Satellite Radio Faces Enormous Challenges

Jul. 1.08 | About: Sirius XM (SIRI)

It is not my intention to get anyone to buy or sell Sirius Satellite Radio (NASDAQ:SIRI) or XM Satellite Radio (XMSR). Maybe if some of you didn’t spend your time on Yahoo stock chat boards, you might realize that not everyone out there has a “pump” or “dump” motive. It is only my intention to help investors understand the full picture regarding the risks to satellite radio. Up to this point, I feel Wall Street has presented the only positive picture. In response, I have offered what I feel to be the missing piece to the puzzle. After considering both sides, it is up to you to determine what to do. Those who get upset and make personal attacks are only confirming the insecurities underlying their investment decisions.

Some of my critics assert that my opinions on satellite radio should be taken seriously since I stated, “I stopped following the industry several years ago.” As you will see shortly, your conclusions have been misdirected because I am about to provide you with a more detailed dissection of this industry, demonstrating I know well what I speak of. Typically, when a person has few investment ideas or capital they tend to focus on the noise surrounding one or two investments they hope will make them rich, wasting several years of their lives to no avail, while better opportunities pass them by. When I see a ship with the engine running at full speed while barely moving, it’s a waste of time to follow the day-to-day soap opera. I can spend my time more efficiently. As it turns out, the big picture has not changed much since 2005. The major change is that the economy is in much worse shape. In addition, this doesn’t stand to benefit SIRI, XMSR or the possible merged entity.

I have mentioned many times that investment in distressed securities is one of the most risky and difficult challenges that an investor can undertake. In my opinion, it should be restricted to only the most experienced investors who are able to withstand complete losses. Although I consider SIRI and XMSR to be only moderately distressed, after assessing the business dynamics and competitive threats, I can see no solid reasons to take a position in either SIRI or XMSR. My position remains unchanged from nearly four years ago. In my opinion, the risk-reward is not appealing and money can be spent on many other opportunities, especially during this period of very high market risk. Apparently, institutions do not see a good risk-reward opportunity either, as the ownership has not changed appreciably over the years. Bottom line: this is not the type of market that investors should be taking excessive risks. Preservation of capital is the most prudent choice during economic contractions.

Understand the Industry Dynamics

Having a subscription to Sirius and “loving it” does not mean you have a good understanding of the growth potential or risks to the company. Following the daily rumor mill doesn’t either. In addition, taking a large position in a relatively distressed security only causes one to become emotionally attached. In order to understand my prognosis for the satellite radio industry, you need to consider basic industry dynamics. This will allow you to estimate the probabilities of earnings growth and the ability of incumbents to fight off competitive threats.

Whenever a new market is formed, direct competition is usually low (although indirect competition as in the case of satellite radio is was relatively high and much higher now), as only one or two players enter the picture. These are the risk takers who spend enormous sums of money to establish the market. Once the market has been established, more players become involved, but only if the market is growing rapidly or the market size is perceived to be very large. At least one of these elements is critical for long-term earnings growth.

If the market continues to grow rapidly, (even with several players), competition is not the dominant force because each player is too busy trying to meet customer demand to worry about market share. All players do well because demand far exceeds supply. As the market saturates, competition heats up as demand weakens relative to supply. Eventually, this forces the weaker players under so that only the strongest players survive. This is the period of the most robust competitive activities such as price wars (which are often the unintended consequences of various competitors calling bluffs) and other activities meant to position each player for market leadership.

Wireless Analogy

A good analogy would be the wireless phone industry. Ten years ago, there were several wireless providers; however, as competition heated up, each player had to fight more for revenues. As a non-combative way to expand revenues, the industry came up with “bells and whistles” – you know new sources of revenue – ring tones, texting, network plans, family plans, etc. This helped delay some of the competitive effects due to market saturation, but these tactics were only temporary. After running out of new ways to generate increasing revenues along with price wars, we now see a heated battle with only a few big players remaining. Today there really only are four big players and a couple of small ones. As we know, the future of Sprint (NYSE:S) and T-Mobile (DT) are questionable. Each stands a good chance of being acquired over the next few years.

Internet Analogy

Early on, virtually every company with a dotcom attached to its name did well because the market potential and market growth were enormous. As well, money was being thrown around recklessly based on the inflated promises of the Internet. The extremes associated with this hype resulted in a massive technology stock bubble. Once we hit a difficult economic period, the washout began. Now we see the industry becoming very competitive as niche markets approach saturation. This has forced the big players [i.e. Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY), Yahoo (NASDAQ:YHOO), Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT)] to seek out synergistic markets, causing more competition. However, the opportunity in this industry is still wide open and will remain so for many years due to the Internet’s continued penetration into numerous business and consumer markets. In addition, this includes media, which does not bode well for radio satellite's long-term survival.

