Auto Sales Rebound Will Help Sirius XM Bounce Back: A recovery in auto inventories should drive demand for the firm's differentiated offering.


While Sirius XM is no longer just a satellite radio service—following the 2019 purchase of Pandora— the legacy service remains the firm's crown jewel, generating three fourths of the revenue and 85% of gross profits. Due in part to the tight auto supply in the second half of 2021, which is expected to persist through the first half of this year, SiriusXM is projected to have one of its worst years in terms of net customer growth. While the market has punished the stock, Morningstar believes that the service is poised to return to growth in 2023 and beyond.

Morningstar's belief is driven in part by Morningstar's projections that the supply issues hitting light-vehicle sales will reverse in the second half of 2022 and the total sales level will return to the prepandemic norms of around 17 million units sold in 2023. The company has also continued to invest in new areas that could expand its reach, with acquisitions in podcasting and digital advertising. Morningstar's new $8.25 fair value estimate is driven by Morningstar's new light-vehicle projections for 2022-26 and higher expectations for growth from 2023-26.

Key Takeaways

  • Despite the growth of music streaming platforms like Spotify and fewer commuters over the last two years, SiriusXM has not only held on to its customers but also continued to convert trial customers at levels just below prepandemic rates. Morningstar expects the conversion rate will continue to decline, offset by increased penetration at both automakers and used car dealers.
  • The increased investment in podcasting will not be enough for Pandora to differentiate itself from the larger music services, and Morningstar expects ad-supported listening hours to continue to decline.
  • Sirius XM's narrow moat is driven by cost advantage derived from the satellite radio service's codified rate for sound recording royalties. This lower rate relatively to music streaming services allows SiriusXM to generate much higher gross margins than peers like Spotify or even its sister service, Pandora.

Sirius XM Owns Two Different Yet Complementary BusinessesEdit

Over the last five years, Sirius XM Holdings has transformed itself from a pure satellite radio company to a more rounded audio platform that now includes streaming music and podcasts. This transformation was accelerated by the 2019 acquisition of Pandora and the 2020 purchase of Stitcher. Sirius XM operates two segments: SiriusXM, the satellite radio side, and Pandora, the pure streaming side of the business.1 While this transition has brought some positive changes, including a deeper focus on the streaming offering at SiriusXM, Morningstar remains unconvinced about the longer-term value of Pandora in a very competitive music streaming landscape. However, Morningstar believes that the issues facing Pandora and worries about the current auto supply constraints are overshadowing the strength of the satellite radio business.

SiriusXM's Unique Programming and Service Drive Subscriber Growth

SiriusXM is the much larger of the firm's two segments, generating 79% of revenue and 87% of gross profit in 2020. The SiriusXM brand nods to the history of satellite radio that launched in U.S. with the first broadcast in May 2001 by XM Satellite Radio followed four months later by Sirius Satellite Radio. Spending over $3 billion combined to launch satellites and build out infrastructures, the two competing firms were staring down bankruptcy in 2008 when they combined. While the combined firm still faced bankruptcy in its first year with revenue of $2.5 billion and an adjusted net loss of $441 million, the SiriusXM service quickly transitioned into a profitable and growing business over the last decade as seen in Exhibit 2.

SiriusXM's content is primarily broadcast across the U.S. by a series of six satellites with two operating as backup for the other four. The satellites generally have relatively long lifespans and are depreciated over 15 years. The firm's newest satellite, SXM-8, was launched in June 2021 and placed into service in September. SiriusXM ordered two more satellites in August 2021 for delivery in 2024 and beyond. The signal from satellites can be broadcast directly into the satellite radio hardware or be enhanced by one of over 1,000 terrestrial repeaters that SiriusXM uses in urban areas to overcome signal blocking from tall building or high-density wireless networks. SiriusXM began to stream its programming over the internet prior to the merger of the two companies, and the service offers internet-only plans, as well.

Content originates from all over the U.S., with the three main studios in New York City, Los Angeles, and Washington, D.C. SiriusXM and its predecessor companies have continuedly expanded both the breadth and depth of the programming lineup. The service now offers over 90 music stations that cover a multitude of genres, eras, and demographics along with multiple artist-branded stations, including Pearl Jam, The Beatles, Bob Marley, Eminem, Drake, Phish, Garth Brooks, and others.

