The next purchase for my Special Situations portfolio will be stock and options on Sirius XM . The stock was hit recently following its third-quarter earnings report and revenue guidance for 2014 that didn't impress Wall Street. But with the massive buyback plan and excellent cash-generating potential, the company should do fine. And add to it all the expertise of super-investor John Malone, whose Liberty Media owns more than half of Sirius shares, and I think you have the makings of a long-term winner.
The business of Sirius is well-known, so I won't go into a lot of details on what it does. However, I'd like to highlight a few recent points about how the company can continue to excel.
- The number of new cars with satellite radio receivers continues to grow quickly. The company has incentivized auto manufacturers to work with it. Even better, as old cars go out of service, the percentage of total cars on the road with Sirius continues to increase, giving the company a natural tailwind.
- Sirius has expanded into telematics with the purchase of Agero. The satrad superstar should be able to leverage its current relationships with car manufacturers to good effect. In addition, new telematics services could bolster its core business through bundling of services, the same tactic used by telecoms and cable companies. This is a potentially huge new revenue stream, and nobody can extract the potential out of a new business like John Malone.
- Not only is Sirius going to continue to grow revenue, it's going to extract even more cash flow from each dollar of sales. During the recent Liberty Media investor day, management noted that it expects Sirius to generate 40% EBITDA margins at maturity. Each incremental sales dollar adds proportionally more cash flow to the bottom line -- excellent operating leverage. After Malone bailed out Sirius XM in 2009, he and his team have managed to raise EBITDA margins from 18% to more than 30%. In part due to Malone's capital allocation expertise, Sirius turns almost 80% of EBITDA into free cash flow.
- With ongoing buybacks, free cash flow per share will grow even faster.
The special situation
So what's the special situation? I would point to two things: John Malone and extensive leveraged buybacks.
Malone is a capital allocator extraordinaire. In his first 25 years as the head of TCI, until its acquisition by AT&T in 1998, he achieved 30% annual returns. That beats even Warren Buffett's record in his first 25 years at Berkshire Hathaway. Malone is a special situation unto himself. Though many investors deride what he does as "financial engineering," he has financial engineered himself into billions of dollars using spinoffs, tracking stocks, and leveraged buybacks.
Sirius has already repurchased 477 million shares for $1.6 billion so far this year. It has announced that it will buy back another $2 billion in addition to the $400 million remaining on a previous authorization. That amounts to more than 10% of the current share count. But, wait, there's more.
Sirius management said that it's targeting leverage ratio of 3.5 times EBITDA, so it's already underleveraged based on 2013 guidance. So expect it to take out more debt to meet its repurchase authorization. Then in subsequent years as EBITDA grows, it can take out even more debt for share buybacks. My calculations suggest a 10% increase in revenue would allow Sirius to take out another $1 billion in debt. As the business matures, I wouldn't be surprised to see that leverage ratio increase to between four and five times EBITDA, a level that is more consistent with Malone-run companies.
Foolish bottom line
So my Special Situations portfolio will take a $1,000 stake in Sirius XM common stock and use another $1,000 to set up a bull call spread on the stock using January 2015 call options (long $3.50 and short $4). If Sirius XM stock moves up to $4 per share, the options should more than double in value. Of course, if the market and Sirius XM go below $3.50 per share at expiration, the options will be worthless. So there's definitely a timing risk with the options position.
The article I'm Buying Stock and Options on Sirius originally appeared on Fool.com.Jim Royal has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Berkshire Hathaway. It owns shares of Liberty Media. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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