Comparing the wireless and Internet industry growth models to satellite radio, we see that even with very little competition, satellite radio has struggled from day one. What does that say? First, there is a big issue with market penetration and market size. It is clear that satellite radio’s biggest barrier has, and will continue to be, market acceptance and market size for a variety of reasons. New entrants have not entered this market because the growth has been relatively slow and/or the overall market potential is not viewed as large enough to support additional entrants. The wireless phone market was much different. Consumers were bending over backwards to sign up for cell phone contracts. This led to the growth of several regional providers. In contrast, satellite radio providers have gone to U.S. auto manufacturers and struck deals to give buyers a limited time of free service. While consumers were lining up for wireless service, satellite radio is knocking on doors. And that, is a huge difference.

Regulatory Risks

Since this industry is regulated, there was a certain level of risk that was not under the control of the radio satellite industry from day one. Many of you are now realizing this as SIRI and XMSR struggle for approval by the FCC to merge. As many have pointed out, the NAB has strong ties with the FCC. Consequently, even if the merger is approved, the combined firm will continue to face additional regulatory risks down the road. These are risks that should have been factored into the initial investment due diligence.

Scaling the Business Will be Difficult

As a way to help drive subscribers, satellite radio providers (SIRI and XMSR) have continued to drop monthly rates, now at $10 to $13 per month. They have even tried to mimic the wireless industries “family plans” by adding each additional line (vehicle) for $7 a month. The bottom line is that the management in this industry is neither financially nor strategically savvy. They need to innovate better ways to drive revenues that optimize the unique attributes of their service instead of following the marketing tactics of the wireless industry. One of the biggest weaknesses of satellite radio is that revenues will be limited to the $10/month (assuming you sign a year contract). I would estimate that until SIRI reaches 30 million subscribers, margins will continue to suffer (margins would be better with a combined XM-SIRI firm). Given the high fixed costs and overly generous payouts to executives and Stern, SIRI needs a certain threshold of subscribers before it can realize an economy of scale sufficient to help fuel future earnings’ growth. The problem is that this threshold (perhaps 40 million) approaches market saturation (50-60 million) in my view. Therefore, the short-term issue is cost containment while the long-term issue is market growth or anything else that might increase earnings growth. The only way to increase market penetration beyond the saturation point is by bundling services so that the market resembles the larger mainstream size. This is something only large media players can do.

Limited Market Potential

Now, what happens once you have saturated the market (assuming we are talking about the limited market potential only possible by SIRI, XMSR or the combined entity)? Do you really think everyone in America will pay for satellite radio? I would say that a total penetration of 50 million subscribers over the next 8 years would be highly optimistic (for a combined XM-SIRI and impossible for each one individually) and would clearly encroach upon market saturation (60 million full saturation, best-case scenario). Unless satellite providers offer a wider array of content and services, I cannot see how they can achieve anywhere near this number under even the best of operating conditions.

Also, understand that, while Stern has a few million very loyal fans, there are tens of millions of others who will never subscribe to SIRI because they deem his content inappropriate. Believe it or not, not everyone wants completely uncensored radio. Think of the millions of elderly who are not accustomed to the language used by Stern or the parents who don’t want their kids exposed to some of the content. Thus, I hope you can appreciate that the 50 million figures is quite generous.

Limited Long-Term Revenue Potential

Even if the combined entity reaches 50 million, subscriber growth would decline thereafter as market saturation is approached. As a result, the industry would be faced with declining earnings growth. In addition, we all know what that means. Even a combined XM-SIRI would need to create “bells and whistles” to boost revenues since it would have limited resources to expand the market. However, the satellite model does not permit this. It is a fixed revenue model that is highly dependent on market growth and limited by the total number of subscribers. This is similar to Vonage (NYSE:VG), a complete dog that most definitely has no long-term future (at least not as a publicly traded corporation). In fact, based upon the competitive landscape that was well apparent prior to its IPO, I would argue that the banks that underwrote the IPO should be charged with civil if not criminal prosecution.

In contrast, a diversified media giant like Time Warner (NYSE:TWX), Comcast (NASDAQ:CMCSA) or Yahoo (along with its strategic alliances with media players) would be better positioned to expand the market by offering an array of services and content via WiMAX Internet. In fact, these players would also be positioned to increase revenues by adding numerous “bells and whistles” (such as a bundled multimedia solution). Even Microsoft (MSFT) and Google (GOOG) could expand the market via alliances with content providers. In addition, of course, we certainly cannot forget about Apple (NASDAQ:AAPL).