Sports offerings include the standard sports talk from ESPN, Fox Sports, CBS, and others as well as stations focused on specific sports and college conferences. SiriusXM is also the live national play-by-play radio home for the NFL, MLB, NBA, NHL, NASCAR, IndyCar, PGA, and the "Big Five Power" college conferences.

Entertainment and comedy stations are headlined by Howard Stern, who has now been on the service for over 15 years, but also includes branded stations from The Today Show and Comedy Central. On the news side, SiriusXM offers simulcasts of every major cable news channel, including Fox News, CNN, MSNBC, and CNBC along with Bloomberg Radio, BBC World News, and several political talk stations.

SiriusXM primarily generates revenue via subscriptions that make up over 90% of revenue for the segment. The vast majority of its stations are commercial free with ads only airing on certain non-music channels. The service offers a dizzying array of plans that range in price from $8 to $35 per month depending on the number and type of stations, streaming-only, in-car usage, and number of cars. A select number of the plans are shown in Exhibit 3. For the plans with music stations, the firm charges an additional fee that can range from $0.44 to $7.49 per month to cover U.S. music royalty costs.

While the firm has added a number of lower-priced plans over the last five years, including streaming only ones, ARPU has increased steadily over the same period (Exhibit 4) due in part to the uptake of higher-priced plans, the growth in advertising revenue, and increases in the U.S. music royalty fee. The fee increases have not impacted net customer additions over the same time period. However, the firm is notorious for discounting its plans in order to retain customers, which has helped drive monthly churn down slightly over the last five years from a peak of 1.9% in the third quarter of 2017 to 1.5% in the same quarter of 2021.

While consumers can sign up for the service directly, the majority come from the conversion of trial subscriptions of buyers and lessors of new and used autos. Every major automaker has signed an agreement with SiriusXM, but these agreements do not specify any specific or minimum targets for a number of radios installed. The trial length can vary from three months to one year. Despite this lack of commitments, the service has steadily increased its penetration within both new cars sold, now at 81% versus 67% in the first quarter of 2013, and used cars, now at around 50% versus 26% in the first half of 2015. Even as the number of trials has increased over the last decade, the conversion rate to paying subscriptions for new cars has only fallen from the mid-40% to the high-30% range, a respectable level given the substantial subscription cost. This continued strong conversion rate combined with increasing new and used car penetration and lower churn has helped drive strong net customer additions. The growth of SiriusXM's self-pay subscriber base is shown in Exhibits 5 and 6.

SiriusXM Weathered the Pandemic Better Than Expected

While many of SiriusXM's plans bundle together in-car and streaming options, Morningstar believes that in-car remains the primary location for most of the listening. Given this assumption, Morningstar viewed the lockdown restrictions and work-at-home at the start of the pandemic as a large potential negative, both in terms of churn and new customer additions, with current customers canceling the service and potential customers deciding to allow free trials to expire. Morningstar also expected the lack of commuting to keep consumers away from car lots, which would hurt the potential pool of trials to convert into self-pay subscribers.

However, SiriusXM proved to be considerably more resilient during the first 18 months of the pandemic even as work-from-home and hybrid arrangements have continued. As shown in Exhibit 7, the service was hit hard in the first quarter of 2020, with less than 100,000 net additions for the first time since the first quarter of 2010. However, SiriusXM bounced back in the last nine months of 2020 to post a respectable 909,000 net adds for the year. The first nine months of 2021 remained strong with the service hitting its 2021 net additional guidance of 1.1 million by the end of the third quarter. The third quarter of 2021 was also the firm's strongest ever with over 616,000 net adds. Despite Morningstar's worries at the beginning of the pandemic, the paying subscriber base actually increased by over 2 million, or 7%, from the end of 2019 through third-quarter 2021. Over the same period, ARPU continued to increase, implying that subscribers were not trading down to cheaper steaming-only plans and that the firm was not offering steeper discounts than normal to retain customers.

All Good Things Must Come to an End: Without Car Sales, Trials Dry Up in Fourth Quarter

Despite the strong performance in the face of the pandemic, the service has begun to experience pandemic-related headwinds, through little fault of its own. Due to the ongoing chip supply shortage, new car inventory collapsed across the U.S. in the summer of 2021 (Exhibit 8).3 The U.S. auto industry began to see a decline in inventory in the front half of 2021 as manufacturers warned about the impact of the tightening chip supply on auto manufacturing. These ominous warnings started to be felt in the market as seasonally adjusted inventories fell throughout the year and the inventory-to-sales ratio fell below one month for the first time since the U.S. BEA began collecting data. That ratio continued to slide in the second half of the year, ending in December at 0.36 or roughly 11 days.

