Kraft actually wrote three related notes this morning, one each on XM, Sirius and Clear Channel.
For starters, he upgraded his rating on XM to outperform from neutral, asserting that expectations for the companyy have been reset to achievable levels, giving the stock an attractive risk/reward ratio. The biggest issues for the stock this year, he writes, have been high costs per gross subscriber addition; declining conversion rates in the last three quarters of 2005 (the rate at which consumers with XM equipped cars sign up to pay for the service); a weak position in retail, with Sirius winning more business; and XM management too optimistic on the outlook for reatil industry gross subscriber additions.
But he now says all of those have turned around. Gross subscriber acquisition costs have come down. The conversion rate has stabilize. Guidance on retail gross adds is now “realistic,” he says. And the stock price makes it clear that the market does not expect XM to regain ground against Sirius, he says.
While the second and third quarters were weak at retail for both satellite radio companies, Kraft sees a stronger fourth quarter, driven in part by declining gasoline prices, increasing square footage devoted to satellite radio in retail stores, and the launch of Oprah Winfrey’s channel on XM this month.
He maintains a $17 price target on XM.
Meanwhile, Kraft also repeated an Outperform rating on Sirius, but nonetheless cut projected third quarter subscriber net additions to 450,000 from 536,000, to reflect production cuts at Ford and Chrysler, the company’s largest partners in the auto market.
OK, so now on to merger-mongering. Kraft theorizes that a merger of XM and Sirius could offer huge synergies for both companies - he figures that the net present value of merger synergies would exceed $12 billion. In short, he thinks it would benefit the shares of both the buyer - which he figures would be Sirius - and the seller. On the other hand, he examines and rejects the notion of a Clear Channel (CCU-OLD) acquisition of XM, since it would be highly dilutive to Clear Channel’s earnings under almost any theory on how to finance the transaction; even if you assume the deal is financed in part by selling Clear Channel’s TV stations, he says, along with debt financing, such a deal would be dilutive to free cash flow for three years, and to earnings for two years.
Kraft concludes that “an XM/Sirius merger would make the most strategic and financial sense for XM shareholders.”
This morning, XM is up $1.26 at $13.77; Sirius is up 13 cents at $4.16; and Clear Channel is down 19 cents at $29.44.