XM Satellite Radio Holdings (XMSR)

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XM Satellite Radio Holdings Inc. (XM) is the larger of two companies licensed to provide satellite radio in the United States, beaming music, news, and sports programming to the cars and homes of over 9 million subscribers. While the company made $933 million in revenue in 2006, its operating expenses were so large that it generated an operating loss of over $400 million. Currently, XM has 52% of the duopoly U.S. satellite radio market in terms of number of subscribers.

In February 2007, XM entered into an agreement to merge with its only direct competitor, Sirius Satellite Radio (SIRI), which has 8.3 million subscribers, lower revenues, and an even higher operating loss. As these two companies comprise the entire U.S. satellite radio industry, the merger may not be approved due to anti-trust legislation. By merging, the companies hope to increase operational efficiencies and turn a profit for the first time in the companies' respective histories.

While a combined entity would dominate satellite radio, XM and Sirius face competition from traditional land-based (or terrestrial) radio companies such as CBS (CBS), Clear Channel Communications (CCU) and Cox Radio (CXR)), which typically operate on advertising-driven business models (as opposed to subscriptions). In addition, all radio companies faces increasing pressure from Apple's iPod, which sold over 100 million units as of early 2007. The MP3 player's ubiquity has paved the way for partnerships with automobile manufacturers such as BMW, Mercedes-Benz, Honda and Volkswagen, which have installed iPod-compatible hardware into new cars. Contracts with automakers have been a historical growth area for both XM and Sirius, which offer free or discounted service with the hopes of turning car buyers into satellite radio subscribers.

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Key Trends and Forces

Potential Merger between XM and Sirius

XM and Sirius have entered into a pending merger agreement which would leave only one company in the U.S. satellite radio business. This would give the resulting company a virtual monopoly on satellite radio, with no direct competition. The combined company would likely eliminate overlapping programming content and condense its infrastructure in order to optimize operational efficiency. This and other synergies between the two companies would help to greatly cut costs while increasing the total number of subscribers and revenue. Neither company has turned a net profit as of their respective fiscal 2006 results.

The merger (filed in March 2007) may not be approved by the federal government because of anti-trust legislation. Sirius and XM claim their merged company would not be a monopoly because it would still face competition from traditional terrestrial radio companies such as Clear Channel Communications (CCU) and CBS (CBS) and from other audio options for consumers, such as iPods and other digital music players.

During Sirius' third quarter 2007 earnings call, executives emphasized their confidence in the merger's approval. A number of major companies directly involved in the satellite radio industry have shown their support for the Sirius-XM merger. Car manufacturers Ford and Toyota as well as retailers Radioshack and Circuit City Stores are among such companies, who have stated their belief that the merger will be beneficial for the industry.

On February 29, 2008 Sirius and XM agreed to extend their merger agreement through May 1, 2008. The agreement was set to expire on March 1, 2008. The terms of the merger agreement remained identical to the original agreement. Each share of XM stock will receive 4.6 shares of Sirius stock. If either company walks away from the merger prior to the expiration of the agreement, there will be a $175 million break up fee. In addition, each company has specific guidelines in how competing offers are handled.

The merger needs to pass muster from the Department of Justice as well as the Federal Communications Commission. It has been widely anticipated that the DOJ will act first, but some recent activity shows that the two government regulators are coordinated in their efforts. If the FCC were to act first, Sirius and XM could close their deal without any word from the DOJ. The DOJ must sue to block the merger if they are against the merger for anti trust matters.

On March 24, 2008 the U.S. Department of Justice gave approval to the merger between Sirius and XM. In their press relaese, the stated, "Evidence Does Not Establish that Combination of Satellite Radio Providers Would Substantially Reduce Competition". The DOJ decision outlined various aspects that gave a broad definition to the audio entertainment landscape. The DOJ concluded that competition existed from terrestrial radio, MP3 players as well as wireless networks. The Department of justice placed no stipulations on the merger. The merger still needs final approval from the Federal Communications Commission.

The FCC has decided, 3 to 2, that the XM-Sirius merger will be approved based on some conditions. The merger is not officially approved but the FCC says that they have reached an agreement in principle to allow the merger. The agreement is based on similar terms to what FCC Chairman Kevin Martin proposed in June 2008. These terms would require XM and Sirius to place a cap on prices for three years, offer selective programming, make radio channels available for noncommercial and minority programming, and provide the option of buying radios that receive both XM and Sirius.^[1]

Growth from automaker contracts

XM, like its competitor Sirius, has a number of exclusive contracts with automakers to distribute XM radios and market its radio service under its original equipment manufacturer (or OEM) promotional subscriber program. It has struck such deals with General Motors (GM), Honda Motor Company (HMC), Toyota Motor (TM), Nissan Motor (NSANY), Hyundai, Porsche, and Suzuki. XM is also available in Subaru, Ferrari, Harley Davidson, Kawasaki, and Lotus. Subscriptions gained through these deals accounted for a growing portion of revenues from 2004 to 2006 (see chart).