Despite posting record net adds in the third quarter and meeting its 2021 guidance in only nine months, SiriusXM only raised its 2021 full-year guidance from "approximately 1.1 million net additions" to "over 1.1 million net additions," implying a very weak fourth quarter versus 2020 (407,000 net adds) and 2019 (341,000). On the third-quarter earnings call, management cautioned that SiriusXM would see 1 million fewer conversion opportunities in the fourth quarter than in the third quarter. Due to the inventory constraints, new car trials fell 21% in the third quarter versus the second quarter and used car starts dropped by 6% sequentially.

The fourth-quarter results bore these worries out as SiriusXM only added 55,000 self-pay customers in the quarter, its weakest since the start of 2010. Citing the inventory shortfall and lower paid trials, management guided for only 500,000 net new paying customers in 2022, a level that would be more than 400,000 less than any year since 2009 when the newly merged firm faced bankruptcy. While the firm does not offer quarterly guidance, management believes that the majority of growth will occur in the second half of 2022.

Returning to Prepandemic Sales Levels Will Take Until 2023

While SiriusXM has suffered due to the recent downturn in car inventory, Morningstar expects these shortages to be resolved over short term, albeit beyond 2022. Morningstar's automotive equity team recently updated its five-year projections for light-vehicles demand on a regional and global basis (See the team's Observer, "Moats, Motors, and Markets 2022," published Feb. 25, 2022). For the U.S., new light-vehicle sales are projected to rebound strongly in 2022 to 15.7-15.9 million units, up 5.8% at the midpoint, well ahead of the recent low of around 14.6 million light vehicles sold in 2020 according to Automotive News. However, Morningstar's 2022 estimate remains well below the prepandemic level of around 17 million light vehicles sold.

U.S. Autos Equity Strategist David Whiston expects inventory to gradually improve in the first half of 2022 but with no potential for major improvement until the second half due to the chip shortage. He projects that demand will continue outstrip supply through 2022, which should fuel even stronger unit growth in 2023, which he pegs at about 8.2% for a range of 17.0-17.2 million light-vehicles sold. Even with very modest growth in 2024-25 and a downturn in 2026, Morningstar expects light-vehicle sales to average slightly more than 17.0 million units over 2023-26 (Exhibit 9).

According to Whiston, the factors driving this growth are varied but include healthy credit access, the lengthening age of the average American vehicle, the large number of safety and luxury features now available on new cars, and the growing appeal and availability of battery-electric vehicles. These factors are countervailed by a potential cap on the growth of leasing's contribution to new sales over the longer term, a ceiling on the length of loan durations, and the increasing size of monthly payments.

Morningstar explores how this view of auto sales influences its thinking on Sirius in the valuation section below.

Pandora Faces Very Competitive Landscape Even as It Pivots to PodcastsEdit

The second and newer segment of Sirius XM is headlined by Pandora, which was acquired in February 2019 for $3.5 billion in all-stock deal. Pandora launched one of the first internet radio services in 2005, which still provides the majority of revenue for the segment. The internet radio service, which creates playlists based on the user's selection of an artist or song, generates revenue primarily via advertising. There is a subscription option, Pandora Plus, for $5 per month that offers advertising-free streams, unlimited skips, and offline listening. In 2017, Pandora launched an on-demand premium music offering called Pandora Premium that is similar to Spotify, Apple Music, Tidal, and other streaming competitors. This service charges $10 per month for the same features as the Plus tier along with the ability to make and share playlists. Despite these changes, advertising remains the primary driver of revenue (Exhibit 10).

Even with the addition of subscription options, Pandora remains a small player in the streaming music landscape within the U.S., the only market that it serves. According to the Recording Industry Association of America, revenue from digital subscription and streaming services totaled $10.1 billion in 2020. Pandora generated $1.7 billion in 2020, implying a market share of roughly 17%. However, the RIAA only counts the distributions from SoundExchange, the non-profit performance rights organization for digital music as designated by the U.S. government, as digital and customized-station music revenue. So, the total revenue from Pandora overstates the firm's importance as the RIAA is effectively only counting the royalties that Pandora and its digital and customized-station streaming music peers pay from their ad-supported services as part of the overall $10.1 billion revenue generated in 2021.

