the NFL and the NCAA.
Yet neither company's business model works without automakers putting the receivers in a major portion of their 16 million new cars per year, and this is where the Sirius story falls apart. XM has successfully persuaded its main auto backers,
, to install its service as standard factory options. And
earlier this week came the news that it will split
business with Sirius.
Sirius, meanwhile, has not managed to get its primary auto backer,
, to do the same. Ford has said it would -- but it hasn't yet, after ample time has gone by. This should make Sirius shareholders very nervous and spook potential buyers. Toyota's decision to make Sirius a dealer option doesn't go far enough; the service needs to be a factory install, not a dealer add-on.
First Albany value portfolio manager John LaForge, who made a killing for his investors on Sirius by buying it below a buck in early 2003, says the valuation of Sirius now has overshot as much on the upside as it had previously overshot on the downside.
The Quest for 20 Million Customers
LaForge points out that the original business model called for each of the satellite providers to have 10 million customers to break even. But considering the amount that Sirius has spent to bring on Stern and major sports -- mostly by issuing stock that dilutes current shareholders and also with big bond deals -- he says he believes they need 20 million subscribers to break even. And without a working Ford deal, that is unlikely to happen. You can't get there with onesies and twosies walking through the front door at Best Buy for holiday gifts.
What drives stocks at tops and bottoms is sentiment. Pushing Sirius below $1 a year and a half ago was the fear that it would go bankrupt before ever launching its service. Pushing it up now is euphoria over its content deals.
At both extremes, somebody pays -- and it is usually the least-educated investment consumer. My guess is that both XM and Sirius will announce terrific consumer sign-up rates after Christmas, and that both stocks will decline soon thereafter, as early investors who bought on the proverbial rumor proceed to sell on the news.
Even after Wednesday's big selloff, the dollar value of Sirius still conceals a valuation that would have even made boom-era Internet companies blush. At the current price, Sirius commands a mind-blowing price-to-sales multiple compared to Apple's or even other leading-edge content delivery systems at similar stages of development, such as satellite television. It is unsustainable even at the top of the most optimistic analysts' expectations. Its seemingly low price conceals the fact that there are 1.2 billion shares outstanding, compared with, say, 50 million to 200 million shares outstanding at similarly sized companies.
And what about Apple? It has no big investment in content, so it can continue to innovate and sell its hardware at a profit while figuring out how to add high-priced accessories and movies and enjoy the follow-on effect of iPod customers switching to Apple computers from Windows machines.
For another hardware play on music, though, consider the king of them all over the past four years:
Harmon International Industries
. The maker of home, auto, computer and theater sound systems under such brand names as Harmon Kardon, JBL and Infinity is up more than 770% since January 2000. This year, it's up 65% -- less than Apple and Sirius, but more than XM.
Jon D. Markman is publisher of
StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, Markman was long Microsoft and Roxio. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
email@example.com; please write COMMENT in the subject line.