OEM promotional subscribers receive free or discounted XM service over a trial period following the initial sale or lease of a vehicle from a participating car manufacturer. XM measures the success of this program with a high "conversion rate", or the rate at which promotional subscribers convert into self-paying subscribers. The conversion rate has been in the low 50% range, and closed 2007 at a bit over 53%

Competition from iPod

One of the biggest indirect competitors to XM is Apple's ubiquitous iPods. These portable media gadgets provide an alternative to satellite radio for consumers who want large amounts of digital music and other media that can be played through their automobiles' audio system.

Apple's iPod enjoys a significant installed base (over 100 million sold since its release in 2001), and sales for the iPod continue to grow. Apple has partnered with automobile manufacturers to produce cars that have audio systems compatible with iPods. Major auto companies such as BMW, Mercedes-Benz, Honda, and Volkswagen have installed iPod-compatible interfaces into their cars' audio systems. In addition to factory-installed compatibility, an abundance of aftermarket accessory kits enable consumers to play the music from their iPod in their cars. As sales of iPods continue to grow and more consumers decide to purchase cars with iPod compatibility or iPod car accessories, fewer consumers may purchase subscriptions with satellite radio providers.

Risk from satellite damage

XM (as well as Sirius) is completely dependent on its satellites in order to provide service to customers. The company currently operates on a system with four orbiting satellites (appropriately dubbed "Rock", "Roll", "Rhythm" and "Blues"). XM also maintains extra satellites in storage in case one or more of its current satellites fails.

If its satellites were to become damaged and need either substantial repairs or replacement, its service capabilities would be seriously impaired for at least six months after the damage was done. If two of its satellites were to stop functioning within the same time period, then XM would have to suspend its service for approximately two years, which would be disastrous for its business. The odds of any of its satellites failing are uncertain, but in the past they have had problems with circuit failures in their satellites' solar panels. XM has not released any statistics on the likelihood of more problems with its satellites but has recognized that there are uncontrollable elements to the operation of their satellites that could cause them to cease functioning.

Competition

Sirius Satellite Radio (SIRI), with 8.3 million subscribers at the end of 2007 (48% market share), is XM's only direct competitor in satellite radio. XM leads Sirius in terms of revenue, subscriptions, and operating income. Other key metrics that favor XM over Sirius include average monthly churn (the percentage of subscribers that deactivate their service in a month) and subscriber acquisition cost (the average cost of acquiring and activating an additional customer).

• Average monthly churn: In 2006, Sirius's average monthly churn was 1.9% while XM's was only 1.7%, significantly better considering that XM has over 1 million more customers than Sirius. It should be noted that the companies calculate churn in differing ways. Sirius counts all deactivations in their churn number while XM does not include OEM subscribers who elect not to keep the service after the promotional period in churn. True comparisons happen when you look at "Self Paying Churn" and "Fully Loaded Churn". XM reports "Self Paying Churn" Sirius Reports "Fully Loaded Chiurn"
• Average revenue per user: Despite being behind XM in most areas, Sirius has produced a higher average revenue per user (ARPU) figure than XM.

Sirius has been closing the gap between itself and XM in recent years, especially in terms of subscriptions and operating margin. This competition may come to an end if the proposed merger between the two companies is approved and completed this year.

Note: All data as of the end of 2006, except for subscriber totals from the end of first quarter 2007.

Competition from other channels

In addition to direct compation from Sirius, XM also faces broader competition for audience from the following sources:

• Traditional AM/FM radio companies compete with XM for radio listeners. These companies include CBS (CBS) , Clear Channel Communications (CCU), Cox Radio (CXR), Entercom Communications (ETM), Radio One (ROIA), and Cumulus Media (CMLS). HD Radio is a new terrestrial radio product that has just announced deals with BMW and Ford.
• Apple's iPod, which is the dominant portable digital media player (over 100 million units sold as of early 2007). Automobile manufacturers have been striking deals to have iPod-compatible hardware built into new cars and trucks, potentially negating the need for satellite radio units
• Internet Radiois becoming a major focus of consumers. Consumers can stream customized content through their computer. Internet radio stations include traditional radio, Sirius and XM, and new companies such as Slacker
• Cell Phonesare also becoming popular with audio entertainment. The iPhone from Apple has been a huge success, and MP3 as well as streaming capabilities are being included as features in all popular cell phones.

References

1. ↑ XM-Sirius Deal Clears FCC Hurdle
2. ↑ XM Satellite Radio (XMSR) Form 10-K, Fiscal year 2007, "Management's Discussion and Analysis of Financial Condition and Results of Operations", p. 37-38