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  • KPB & Co Research

The investing game is not for boys, as there are usually millions if not billions of dollars at stake. So, when a senator calls an investor "Darth Vader" beware as you may find yourself in a predicament when you stand against this guy. John Malone aka "Darth Vader" keeps expanding his US$7Bn empire by making sublime moves, where if you were to blink once you'd probably miss it. Recently, John Malone's Sirius XM holdings (NASDAQ: SIRI) bought out Pandora (NYSE:P) in all stock transaction valued US$3.5Bn. This business combination, if approved will lead to the world's largest audio entertainment company with US$7Bn in FY-18 proforma revenues.

A deeper look into the history of the relationship between both companies show that this deal was probably in the works for more than a year. It started when Pandora (NYSE:P) weakened financially and was in desperate need for a cash infusion. In FY-15 Pandora's (NYSE:P) cash flow from operations turned negative as the company decided to move away from a revenue dominated by advertising to a subscription-based model following the likes of Spotify. In the same year, the company also acquired Ticketfly - a live events technology company serving venues and event promoters in North America - for US$335.3Mn in stock and cash. The company also issued approximately US$300Mn in convertible senior notes due 2020 in a private placement to institutional investors. The resulting transactions expanded the deficit in the company's cashflow from operations to negative US$181Mn coming from positive US$21Mn 2 years earlier, and the stock price plummeted from a high of US$35 per share to US$5.

In swoops Sirius XM Holdings (NASDAQ: SIRI) in June 2017 (a business that generates a US$1.4Bn + in free cash flows), to provide a US$450Mn strategic investment in the form of a convertible preferred stock. According to the press release:

"The Series A preferred stock is convertible into common stock at a purchase price of $10.50 per share. The Series A preferred stock bears a 6% cumulative dividend, payable in cash, accretion of the Series A preferred stock or a combination thereof. The Series A preferred stock represents a stake of 19% of Pandora's (NYSE:P) currently outstanding common stock, and a 16% interest on an as-converted basis."

Following this investment, a number of strategic moves occurred that led to more improved financial statements. First, they replaced the CEO - Tim Westergren with Roger Lynch - the chief of the video streaming service Sling TV. Second, the company sold Ticketfly to Eventbrite (NYSE:EB) for US$200Mn (this was bought for US$335Mn previously) and finally the company hired a new marketing exec Nick Bartle from the Gap.

After these strategic moves, the stock price began to move upwards steadily from US$5 per share towards US$8 per share. In our view, this occurred because of the reduced operating losses from the sale of Ticketfly. The reduced losses became evident in Q2 of FY-18, where losses from operations in the six months ending in Q2 narrowed to US$31Mn, relative to US$136Mn a year earlier. We believe that the strategic investors, who had board seats, believed that the results would appear increasingly better as the year went by, possibly putting the stock price above the US$10.50 per share exercise price negotiated in the preference share deal. It is not surprising that Sirius XM (NASDAQ: SIRI) holdings acquired Pandora (NYSE:P) for an implied price of approximately US$10.14 per share.

The jury is still out on whether or not this will be a good deal, as the market for streaming music is getting increasingly tough as the days go by. What is certain however, is that if you were smart enough to figure out that this acquisition was going to happen at this price, you would have easily doubled your money in less than a year. This industry remains tough given the level of competition that is already in the market. First, traditional radio companies such as iheartmedia are facing bankruptcy. Second deep pocketed technology companies have been doubling down on music streaming. Spotify has been intensifying competition in the industry, along with Apple Music, Amazon, Sound Cloud and others. Sirius XM (NASDAQ: SIRI) has some amount of downside protection as they did not pay a high price for Pandora (NYSE:P), and they provided an overvalued stock in exchange for ownership. In our view, based on a DCF analysis of the company's cashflow, Sirius XM (NASDAQ: SIRI) is overvalued by at least 30%.

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