XMSR: Thesis For A Controversial Investment

XM Satellite Radio is a controversial investment, and should be looked at in conjunction with Sirius Satellite Radio. The stock has bounced around, hitting a high of around $40 in early 2005, and has dropped to the current $10 and change. Is the future really that bleak?

I started buying in January of 2007, and built up a rather large position by opportunistically grabbing shares below $12. There is no magic formula to that price point, just that the stock has traded between $10 and $12 when sentiment was at its lowest point. It peaked this year at around $16 when investors got excited about the pending merger with Sirius.XMSR and SIRI are two highly speculative investments, and are suitable for only portfolios that can withstand volatility and potential loss.XM has two points of controversy:

First, they have agreed to merge with Sirius Satellite Radio into a single radio company, where Sirius would be the surviving entity (and surviving management team). This is controversial because there are only two satellite radio companies in existence in the US, and therefore the merger would result in only a single satellite radio company. According so some, this would create a monopoly, and thus has resulted in intense scrutiny by the Department of Justice [DOJ] and the Federal Communications Commission [FCC].

There are additional legal obstacles, not the least of which is that the companies agreed not to merge when they were awarded the radio licenses ten years ago. They also agreed, incidentally, not to offer local radio content, like traffic reports and weather reports.

When the merger was announced in early 2007, very few observers gave it a chance. Nobody thought that the DOJ and the FCC would ever allow such a merger. It turns out, however, that the DOJ and the FCC may actually approve it. What was not factored in when people didn't give it a chance was the fact that nobody really believes that the merger would create a monopoly radio company.

There are actually other radio companies out there providing a substantially identical product - I know that might come as a shock certain politicians, but it is true. Combined, the two companies have only 7% penetration of the automobile market, and listening market share (the percentage of time listeners actually listen to their satellite radio, as opposed to other formats) is less.

Then there is the iPod, and the prospect for wireless phone companies to join the market for delivering audio content. Thus, there is absolutely no economic reason to oppose the merger.Guess who the biggest opponents of the merger are? The FM radio broadcasters. The National Association of Broadcasters [NAB] is the lobby group for FM radio broadcasters, and they have spent millions in Washington lobbying against the merger.

But if the combined, XM and Sirius would create a monopoly, why would the NAB care? Satellite radio is the first direct competitive threat to FM radio in 30 years, and has forced the FM broadcasters to introduce an innovation for the first time in their history - HD radio. However, HD radio will cost the broadcasters extra, will at best only slow the defection of listeners, and provide no extra advertising revenue. They will be forced to innovate further to remain competitive.

By hobbling their competition in Washington, FM radio hopes to protect their market share from the extra competition. The big question mark is: Will the FCC and the DOJ see the light? It was believed that they would approve the merger by year-end 2007, but that date has come and gone without a decision. I don't know the answer to that question with certainty, but I personally believe the merger will be approved.

In my reasoning, the longer the decision takes, the higher the probability of approval. A negative decision would have been easy - politically and timewise - and probably would have come by last summer. A positive decision requires time to write new regulations, negotiate with lawyers and legislators, and basically cover the regulators' little hineys. FCC Chairman Martin has indicated that he hopes to have the merger decision wrapped up by the end of the first quarter of 2008.

The second point of controversy is the future of satellite radio itself. This controversy stems from the fact that the two companies continue to report losses and subscriber growth has slowed. Analysts have pointed to the iPod as the innovation that will kill both FM radio and satellite radio. I admit that I think that these are very real problems, but I think that the analysts come down with a case of hyperbole.I'll take each objection in part.

Subscriber growth: Both companies got their start by focusing on retail aftermarket sales. That is, you could buy a satellite radio by going to Best Buy and have it installed in your car. Most cars built before 2009 do not have a satellite radio pre-installed in the dash. However, XM has started the trend of striking deals with automakers to have the radios pre-installed in new cars rolling off the lot, usually with a promotional subscription period of 3-12 months (which the automakers actually paid for).

Therefore, XM was the first to shift marketing dollars away from retail towards OEM. Their conversion rate - the rate at which buyers of new cars convert to paid subscribers after the promotion period ends - currently stands at around 52.5% average (conversion rates vary significantly from car dealer to car dealer). Sirius over the past year has taken the bulk of new retail subscribers, but has deals with only a third of the OEM carmakers (with XM mostly dealing with the balance).

Retail electronic sales are notoriously fickle. Dollars chase the latest hot thing, currently the iPod. Dollars also chase what the retailers are promoting, which is what they are paid to promote by the vendors: if you see a big display for an iPod, you can bet that Apple is paid top dollar for it. You can find the satellite radio stand at Best Buy, but you have to look hard for it. That is because the sat radio providers aren't paying Best Buy very much to promote their product.

With the economy going into recession, retail sales slowed considerably in the fourth quarter, Thus, the retail sales of satellite radios has slowed down. Yet, OEM sales have yet to fully ramp. There is a lag of one to two years after a deal is struck before the radios are actually put into the manufacturing line. Car sales have slowed down due to the economy. Therefore, subscriber growth has entered a 1 to 3 year lull.

I am forecasting growth to slow again in 2008 from 3.7 million net subscriber additions in 2007 to 3.0 million. It won't re-accelerate until 2009 or 2010, depending on the economy. It is also possible that the merger integration will result in a slowing of growth initially as they focus their efforts on delivering service to existing subscribers.After that, subscriber additions will vary according to automobile and other vehicle sales. Vehicle sales in the US typically vary from 14 million to 16 million, or about 6.5% to 7.5% turnover of all automobiles, trucks, boats, and RVs on the road (around 250 million, growing at about 1-2% per year).