Combining the content costs for the ad-supported service with the revenue from the subscriber services provides a more accurate representation of Pandora's size within the U.S. music landscape, though possibly slightly underestimating its importance. Using this methodology, Pandora's "RIAA revenue" for 2020 came in at $1.0 billion or roughly 10% of the $10.1 billion RIAA estimate for U.S. digital subscription and streaming service revenue. In contrast, Spotify's U.S. revenue hit $2.9 billion for 2020 or 29% of the total. Given the weak advertising market in 2020, Morningstar thinks that the 10% share for Pandora likely underestimates the importance of the service. However, Pandora has lost market share every year from 2016-20 due to the much faster growth of paid subscription music streaming (Exhibit 11).

The rise of subscription services with on-demand music selection has led to a sharp decline in total hours of usage on Pandora, which have fallen 40% from 2016 to 2021 as total monthly active users dropped from 81.0 million to 52.3 million. Offsetting this decline has been an impressive growth in advertising revenue per thousand listener hours (RPM), up from $54.94 in 2016 to $102.74 in 2021. This growth has been the result of more impressions per hour and better ad targeting. As a result, total ad-supported listener revenue has expanded by 11% over the same time frame, as seen in Exhibit 12.

While ad-supported revenue has grown slowly over the last five years, subscriber revenue has more than doubled to $530 million. However, the total subscriber base remains relatively small, with only 6.4 million paying users at the end of 2021 versus 4.4 million at the end of 2016. In comparison, Spotify ended 2021 with over 52 million paid subscribers in North America versus 16 million at the end of 2016. The difference in the paid subscribers and net additions over the last five years demonstrates the issues that Morningstar believes Pandora faces in competing in a very crowded market. Pandora likely claims only a bit more than 1% of the total global streaming market by subscribers.

Podcasting Could Turn Into an Expensive Misadventure for Pandora

In an attempt to differentiate its service, Pandora has made a number of investments in content and technology. These included the 2020 purchases of Stitcher, a company focused on creating, distributing, and monetizing podcasts, for $266 million and Simplecast, a firm that offer hosting, distribution, and analytics to podcasters, for $28 million. Pandora also owns AdsWizz, a digital audio advertising platform that focuses on placing ads across music and podcasting platforms. Many of the podcasts hosted by Pandora are available to SiriusXM subscribers and vice versa. The focus on generating advertising revenue from non-music listening has started to bear fruit as Morningstar estimates that Pandora generated over $350 million in non-music advertising in 2021, up sharply from around $50 million in 2019.

However, the podcasting market is becoming increasingly competitive with multiple media and technology firms entering the space and spending significant money. Spotify is one of the most prominent players and has signed a number of major podcasts, including Joe Rogan for a reported $200 million over five years. Spotify has also acquired a number of podcast firms, including two podcast marketing and ad attribution companies in 2022.

The two largest radio station owners in the U.S.—iHeartMedia and Audacy (the fruit of the Entercom/CBS Radio merger)—both operate large podcasting platforms, as well. Multiple media firms including the New York Times, Vox Media, ESPN Radio, and NPR, create and host podcasts. Amazon jumped into the space in 2020 by acquiring Wondery, a podcast network, under its Amazon Music service and made numerous deals to obtain exclusive or early access to shows. HBO Max launched its own podcasts in 2021 that are only available within the service. YouTube has recently begun to offer money to specific podcast shows and networks to film shows and put on them on the service.

One of biggest potential podcast players, Apple, is deeply involved in the space but in a non-exclusive manner. Apple Podcasts is one of the largest and most popular apps for listening to podcasts. The service offers access to both free and subscription podcasts but doesn't offer any exclusive content or ad placement. Apple provides marketing and measurement tools to help with monetization, and it added in-app subscription options in 2021. Morningstar thinks that Apple could easily increase its involvement in the market due to the popularity of the app and to better compete with the increasing number of Apple Music competitors like Spotify, Pandora, and Tidal that are using podcasts to differentiate their service. Given the firm's staggeringly deep pockets, Apple could buy the tech and people required to move deeper into podcast advertising and create a ton of exclusive content. However, Apple appears comfortable with its current level of involvement and may not see the need to jump into a relatively small market (estimated to hit $1.3 billion in 2021 in the U.S. by the IAB U.S. Podcast Advertising Revenue) for a company that generated revenue of almost $386 billion in fiscal 2021.