Due to these inherent limitations, in order for the satellite radio players to achieve long-term growth they would have to add other sources of revenues and/or expand the market. Higher subscriber fees would diminish subscribers. The radio satellite providers need more content and more business diversity. As we have seen, the industry lacks the typical growth dynamics seen in new industries. At the same time, it is faced with converging technologies as well as a very intense media war. This is precisely why institutional ownership has been small from day one. Both SIRI and XMSR have struggled even in the early stages for market demand. In addition, the lack of any clear means to add per-subscriber revenues will be the death of the industry unless this is addressed.

Wall Street Profits, Not You

Now do you think Wall Street analysts would bother telling you all of this? Of course not. If they did, they would not get any banking business from SIRI and XMSR. As well, they aren’t going to tell you that the airlines industry is one of the worst to invest in for the same reason; not just now, but it has been one of the worst for decades. Think about it. You have a saturated market whose health is determined by gas prices and can easily be hammered with a wave of terrorist attacks. As well, the airlines have unreasonable unions, generally terrible corporate culture, and the security of management knowing they will get a government bailout if needed. Most airlines do not even own their planes. They lease them. As a result, they do not build equity. All they are doing is churning through cash and debt to survive the next day. Wall Street won’t ever tell you that this industry displays one of the poorest sets of business fundamentals because it is also an industry that needs a lot of banking business.

Market Risk

Understand that it is going to be a very difficult road ahead for the US economy and stock market. I doubt very seriously that SIRI management has factored in a reasonable downward adjustment for post-merger subscriber numbers, given the fact that even most “experts” fail to understand the severity of what promises to be the most severe recessionary period in several decades. While this is more of a short-term consideration, both companies are in need of some first aid in the near future if they expect they remain viable. Even post-merger, I would anticipate the cash flow and EBIDTA guidance reported by SIRI management to fall short of expectations.

In addition, I am sure you are all familiar with the old adage “80% of a stock’s price movement is based on the direction of the market.” There will be a strong rally in the market no doubt, perhaps soon. In fact, it is possible the market could ultimately rally as high as 12,500-12,700 over the next several months. However, I have little doubt this will only be a bear rally. According to my current forecasts, the market is very likely to fall well below 11,000 after any rally, if not before. Therefore, for those of you who have positions in SIRI or XMSR, you might want to consider an opportune exit upon a rally of these stocks. Any post-merger rally might also represent a nice time to exit. Regardless what happens, I know my investment analysis is correct. However, this does not mean SIRI or a combined XM-SIRI will necessarily go under. It only means the high risks and huge barriers are not worth the small returns. If significant changes are not made, I cannot see how even a combined entity will survive as a thriving business.

Need Does Not Always Dictate Demand

The next time you read something from something that does not bode well for your investments, just remember, I am on the side of individual investors or me that you do not agree with. In addition, there are very few of us out there. There are even fewer like myself who have no agendas. I get very upset when investors continue to be fooled and lied to by the media, Wall Street and Washington. I don’t like to see anyone lose money, especially when Wall Street has made so much from these people and has refused to point out the fundamental challenges from the start.

As well, I would love to see a successful satellite radio service. There is a tremendous need for a broadcasting service free from the agendas of Washington, Wall Street and large corporate sponsors. Eliminating commercials serves to keep broadcasting content less infested with agendas. Today the media is one of the most destructive forces in America. This is especially true for investors. It even appears that the other networks are adapting the CNBC model. These shows are fooling investors while promoting the market as a casino. Wall Street loves this because it brings in more dumb money for them to take. If the SEC was not so corrupt it would have shut down CNBC by now.

Although the need for satellite radio is enormous, I do not think the business dynamics are in place for even a combined XM-SIRI to make it work. They need the financial power and content of big media players. While my predictions for satellite have panned out so far, that does not mean they will go bankrupt or be sold off to big media giants. Without a timely rollout of Internet-based radio in autos, an XM-SIRI entity could survive, but only if it rolled out a strategy that leverages a big player with large reach. It would take many years to wash away all of the wasteful mistakes SIRI management has made, but it is possible.

Competitive Threats

Make no mistake - internet radio is already very big and it is only going to get much bigger. If the media giants go forward with their own Internet radio service and do it over the next few years, this could be the deathblow for XM-SIRI. Only a media giant can alter these dynamics by bundling services to ensure revenue growth beyond market saturation. As well, they have the financial power and endless media content to expand the market.

If competitors offer WiMAX Internet or even satellite broadband radio, they could bundle services at a lower fixed cost. Within the next four years, WiMAX is expected to be in service in most metropolitan areas. For those of you who are not familiar with WiMAX, basically, it is mobile broadband based on the IEEE 802.16 standard. South Korea has its own version called WiBro, which is complementary to WiMAX. Although the details of who will pay have not been worked out, there is talk that cities would bear these costs and the Internet would be free. Either way, someone is going to have to pay because Sprint and its partners (Intel, etc.) have invested several billions in this venture. In addition, this may be Sprint’s last chance. Details aside, in my opinion consumers would rather pay for a mobile Internet or bundled media service rather than a single service like satellite radio.

