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Tune In to Sirius Satellite's Fatal Flaw

Sirius wins the content race, but comes up short in the areas that really matter to long-term shareholders.

On Tuesday morning, the news out of the Sirius Satellite Radio (SIRI) - Get Report PR machine in midtown Manhattan was the unveiling of an all-Jimmy Buffett channel called Radio Margaritaville.

Meanwhile, down the street on Park Avenue, a well-regarded capital-structure research firm called CreditSights was explaining to its institutional bond holder client base why such content deals were dooming Sirius investors to a very serious hangover.

Its analysts believe, as do I, that Sirius has a bright future as one of just two digital satellite radio services licensed to beam music to a gridlocked nation, but that its success at attracting subscribers won't necessarily be shared with shareholders.

CreditSights has little doubt that with the market opportunity presented by nearly 1 billion radios in homes, cars, boats and offices, Sirius will be competing for a subscriber base that could hit 46 million by 2011. It gets to that number by figuring 10% of new car buyers annually over the next five years will opt for a satellite radio subscription, while 20% of installed boat buyers will go for it, plus 10% of installed car buyers and 2% of households. Those numbers provide 8 million, 2.6 million, 23 million and 13 million subscribers, respectively, for Sirius and its competitor,

XM Satellite Holdings

(XMSR)

to divvy up.

The two services compete along three axes, CreditSights says: Programming/Content, Consumer Technology/Retail, and OEM Auto Distribution. XM has big leads in the latter two categories, while Sirius has chosen to compete in the first. Sirius' biggest content splash was the signing of Howard Stern to a deal for $100 million a year over five years, rationalizing that his audience of 12 million listeners would yield at least 1 million subscribers a year -- more than covering the cost. Other costly deals the company has inked include NASCAR, Martha Stewart and the NFL, with contracts covering four to seven years and costing $21.5 million, $7.5 million and $27 million annually, respectively.

Finding the Right Road

The big question now is whether Sirius gets the lion share of new subs because of its splashy content-deal strategy, or XM gets the greater share because of its methodical distribution-deal strategy.

The car universe has been divided in a way that has left Sirius well behind in the race to get the easiest sort of subscribers: those that come with new cars. Sirius has also lagged at releasing cool radios at retail. The company has threatened to catch up with a smaller and livelier chipset for devices this fall, but of course XM's technology isn't standing still, so the lag remains a factor.

So let's just stipulate that the market is huge, Sirius wins at content, XM wins at distribution, and they are both subscription-generation machines over the next five years. But that is where the two companies part company as investments, because XM's lower cost structure will allow it to be much more profitable, much sooner.

CreditSights' analysis suggests Sirius will continue to fall behind at generating gross profit in part because there is a big timing lag between it paying for content and the ramp in subscriber inflows. In other words, it needs to pay Martha, Howard, NASCAR and the NFL well before it benefits from the fat part of their subscription contribution.

As a result, CreditSights says that even if Sirius' subscriber base grows to 6.3 million, it will need to return to the capital market for more money by the end of next year to support its business. That means an additional dilution of current shareholders, and it will be compounded if the company pays Stern in stock instead of cash.

At the current $5.19, Sirius is priced as if it were already even with XM in subscribers -- instead of well behind -- and will hit or exceed each of its promises for the next several years.

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On a enterprise value basis, it is priced as if it were already cable goliath

Comcast

(CMCSA) - Get Report

even though Comcast has proven its execution skills and fiscal prudence over many years and Sirius has only begun to right its ship in the past nine months.

One of the biggest problems with the Sirius model, in the view of CreditSights, is that it has a fixed-cost model for an emerging product "in a notoriously fickle consumer industry." In other words, it is locked into paying these big contracts even if some cool new electronics medium or device emerges to steal customers. Blinded by the celebrity value of the content deals, the market has decided to value Sirius nonetheless at parity with XM despite the fact it's clearly lagging on all financial measures.

CreditSights' discounted cash flow analysis, which assumes strong subscriber growth, an improved market share of 40% (to XM's 60%) and a decline in subscriber acquisition costs, yields a present value of $3.50 to $4, or about a third lower than today's quote. Let's hope nothing actually goes wrong.

CreditSights ends its study with the observation that it may not be coincidental that XM focused on distribution and technology while Sirius focused on content, as these strategies would be complementary should the firms decide to merge, and somehow win federal regulatory approval. But Sirius by itself is so richly valued, despite its tremendous opportunity, that it will probably not be attractive to any but the most spendthrift acquirer.

In the meantime, the only way out of this mess for Sirius holders would be an announcement by Ford that it plans to factory-install Sirius radios in 80% of its cars by 2008.

Until then, company partisans will need to double up on the margaritas.

Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at

jon.markman@thestreet.com.

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