Even without Apple jumping fully into podcasting, Pandora and SiriusXM are both facing a very large amount of competition in the U.S. Additionally, firms like Spotify are attempting to place podcasts behind subscription walls. While this tactic may work for established shows, podcasts based on well-known content like Marvel, or ones hosted by celebrities, Morningstar thinks many newer shows will have a harder time gaining an audience. Additionally, placing shows behind a paywall automatically lowers the size of the potential audience and thus the advertising opportunity. Although certain podcast libraries may have some longer-term value, particularly with the advent of dynamic ad insertion, Morningstar believes that many podcasts will have a limited shelf life similar to unscripted filmed content. As a result, the investment in podcasting by Pandora is unlikely to help the service differentiate and compete with peers like Spotify. While the investment in podcast can help SiriusXM, Morningstar doesn't believe that the increased investment in podcasting will generate significant top-line growth or spark subscriber growth.

Sirius XM's Cost Advantage Drives Its Narrow Moat

As discussed above, Sirius XM like any another business that uses music to generate revenue must pay out recording royalties. Modern music generally contains two copyrights: the first covers the sound recording itself (known as the master) with royalties paid to record labels, publishers, artists, and songwriters. The second covers the underlying composition (musical composition or publishing rights) that includes the lyrics and the musical composition, with a publishing royalty paid to the recording artist, songwriter, publishing house, and any other copyright holders. The person or persons who are compensated depends on the distribution platform and the copyright law.

For SiriusXM, Pandora, and any of their streaming competitors in the U.S., content cost, especially music royalties, represents one of the largest expense categories, if not the largest one. In terms of master or sound recording royalties, as a satellite radio broadcaster, the SiriusXM satellite service pays a fixed 15.5% of its gross revenue to sound recording copyright holders. This rate was set by the Copyright Royalty Board in 2018 and will be held at this level until 2027 as a result of the passage of the Music Modernization Act in 2018. Pandora and other streaming rivals generally pay either on a consumption basis or as a percentage of revenue.

On the publishing side, SiriusXM and Pandora along with platforms as disparate as Spotify and terrestrial radio all pay performance royalties to musical composition copyright holders. Spotify, the on-demand version of Pandora, and most streaming music platforms must also license reproduction or mechanical rights to offer interactive features like songs on demand. These rates and other musical composition rights are negotiated with the performing rights organizations (PROs) for respective countries, which in the U.S. includes Broadcast Music, Inc. (BMI), American Society of Composers, Authors and Publishers (ASCAP), SESAC, and SoundExchange. SiriusXM generally pays fixed installments over the term of its agreements with PROs, while Pandora makes variable payments based on usage and ownership of a royalty pool.

While the SiriusXM satellite service faces a number of additional costs that the streaming platforms do not (including a revenue share with car manufacturers), the segment has generated a gross margin above 60% over the last five years, well above the average gross margin of Pandora (34%) and Spotify (25%) during the same period.

Drilling into the components of cost of revenue for these three services illuminates the cost advantage moat source at SiriusXM. SiriusXM and Pandora break out cost of services into four categories, including "revenue share and royalties." For SiriusXM, this category includes the royalties paid to both sound recording and composition copyright holders as well as the revenue share agreements with certain automakers and talent on non-music networks such as Howard Stern. As a result of the fixed sound recording royalty rates and its fixed installment agreements with PROs, SiriusXM pays out a lower percentage of its revenue in music royalties than its on-demand streaming competitors. This level of payment does not directly corollate to usage by listeners. As shown in Exhibit 12, revenue share and royalties expense for SiriusXM has averaged 25.2% of estimated gross revenue over the last three years. Gross revenue is defined as advertising revenue combined with subscriber revenue excluding connected vehicle services revenue.

At Pandora, the revenue share and royalties category includes all royalty costs and payments to third-party ad servers as well as payments to podcasting talent. Pandora has signed direct license agreements with most major and independent record labels that cover the majority of songs streamed on the service. Depending on the agreement, Pandora pays sound recording royalties on either a per-performance fee, based on the number of streams, or a percentage of revenue. In certain agreements, Pandora has consented to pay minimum amounts per subscriber.

While Spotify does not offer further detail into its cost of revenue, the category is likely dominated by royalty payments. The other pieces it puts in this category include payment processing fees, customer service, specific employee compensation, cloud computing, streaming, and facility and equipment costs. A growing piece of the category is the amortization of podcast content assets. Even with this growth, Morningstar expects that a significant majority of the cost of revenue remains music royalties. The other major difference with SiriusXM and Pandora is that Spotify is available in over 180 countries while the other two are U.S.-only, which means that Spotify's royalty structure is considerably more complex with numerous different types of agreements in many countries and regions, creating complex payment calculations.

