Satellite Radio 2Q07 Preview
The Next Two Months Are Pivotal for the XM/Sirius Merger Hopes — But Chance of Approval Is Still <40% – We Remain Neutral on Both Stocks
Our D.C. contacts believe that XM and Sirius’ recent lobbying campaign has been effective – but several hurdles to regulatory approval remain.
Karmazin has won support from a number of minority & public interest groups through concessions, building momentum for the merger. However, our contacts also believe that there is still only a 35% chance of FCC approval, up from less than 30% a few months ago. And they believe that for Karmazin to increase the percentage, he will need to clearly delineate concessions (reducing potential synergy value) that he is willing to make. BUT, it appears that there are simply too many opportunities for the approval process to be delayed or “left for dead.”
Watch the clock & the September 10 date, as there are two key hurdles that could stop the clock and essentially “kill” the merger – but the chance of approval increases to above 50% if the clock doesn’t stop by that date, according to our contacts.
The FCC issued the “starting clock” public notice on 6/8/07, and the 180-day timeline calls for a decision around 12/8/07 — though this is NOT a strict deadline. There are two potential procedural hurdles between now and September 10 that could push timing into ’08, diminishing hopes of any resolution prior to the upcoming elections.
The comment period on the NPRM addressing the prohibition of a single entity holding both SDARS licenses could be extended.
The NPRM is not itself a clock-stopping event. HOWEVER, there is the possibility that some party asks for and receives an extension to file comments after the 8/13/07 deadline. Our D.C. contacts note that such requests are regularly granted. Given the strong opposition to the merger, an extension request is likely.
The FCC could seek additional information from XM and Sirius.
XM and Sirius’ reply comments are due 7/24/07. If the FCC determines that XM and Sirius have not submitted sufficient information on which the FCC can make a decision, they can stop the clock and seek additional information from the merging parties.
The merger could fall victim to politics even if procedural hurdles are cleared.
Given the potential political firestorm surrounding the 700 MHz auction and other agenda items (e.g., media ownership rules), the Chairman might want to avoid any political fallout from allowing the XM/Sirius merger to pass.
We expect both companies to top 2Q07 sub estimates.
We believe that XM will easily top the Street consensus estimate of 310K net sub adds and also beat our 345K estimate slightly. We expect that Sirius will easily top our 441K net sub add estimate and could beat the Street consensus estimate of 470K by as much as 25K. XM and Sirius will report 2Q07 results on July 26 and July 31 respectively.
We remain neutral on XMSR and SIRI as the current stock prices seem to suggest that the probability of regulatory approval for the merger is roughly 45-50% — up about 10 percentage points from 3 months ago and much more optimistic than the assessment of our D.C. contacts.
If the merger fails, we prefer XM over Sirius as XM’s relationships essentially guarantee it a 60% share of the OEM subscriber market over the next several years.
Audience erosion will continue to cap top-line growth for terrestrial radio over the next decade, whether radio “goes Google” or not
Portfolio Managers’ Summary
Our 12-month thesis on the sector.
‘07 will be the transition year from a retail-driven model to an OEM-driven subscriber model. Going forward, we expect OEM gross adds to be greater than retail gross adds in every quarter — including the traditionally retail-heavy fourth quarter. We expect new cars with factory-installed radios to account for 60% of new subscribers in ‘07 (or 4.9M new activations), up from 48% in ‘06 (or 3.6M new activations) and 39% in ‘05 (or 2.6M new activations).
Our call today in a nutshell.
We maintain our neutral ratings on SIRI and XMSR but feel that XM is better positioned if the deal doesn’t pass the regulatory tests. XM’s stronger OEM position essentially ensures that XM’s OEM gross add share will be 60% over the next several years. We estimate that the OEM channel will account for 60% of new subs in ‘07 and average 70% of new subs from ‘08-’10. Sirius has been and continues to be more aggressive in the retail channel, but we believe that XM’s OEM advantage will leave it the larger company if the merger doesn’t occur.
Risks to our call.
Subs accelerate, churn rates improve, or merger is swiftly approved
Cowen also issued a report on Sirius yesterday. Yet another analyst seeing increased odds in merger approval. Excerpts below:
Negative M&A Tenor Reversing.
Ever since the FCC comment period opened on June 8, sentiment for XM.s merger with SIRI has shifted from negative to positive with more than 3,500 diverse supporters contacting the FCC. We believe the merger stands a 50% or better chance.
High Operating Leverage Should Drive FCF Even w/o a Merger:
Incremental margins for Pre-SAC Cash Flow were 42% for SIRI in 2006. We project increasing margins of 47% in 2008, and approaching mid-60s through 2012. We expect significant cash flow potential once SIRI turns cash positive in 2008, likely ahead of XMSR.
2007 Guidance Low.
We believe both XMSR and SIRI set sub guidance low for FY07, setting the stage for outperformance in H2 as subs ramp from new OEM programs and seasonality.
Gaining Market Share. We expect 465K Q2 net adds, down from 600K in Q2:06. This compares to XMSR.s 297K net adds in Q2:07. For FY07, we expect 2.2MM net adds vs. 1.4MM for XMSR. We expect market share to reverse in 2008 as XM.s larger OEM base ramps up installs.
SIRI trades at $677 per 2007E sub and $539 per 2008E sub.. These values compare to XMSR.s $545 per 2007E sub, and $447 per 2008E sub . a 24% and 20% difference. Our DCF analysis implies 74% outperformance relative to the market over the next 12 months.
We maintain our Outperform rating on SIRI even without M&A potential with XMSR. We believe SIRI can outperform based on its FCF potential alone. Compared to XMSR, we prefer XMSR based on its stronger OEM relationships (60+% market share) and better relative value . 47% of industry enterprise value, vs. 53% for SIRI.