Note that Chrysler (DCX) has already started selling autos with internet access.

In addition, Japan recently released a test version of its 1.2 GIG satellite broadband service.

In addition, if these things have not caused sufficient reason for concern, you need to understand that it will not be long before WiMAX or satellite broadband will be delivering TV into autos as well as radio. In fact, this is already a reality.

How many subscribers do you think will be willing to pay for radio satellite and even a TV version of radio when consumers will soon be able to surf the net and select from hundreds of channels, all billed perhaps to their ATT bundle package, along with their wireless phone etc.?

I wish I could say that my long-term prognosis for Sirius, XMSR or an XM-SIRI combined entity was brighter, but it is not. If I stated anything, otherwise, I would be lying or fooling myself based upon what I know. However, there are many variables at play here and anything could happen. No one can predict the future. We can only make guesses based upon what we know today. In order to form reasonable conclusions we must carefully analyze what we do know and try to account for all possibilities.

Given these considerations, I am especially bearish on SIRI, XMSR and any XM-SIRI merger given the fact that my viewpoints since my 2004-2005 have not changed. To me this confirms the trend of difficult operating conditions and unfavorable industry dynamics I first identified. Without a doubt, both players need this merger to secure their intermediate-term sustainability. Given the difficult credit markets, they will find it increasingly difficult to borrow money. In addition, as you know, SIRI continues to tap into its credit lines. However, their fate beyond that time frame is going to be extremely shaky if things play out as I suspect. In short, a merger of two troubled players does not provide any long-term solutions and does not address competitive threats.

Merger of Two Troubled Firms

One of the first rules of acquisitions is that you should never merge two firms that are struggling. Some feel that this strategy will capture cost savings resulting in improved margins. However, if the core business of each is not sound, all you will create is a larger piece of junk. One of the more recent examples of this was the Sears/K-Mart merger a few years ago. From the beginning, it was clear to me that this would not work. This was an act of desperation that will only end up delaying the inevitable liquidation of assets. While an XM-SIRI merger will most likely provide more synergy and cost control, even if we look past the challenging issues of market penetration and limited revenue growth per subscriber, competitive threats will be very difficult to overcome.

Based upon the troubling business dynamics of SIRI and XMSR, I would be very surprised if the FCC did not permit the merger. However, a merger alone will not secure the long-term future of this struggling industry. It will take much more….most likely, much more than management is capable of delivering. Solutions

Both SIRI and XMSR have and will continue to face a very a challenging business environment because each has to build (or lease) content while increasing market penetrance - both very costly undertakings. As well, the current and continued declining economic environment promise to add more stress to the proposed combined entity. While a merger would cut much of these costs, it would not address core problems that have plagued each company from the beginning – limited market potential and slow market growth.

If I was running SIRI (or the XM-SIRI entity), I would be more focused on forming strategic alliances with Apple, Google, or Yahoo that would promise to increase the market potential, rather than paying Stern ridiculous sums of money for the same played-out and predictable material. SIRI’s management needs to start figuring out that there’s a lot of great content out there that can be bought for $700 million. Betting your entire future on one person is a very risky bet by any standards. In addition, the audience base of Apple and Google make that of Stern’s look nonexistent. Finally, the revenue potential of these possible media partners is without limit. Internet and satellite are the future of media. The only problem is that satellite will be delivering Internet signals, which will carry radio, TV and other forms of media.

It Always Comes Down to Management

In conclusion, the chances of long-term success of SIRI or an XM-SIRI combined entity would require significant changes in strategy. I cannot see how they stand a chance without partnerships with one or more of the companies mentioned above. Even with partnerships, they will have to contend with Internet radio. Although management could wake up in time, it is doubtful.

Once again, I personally could care less what happens either way. I am just presenting something Wall Street has failed to – a more complete unbiased research summary that focuses on strategic direction and competitive landscape rather than pumping out financial forecasts, which have little merit.

Incidentally, I sent Blockbuster (BBI) management a turnaround strategy four years ago which was ignored. Now they are learning the hard way after suffering from a long period of terrible management and strategic confusion. Apparently, the former CEO was more focused on tripling his compensation during a period of massive losses. In what could be their last stand, Blockbuster is now looking for a real business to merge with because they waited too long to respond to industry change. One of the things I have learned in dealing with companies (and investors) in denial is that prior to opening themselves up for guidance they must realize when they need help. Often this is a more difficult challenge than providing viable solutions.

Disclosure: none