Even with these caveats around comparability, the cost advantage enjoyed by SiriusXM over its streaming rivals is significant (Exhibit 13). Revenue share and royalties as percentage of revenue for Sirius XM has only increased to 23.1% in 2021 from 22.1% in 2016 despite the sharp rise in the sound recording royalty rate in 2018 to 15.5% of gross revenue from 11% previously. Spotify continues to diversify its platform away from music toward podcasts, which has helped to drive cost of revenue down from 86.4% in 2016 to 73.2% in 2021. However, Morningstar expects that a large part of the margin expansion potential from this shift has occurred and that cost of revenue will only fall to 67% of revenue by 2031.

As discussed above, SiriusXM charges its customers a music royalty fee on most of its plans with music channels. This fee is intended to cover all the royalty fees paid by the firm, not just the sound recording fee. The fee can range from $0.44 to $7.49 per month. In response to a higher sound recording royalty rate in 2018, the service increased its own U.S. music royalty fee to 19.1% from 13.9% on most of its plans that offer music channels. While the increased rate could have driven up churn, there doesn't appear to have been any long-term lasting effects (Exhibit 6). SiriusXM treats the fee as an additional charge and keeps it separate from the base price of its plans, obscuring the charge in the same way that pay-television providers have in recent years with regional sports network or broadcast network fees.

In contrast, the streaming music platforms tend to have very simple plans with slight discounts for families or students. Spotify has been in subscriber acquisition mode for the majority of its lifespan thus far and raised prices in the U.S. for the first time in 2021—and then only on its family plan. The premium plan in the U.S. has been priced $9.99 per month since launching in 2011. As a result, Spotify has yet to post positive net income (though Morningstar does expect that to change in 2022). Similarly, Pandora reported net losses in every year prior to being acquired by Sirius XM in 2019. Neither service nor any of their competitors in the U.S. to Morningstar's knowledge, have ever even attempted to pass on content costs to their customers.

The U.S. music royalty fee increase is one of the reasons that revenue share and royalties expense as a percentage of revenue has and will likely remain relatively steady at SiriusXM in the coming years. The passage of the Music Modernization Act in 2018 by the U.S. government set the royalty rate for SiriusXM at 15.5% of gross revenue (subscriber and advertising revenue) from 2018 to 2027. While a sharp rise from the previous 11% rate, the firm still enjoys a cost advantage over its streaming rivals.

Sirius XM Offers Attractive Value as Auto Inventory NormalizesEdit

The pandemic, worries about auto inventory, and the relatively weak guidance for 2022 have left Sirius XM's share price down over 15% from its prepandemic 2020 high closing price of $7.34. Morningstar's $8.25 fair value estimate implies a price/fair value around 0.75 and a 4-star rating. Morningstar's newer fair value estimate reflects the adoption of the Morningstar projections for new light-vehicle sales over the next five years. Overall, Morningstar projects revenue will grow by 5.6% on average over the next five years and the operating margin will improve to 28.3% in 2026 from 23.4% in 2021.

Our model now includes more granular estimates for gross additions based on Morningstar's new light-vehicle sales projections along with Morningstar's estimates for used light-vehicle sales. While the new light-vehicle sales estimates assume that sales volumes return to prepandemic levels in 2023, Morningstar projects that the used market will take until 2024 to return to 2019 levels due in part to used vehicle pricing remaining elevated in 2022 and lower potential inventory from both fewer leases and an increase in lessees buying out leased cars due to constrained supply Morningstar expects the average annual volume over 2024-26 to be roughly equal to the volume from 2017-19.

Morningstar projects that SiriusXM will continue to slowly improve its penetration in both the new and used markets over the next five years, hitting 84% for new vehicles in 2026, up from 81% in 2021, and 54% in used market by 2026 versus 51% in 2021. Some of the improvement in new vehicle penetration will come from the firm's push to have its radios placed in lower-priced cars. Additionally, the ongoing rollout of the 360L platform that combines satellite radio with internet streaming should also tempt manufacturers to add SiriusXM to more models.

