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These Shares Are On Sale, More Profits Are On the Way

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Warren Buffet once said “Price is what you pay, value is what you get.” With shares of Sirius XM (NASDAQ:SIRI) having gained over 60% last year, the stock this ranks as having been one of the best value plays on the market. Remarkably, that it closed up on Wednesday at $3.02, this further reinforces the value that still remains  albeit psychologically. But improved profitability is how this stock will move from spec play to value. And it's coming.

Where Can Meyer Take the Company Next?

That’s what investors want to know, but it’s not an easy question to answer  particularly since new (interim) CEO Jim Meyer has yet to “officially” introduce his vision. The good news is, with each passing month Sirius has been able to shed the “speculative” stigma often associated with low priced stocks.

Although uncertainties remain surrounding Liberty Media’s (NASDAQ: STRZA) fight for control of Sirius, that Liberty only needs to buy up less than 1% of Sirius shares, it is a foregone conclusion that the company will be granted FCC approval. Likewise, there continues to be rumblings about Apple’s (NASDAQ: AAPL) entry into the realm of music streaming.  While it will mean nothing for Sirius, this threat gives rival Pandora (NYSE: P) everything to fear.

Apple always had ambitions of creating the “smartcar” market, of which IOS will be the central component. Aside from music, features will include auto safety and maintenance notifications. Likewise, there are rumors that drivers will be able to receive an “imessage” notification between songs that the rear tire is underinflated or the car is due for a tune-up. How can Pandora compete with that?

On the other hand, Apple does not have Sirius’s premium content. This will leave Pandora searching for an acquisition – it’s only means of survival. Google and Facebook seem as possible landing spots. Meanwhile Sirius is able to gain more market share with one less threat out of the mix.

Pandora investors have already begun bracing for the worse as the stock dropped 20% upon the Apple rumors. Meanwhile shares of Sirius actually took a slight bump upward. Wall Street realizes that in Sirius’s model, growth has been constant and despite these threats, the company has remained a model of execution. Its Q3 proved that.

However, for the stock to truly work in the long terms, investors will want to see the company focus a bit more on its bottom line. The possibility exists that the stock will reach $4.00 by the second half of this year. For shares to get to $5.00 and beyond, profitability will matter. And in my opinion, that's should be Meyer’s main objective. The good news though, is that Sirius has been given the blueprint.

More Rate Increases, More Profits

Several weeks ago, Sirius won a favorable ruling with SoundExchange, the organization that collects royalty payments for musicians. This was broadly considered a “one less thing to worry about” event. However, it was more than that. Sirius was given a road map towards increased profitability.

While it was determined that the royalty fees would increase from 8% in 2012 to 9%, the most important aspect of the decision was that the fees will then increase by (only) half of a percentage point every year until 2017. This is important because since Sirius passes these costs on to the subscribers, the degree with which the royalty rates are scheduled to increase makes this more manageable for Sirius.

This will help offset some noticeable weakness in the company’s recent Q3 report. Despite signs that Sirius is transitioning from spec to value, the company's reliance on auto sales is still too high. This is something that Meyer also needs to address. For instance, Sirius posted revenues of $867 million  representing a year-over-year increase of 14%. Likewise adjusted EBITDA surged 24% to $245 million.

While these numbers are impressive, they were offset by dismal net income, which dropped 30% year-over-year. This means that although the company is making excellent progress in terms of subscribers, profitability and expenses remains a challenge. Meyer will need to figure out how to marry the two together. This is how Sirius will transition into its next leg of growth.

On the other hand, I appreciate that one reason for the 30% decline in profits was that the company used cash to pay down $107 million worth of debt  can’t fault the company there. But it also points to one obvious solution for the company - more rate increases in the near future. My prediction is that rates will be raised as early as 2014. Investors should not be surprised to see hints of this as early as the Q2 conference call.

For Sirius, the good news is that customers are proving that they love the service and are willing to pay for it themselves once the promotional trials expire, a number that has now reached 19 million. That's quite an accomplishment considering where Sirius was three years as it battled cancelations - not anymore.

Bottom Line

As the title suggests, there is plenty of value in the stock at current levels. That said, for the stock to reach that $5.00 pinnacle, which will prompt more institutional buying, Sirius will have to start raising rates or figuring out ways to lower costs. So far its model has not been adversely impacted by the off-setting dilemma, but at some point, the two will cross paths. Let’s hope they shake hands.

rsaintvilus is long AAPL and has no positions in the other stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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