When investors look at the satellite radio sector, there has always been a question of how to establish the value of these companies. Are they technology or media? The valuations for the two can differ. When Sirius and XM were start-ups, most tended to establish valuation as technology companies, and assigned a certain valuation metric to their potential.
Early on valuation was determined by many things such as anticipated cash flows, rate of growth, and the perceived potential of Sirius and XM. To date, neither company has really taken on the behavior of being valued as a large media company. The key factor to understand is whether or not this will happen with satellite radio, and if so, when it will happen.
Many large media companies become valued at a multiple of their cash flows, among other things. For Sirius and XM, the costs associated with doing business are often not understood, and for these companies to get to a point of profitability has been a long and arduous task, which at times has continued to muddy the valuation waters.
On one hand you have companies that are spending large amounts of cash. On the other hand you have companies that have potential to bring in large amounts of cash. What we have, still, is an “unproven business model” (unproven in that profits have not yet been obtained). Thus, valuation becomes built partly on faith, or lack of faith that these companies can become profitable large media companies.
With a merger, people often want to discuss synergies in the form of capabilities in technology that these companies have. What should be a center of focus is what type of synergies will allow these companies to effectively clear the hurdle to profits. At that point in time, valuations should begin to shift from what is possible to what is real.
For many large media companies, one method of valuation is a multiple of the cash flow. Some valuations are 9 times cash flow, others are 19 times cash flow. Realistically speaking Sirius and XM have never really been valued in this manner, and it will be interesting to see if this type of valuation becomes the bench mark for these equities.
As an investor in this sector, consideration as to how these companies will be valued at that point in time should be central to your thought process. There is a substantial difference between a multiple of 9 and a multiple of 19. Where on this scale will satellite radio land? To help determine what will be a perceived value investors should ask themselves how they perceive the companies. Are they media companies or are they technology companies? In my opinion, cash flow valuations for technology companies tend to be less than for media companies. Satellite radio had substantial up front cost that traditional media companies do not have. Satellite radio possesses fixed costs that traditional media companies do not have.
To give some insight on the paths companies take, we can look at the cellular industry and the satellite television industry. As an industry, cellular took 19 years from their first customer to reach positive free cash flow. Satellite television took 12 years to accomplish the same. Satellite radio is anticipated to be at that milestone in 2009, or 7 years after the first subscribers were signed. It can be argued that satellite radio has a better economic model than did cellular or satellite television based of its ability to carry a fixed capex.
There will come a day when satellite radio quarterly conference calls shift once again. We have already seen the shift fro “Losses Widen” to “Losses Narrow”. The next shift comes with the transition from “Losses Narrow” to “Profit Announced” and then to “Profits Grow”. It is my opinion that this next shift will bring with it a new way that these companies are valued. More attention will be placed on actual numbers, and less on perception of potential. Many analysts already use various models for valuation, but those valuations are out into 2008, 2009 and beyond. A lot can happen between now and then, and at the moment these companies maintain Cash Flow Break Even, the valuation models will transform from theory on paper to reality in the stock prices.
The key for investors is to try to understand what will happen when this shift takes place, and to consider, both with and without a merger, when that shift happens.
Position - Long Sirius, Long XM