This growth in penetration will, in Morningstar's view, help offset an ongoing slow decline in trial conversion rates, which Morningstar forecasts will fall to 34% in 2026 for new vehicles from 37% in 2021 and 23% for used ones from 26% in 2021. Owners of lower-priced vehicles will likely be slightly more price sensitive than owners of higher-priced cars. An additional factor that will lower penetration rates is the increasing number of younger owners who likely already pay for a music streaming service and may not perceive a need for another audio offering. Morningstar does expect the firm to continue to add more streaming-only and aftermarket conversion customers over the next five years. However, Morningstar doesn't expect that SiriusXM will meaningfully push either offer, making the total gross adds from these channels relatively small.

Summing Morningstar's expectations across channels, Morningstar now expects the firm to add almost 1.9 million more gross new customers over the next five years than in Morningstar's previous projection (Exhibit 12). While these additional adds are spread out over the next five years, the improvement is back-weighted with Morningstar's estimates for 2022 showing the least change.

While churn has fallen by 20 basis points over the last five years, Morningstar expects that management will be willing to trade off further churn improvements for higher average revenue per user over the next five years, resulting in flat churn of 1.6% over the projection period. Coupled with Morningstar's new gross projections, Morningstar now expects SiriusXM to add 4.9 million net new subscribers over the next five years, up versus 4.4 million in Morningstar's previous model. However, Morningstar's higher new projection remains well below the 6.1 million net new additions that occurred over the previous five years. When combined with modest 3% growth in subscriber ARPU over the next five years, Morningstar estimates that SiriusXM revenue will expand 6% on average to hit $8.9 billion in 2026.

On the gross margin side, Morningstar is only projecting a slight improvement to 62.2% from 60.8% in 2021. The largest component of cost of revenue for the satellite radio remains the revenue share and royalties expense that has averaged 25.2% of estimated gross revenue over the last three years. Gross revenue is defined as advertising revenue combined with subscriber revenue excluding connected vehicle services revenue. Morningstar expects that the firm is unable to gain leverage on this category over the next five years as its sound recording royalty rate is set at 15.5% through 2027, and the service pays fixed percentages for publishing royalties and on its revenue share agreement. SiriusXM should be more successful in gaining leverage on its direct programming and content costs and billing expenses.

For Pandora, Morningstar expects total revenue will grow by 4% annually over the next five years to $2.6 billion in 2026. Advertising will continue to generate the vast majority of revenue as the service will likely continue to lag its much larger subscription peers on customer acquisition. Morningstar projects that advertising will expand by 4% annually and will represent 75% of Pandora's revenue in 2026, slightly above the 74% in 2021. The revenue improvement will be driven by average annual advertising revenue per thousand impression (RPM) growth of 7% as Pandora attracts more advertisers to both music and podcast content. Additionally, the AdsWizz service should help spark growth with improved digital ad insertion and cross-digital platform advertising campaigns. This growth will be partially offset by an ongoing decline in ad-supported listening hours, which Morningstar expects will drop from 11.6 billion in 2021 to just under 10 billion in 2026. The 10 billion listening hours in 2026 would be less than 50% of the 21 billion hours listened to in 2015 on the service.

Subscriber revenue will expand slightly slower at 3% as the on-demand service remains an also-ran in a very competitive U.S. market headlined by Spotify, Apple Music, and Amazon Music. While Pandora is adding more podcasts to its service, Morningstar doesn't believe that those additions will be enough to differentiate the service, particularly from its much larger peers. As a result, Morningstar projects that the service will only add 145,000 net new subscribers annually over the next five years and will end 2026 with just over 6.9 million paying subscribers, well behind the Morningstar estimate of 82 million Spotify Premium subscribers in North America. Average revenue growth per subscriber will expand by only 1% on average over the projection period as Morningstar expects management will need to remain lower cost than the larger peers to attract subscribers. Morningstar expects that Pandora's gross margin will remain around 36% over the next five years as non-music content costs will continue to rise and offset the leverage that the service will get on its music costs.

Examining What Might Happen If It All Goes Right or WrongEdit

Our fair value estimate of $8.25 represents what Morningstar believes to be the most likely outcome for Sirius XM given Morningstar's current outlook for U.S. auto sales and the firm's current strategy. To help frame Morningstar's current outlook, Morningstar has created two distinct scenarios separate from Morningstar's traditional bull and bear cases. These two cases will examine what could happen if it all goes right or wrong for Sirius XM. In both cases, Morningstar will maintain the same U.S. light-vehicle projections and change factors that the firm has greater control over. As shown below, the two scenarios generate fair value estimates of $12 for "all right" and $3.75 for "all wrong."

