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The Safest Way to Buy Sirius XM Stock May Not Be the Best Way

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Billionaire John Malone likes Sirius XM (NASDAQ: SIRI) satellite radio so much that he bought the company -- or at least most of it. Malone's Liberty Media Corporation (which he chairs) owns 68.8% of Sirius XM stock, according to data from S&P Global Market Intelligence. Over time, it's likely that Liberty Media will come to own all of Sirius stock.

Before that happens, Deutsche Bank thinks that you should buy Sirius XM stock for yourself. Here's what you need to know.

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Image source: Getty Images.

An early fan of Sirius XM (tracking stock)

We first wrote about Deutsche Bank's enthusiasm for Sirius XM back in 2016, when the German banker announced a new buy rating for Liberty Media's tracking stock representing its 68.8% interest in Sirius. Back then, Deutsche favored investing in Liberty SiriusXM (NASDAQ: LSXMA) (NASDAQ: LSXMB) (NASDAQ: LSXMK) as a way to buy an interest in Sirius XM on the cheap, and profit as Liberty Media steadily increased its stake in the company that's its primary asset.

As an investment thesis, that's worked out pretty well. Over the past 20 months, Liberty SiriusXM has upped its ownership stake in Sirius by nearly 5%, and is well on its way to the "80%+ ownership" that Deutsche predicted back in 2016. Liberty SiriusXM shares, trading for about $32 at the time of Deutsche's initial endorsement, sell for more than $41 today -- a 28.5% profit.

An even bigger fan today

But Deutsche Bank doesn't think this growth story is played out yet. To the contrary, this morning, StreetInsider.com reports that Deutsche has announced twin upgrades (requires subscription) on both Sirius XM stock and on Liberty SiriusXM tracking stock as well. The latter upgrade hinges on the former, though, so let's tackle that one first:

Deutsche Bank says it remains "constructive" on Sirius XM, and believes things are going so well with the "core business" that Sirius is set to beat and raise guidance throughout 2018. The analyst sees opportunities for Sirius to grow its business in "connected vehicle[s]," through partnerships with "mobile service providers," and through "[l]everaging" its investment in Pandora to capture more revenue from advertising-supported free internet radio. Deutsche also lays out a merger and acquisition scenario that could benefit the shares.

In 2016, Deutsche postulated that Liberty SiriusXM was planning to increase its stake in Sirius XM to 80% or more. Now, the analyst believes it may end up owning much more. Examining Sirius' pattern of buybacks, Deutsche believes that by 2023, Sirius' outstanding share count may have shrunk so much that the shares Liberty SiriusXM already owns will account for 94% of Sirius' total equity.

At that point, one wonders if Liberty SiriusXM might just go ahead and buy out all the rest at a nominal premium to the shares' market value. It's also reasonable to speculate that by simplifying the ownership structure of Sirius, merging it 100% into Liberty SiriusXM, the then easier-to-understand stock will look more attractive to investors, and Liberty SiriusXM shares would rise in value.

"Simplify, simplify..."

Which brings us to the subject of Liberty SiriusXM's own stock. Valued at $13.9 billion, Liberty SiriusXM has a market capitalization only 55% that of Sirius XM proper -- yet Liberty SiriusXM owns nearly 70% of Sirius' stock. It's hard to know precisely why investors impose this discount on Liberty SiriusXM. Possibly, investors simply see Sirius XM as the "safer" way to invest in Sirius. It's certainly the most straightforward.

There may also be a bias against owning tracking stocks at work here -- a investor preference for owning shares in the actual company investors want to own, rather than a vicarious interest in it. (Then again, what is every S&P 500 ETF that you've ever heard of but a tracking stock for hundreds of companies at a time?)

In any case, the closer Liberty SiriusXM gets to 100% ownership of Sirius XM, the more these arguments against Liberty SiriusXM go away, and the more likely that Liberty SiriusXM shares will rise to reflect the true value of their main underlying asset -- on top of any growth that Sirius XM's own business enjoys.

As for what that value is: Given that analysts currently expect 22% annualized earnings growth from Sirius XM, and that its stock sells for only 16.4 times free cash flow, Sirius XM shares themselves already look attractively priced. The opportunity to buy them at an even steeper discount -- via buying the Liberty SiriusXM tracking stock -- makes that option even more attractive. I think Deutsche Bank is right to recommend Sirius XM stock...

...and even more right to recommend Liberty SiriusXM.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.