With a very conservative conversion rate estimate of 40% (well below the current experience of 52%), that results in a trendline subscriber addition estimate of 5.5 million to 6.5 million, edging upward over time. Modify that by deactivations and cancellations plus other types of subscriptions, and I get conservative net subscriber addition rate of 5 million per year, plus or minus depending on the economy. That gives me 25% penetration and 80 million subscribers in ten years, continuing to grow at 10-12% per after that.

Of note, an irony about the move to OEM radio sales: buyers of cars don't have a choice between satellite radio providers, unless they choose the model of their car based on the radio installed. The car manufacturers don't give consumers the choice between XM and Sirius. Thus, the merger will change virtually nothing in terms of consumer choice.

The iPod - radio killer?

Is the iPod the radio killer? It certainly is very popular right now. But consider this - to listen to one song on the iPod, you pay $1. So for $10, you get 10 songs (there is some free content for the iPod, too). The average price subscribers pay for satellite radio is $10 per month ($13 for the first radio, $7 for each subsequent radio). For $10 a month, then, you get virtually unlimited music plus additional content like comedy, sports, talk shows, and news.

The only catch is that you don't get to customize your playlist the way you do for an iPod. But then, you also don't need to spend the time to find, download, and organize your playlists, either. If you are not a teenager, chances are that you are time-constrained. Tapes and CD players have been around for 30 years, and FM radio lives on.

Indeed, the existence of CD's and radio is symbiotic as well as competitive. You hear a song you like on the radio, then you buy the CD. iPod playlists exist partly because people don't like what they hear on the radio (ads, significant repetition). If radio content improves, they will be less likely to spend money on alternative formats. I also expect that satellite radio to improve their customization features, especially once the merger gets approved (why invest in manufacturing new radio models prior to the merger?).Generally, I think there is room for both the iPod and satellite radio, and FM radio if they get their act together.But they're losing money!

Yes, both satellite radio providers are losing money. A lot of it. That is why the stocks are so volatile now - few investors know how to value them. However, satellite radio is a (mostly) fixed cost business model. That is, they put the satellites in orbit, they buy the repeaters, they pay for content, they pay for overhead. Most of their expenses are unrelated to the volume of revenues they receive. As they add new subscribers, their profitability will improve disproportionately.

Estimating their profitability in ten years is entirely speculative. However, there are some facts that we do know. First, from 2006 to 2007, the incremental profit margin (the profits added divided by the revenues added) was about 60%. That is, for each new dollar of revenue added, they added $0.60 of profit. Incremental profits will fluctuate (the companies can choose to increase or decrease their spending), but 50%+ incremental margin is typical for a fixed cost business of this nature - similar to cable, satellite TV, wireless phone, and fixed line telephone.

Because the incremental margin is so high, management will have the flexibility to increase spending to accelerate growth (promotions, increase conversion rates, etc.).Generally, content costs (royalties, licensing, etc.) ranges from 30% to 45% of revenues (it goes down as the company gets more subscribers), while marketing costs vary depending on the number of subscribers added.

The remaining costs are largely fixed, though there are some customer service and administrative costs.I have a number of scenarios on profitability, but generally 30% cash flow margins in ten years is doable - if the company wants those margins. This results in about $3 billion or more in annual profits for the two companies combined after ten years.

From there, I derive my intrinsic value estimates. Therefore, I am not especially worried that they are losing money. I would only worry about it if I thought they would be unable to pay their bills between now and the time they achieve profitability.

The Financial Impact of the Merger: If the two companies merge, it will have three primary impacts - cost cutting, improved marketing, and better content offerings. Cost savings will probably be on the order of $1 billion per year, adding about $2 per Sirius share of value and wiping out their combined losses. The cost savings will take effect over 1 to 2 years at the earliest and may take longer.

Improved marketing means that they will be able to acquire a greater number of new subscribers at less cost over time. That is hard to quantify, but it increases the probability that they will get to 75 million or more subscriptions by 2017. Better content offerings means that subscribers will have more content and better content. For instance, baseball is offered only by one of the two and football is offered only on the other. Only Sirius has Howard Stern. Combine the two, and all subscribers have access to all of the content.

The merger spread is currently 23%, plus or minus depending on the day. That is, if the merger is completed, the prices of the two stocks will converge by an amount equal to the merger spread. Most likely, XMSR will rise by at least 23%, and then the two will rise further if the deal is approved.

Why is the spread so large if I believe that the chance of merger approval is so high? Because the market is impatient. Especially, in the midst of a bear market when investors flee to safety. Investors who bought in at $15 are now 33% in the whole - that makes people scared. And, quite frankly, many investors are interpreting the delay by the FCC/DOJ negatively, though I'm not entirely sure why.

Conclusion: My analysis suggest a unabashed bullishness on both stocks at these prices. Hence my large position in XMSR. However, a word of caution. These are speculative investments. Nobody knows what will happen in 2017. There are many factors that could sideline my analysis, not the least of which is the behavior of management. The ability to create or destroy value over time is a function of the companies' ability to execute against a competitive and dynamic landscape. Some companies will succeed, some will fail, many will muddle through. New technologies can help or hurt satellite radio accomplish its goals.

Therefore, when I invest, I do so knowing that my valuation estimates could be dead wrong.

Disclosure: Long XMSR

Comments

[PocketRadio:]

HD Radio is a farce:

hdradiofarce.blogspot..../

2008 Jan 28 08:20 AM

[tcsnetwork:]

I love my Sirius!!

We went on a road trip from California to Chicago and listened to our favorite channels the whole time.

2008 Jan 28 10:19 AM

[metavalent:]

comprehensive and even perspicacious; yet, concise and pragmatic. outstanding work.

2008 Jan 29 08:16 PM