Everything Is "All Right"

In Morningstar's "all right" scenario, the firm emerges from the lower auto supply issues of 2022 with a raft of new agreements with both manufacturers and auto dealers that drive a faster rate of improvement in penetration in both the new and used markets, reaching 90% for new cars and 60% for used ones in 2026. By crafting a deeper product offering with further Pandora integration for both music and podcasts, SiriusXM arrests the decline in conversion rates and improves both rates back to 2016 levels of 40% and 32%, respectively, in 2026. As a result, projected net adds over the next five years for the satellite radio service jumps to 10.4 million, more than double Morningstar's new estimate, and the self-pay subscriber base increased by 32% to over 42.4 million.

This more integrated offering lets SiriusXM raise pricing and drive faster subscriber ARPU growth of 5%, resulting in 10% revenue growth up sharply from 4% in Morningstar's base case. Gross margin for the segment would only expand slightly faster to 63.1% in 2026 versus 62.2% in Morningstar's base case as the majority of the cost of revenue is paid out as a percentage of revenue in royalties and revenue share. However, the segment would generate about $1.6 billion more in gross profit over the five-year projection period under this scenario.

For Pandora, the addition of more podcasts and content from SiriusXM helps to reverse the decline in listening hours that grow by 3% a year to hit 13.4 billion hours in 2026, the same level as 2019. Due to the growth in listening hours, ad RPM growth averages 11% growth over the next five years. As a result, ad-supported listener revenue jumps 14% per year to $2.3 billion in 2026, 58% above Morningstar's base case. The additional content attracts more subscribers, leading to total net adds of 3.7 million, a paid subscriber base of 9.7 million in 2026, and 12% subscriber revenue growth. Overall revenue for Pandora will expand by 12% annually and reach $3.7 billion in 2026. Unlike SiriusXM, Pandora will be able gain additional leverage on its royalty expenses that allow the segment to improve gross margin to 45.5% in 2026, well ahead of Morningstar's 36% base-case scenario.

The increased growth and margin improvement at both segments would create 10.6% average revenue growth and 32.5% operating margin in 2026. In contrast, Morningstar's base-case revenue growth is 5.6% on average and the operating margin only hits 28.3% in 2026. This combination generates a fair value estimate of $12.

Everything That Could Went "All Wrong"

Under Morningstar's "all wrong" scenario, Morningstar assumes that new and used car penetration do not improve but hold steady at the 2021 levels. However, conversion rates drop faster to 30% for new light vehicles and 20% for used ones in 2026 as younger buyers see less of a need to pay for another music service. This leads gross adds to drop to just under 34 million in total for the next five years versus 37.6 million in Morningstar's base case. The rise of music streaming also negatively impacts churn which rises back to 1.8% in 2026, equal to 2017. As a result, the firm only adds 500,000 net self-pay subscribers over the next five years and actually loses net subscribers in 2025 and 2026. In order to offset churn and a smaller funnel, management holds off on price increases and offers more discounts, leading to 2026 ARPU falling just short of the 2021 levels. This leads to average top-line growth of only 1% for satellite radio.

On the gross margin, Morningstar assumes a contraction as the largest component remains at a fixed percentage of revenue. The firm will continue to spend on non-music programming, including sports rights that have a fixed dollar amount. As a result, gross margin declines to 59.9% in 2026 versus 62.2% in Morningstar's base case. Total gross profit over the projection period would be roughly $3.4 billion less than the base case.

For Pandora, the service continues to lose ground against the larger music streaming services on both the ad-supported and subscriber sides. Ad-supported listening hours will fall by 7% a year to 8.0 billion in 2026, well below the 9.9 billion hours in Morningstar's base case. Ad RPM will fall by 4% on average as the firm finds it harder to hold pricing as listening hours drop off. Advertising revenue falls 10% annually to $686 million in 2026, 42% below 2021 and over 50% below Morningstar's base case. Due to an inferior offering, the subscriber side loses 750,000 net customers and ARPU remains flat as management tries to compete on price, leading to an average decline of 1% for subscriber revenue. Pandora's top line falls by 5% on average and the gross margin falls 27.1% as content costs do not contract as fast as revenue.

Total revenue under Morningstar's "all wrong" scenario remains roughly flat over the next five years but the operating margin shrinks to 21.7%, leading to a fair value estimate of $3.75.