It was back in June 2006 that Sirius Satellite Radio boss Mel Karmazin first mentioned the idea that he would welcome a merger with his arch-rival XM, and it is now over 21 months later and the US Justice Department has finally cleared the deal, saying that it is not anti-competitive.
Most commentators still refuse to look at the type of business that is going to be created, instead reminding us all that the FCC still has the final casting vote. This is no longer about whether or not the FCC will allow this deal. In fact it never has been. It is about under what conditions the FCC will allow the merged entity to operate, and the deal would never have come this far if it had not been for the fact that back in March 2007 CEO elect Mel Karmazin told a House Judiciary Committee’s anti-trust task force that the merged company would accept a price cap, that devices that can receive both services would be available day one and hinted the he would offer tiered services at different prices so that some cheaper tiers would be created.
He also promised the current radios wouldn’t be made obsolete by the merger and that they would continue to work unless someone wanted both services, in which case they’d get one of these new ones.
Sirius and XM have also carefully orchestrated a period of mutual subscriber growth that on the one hand has not been a runaway success, but neither has it been achieved cheaply enough to make either of the companies cash positive.
So the FCC is more or less hamstrung in its decision. It can enforce all the things that Karmazin has already promised and offered freely and it risks legal action and the ire of the entire investment community if both companies are allowed into free fall with the financial markets in their current states.
The financial markets read the situation in much the same way that we have, and lifted the combined value of the two companies from $7.2 billion to $8.8 billion, still radically low compared to the astronomic values that the two have achieved in the past, but for Sirius, now growing faster than XM, this was a value hike of 18% in a few days, while for XM, which has been perceived to be the weaker half of the equation if forced to plow ahead on its own, this meant a rise of 27%. The two price moves bring the value of each business precisely to $4.4 billion a piece, which is the first time for a while that the equality of value which is predicated in the merger deal (respective shareholder groups will each have 50%) has been achieved in the market. That’s a clear signal that the market expects this to happen, and to leave the values out of kilter would have just invited arbitrageurs to make hay.
It’s not new to us. Faultline embrace the deal as ‘necessary’ on the day it was announced, noting the slowing rate of customer acquisition, but more importantly the rising cost of customer acquisition, and noted that an administration which sees little wrong in agreeing the tripartite merger of SBC, AT&T and Bellsouth, was unlikely to stand in the way of a deal that is good for investors.
When the deal was first announced, it would have meant the creation of a company that had 14 million customers, now with XM on 9 million and Sirius on 8.3 million, that number has risen to 17.3 million. The combined company might expect to have day one annualized revenues of $2 billion, and debts of $2.8 billion. The FCC will be perfectly in its rights to insist on tiered pricing, unbundled radio stations or at least smaller bundles, and cross over deals with parts of each of the service, as well as continuation of service for existing devices ‘ but it’s already been promised those, so what else is it likely to ask?
Well actually that’s all about protecting tied in customers, not protecting the marketplace, and to us this seems all that the FCC is entitled to do at this point. The US has 13,000 radio stations and since the arrival of satellite radio they have been thought of on life-support with massive downward revaluations, but since the announcement of this merger the top 3,000 or 4,000 stations have moved rapidly to embrace HD radio, to give them the ability to improve their overall service levels and fight back against satellite.
But since those ground radio stations for the most part are free to air, and compete by offering local advertising, their enemy is a segmented and localized web service ‘ and it is Google and co which are taking away all their revenues, not the satellite radio business, at least not yet. Sure some of their listeners have deserted them for satellite radio, but if you share all those 17 million losses over the top 3,000 stations, they’ve lost perhaps 5,600 listeners each ‘ hardly an earth shattering body blow, and not enough of a defeat to account for the mass revaluation of the radio industry in the US, which has happened on the balance sheets of companies like Clear Channel and CBS, over the past three years.
Eliminating the satellite radio channels would not bring back a golden age of radio, and merging them won’t eliminate what’s left of the radio business. So once the FCC gets that off its plate, which we think will be sooner rather than later, it remains to be seen what other damage a revitalized satellite radio business can do to the rest of the telecommunications and entertainment industry.
So let’s put ourselves in Mel Karmazin’s shoes and think what we would do, once the FCC gives Sirius XM its blessing, and the legal niceties are completed. One of the first things that has to happen is that any future talent which satellite radio signs will be paid less money. Previously these two were in bidding wars against one another, now they are not, and there’s not yet anyone else in pole position to challenge how much they have paid for talent.
Already Sirius has shown a huge decrease in the spending on programming down to $236 million last year from $520 million the previous, year, the highest it’s ever been. So during the year that these two companies have been talking about a merger, content costs have more than halved at Sirius and while they have gone up by $18 million at XM which only takes them to around $188 million, so the two combined programming costs day one will be around $424 million, and likely to be falling as some programming will, in the fullness of time, inevitably be cut or be replaced with something cheaper. Why would programming costs be more than $250 million on a merged entity? It would still give it the best radio content that any US money could buy.
Looking at the way these businesses operate, they offer advertising-free pure entertainment services as their core pull to the customer, but they also offer advertising on the more local services such as traffic and weather. At present this is minor, but there are two things that will drive this up. Firstly because much of the two subscriber bases are in-car devices, this means that these cars tends to be leased over a period of time, say three years. At the end of such a lease an owner may have had their satellite radio removed and placed in their new car, or since that may have left unexplained dashboard holes, and added costs in the replacement of a different kind of radio, they may have simply acquired a new satellite radio with the new car and transferred their license from one to the other.
Either way this leads to a huge swathe of second hand devices, many of them in second hand cars, a considerable number of which where the owners will not want to take on a monthly payment. They might however be happy to listen to any satellite free to air services, and that means a rise in the potential for advertising on these services.
At the same time it makes lots of sense if the terrestrial repeaters that are used by these two services were also used to deliver more advertising based services, which are different from the services which are sent in the same spectrum from the satellite. Currently XM has 800 repeaters installed across 60 markets while Sirius operates 124 terrestrial repeaters in 98 urban areas. It is likely that right up until 15 months ago these markets were all duplicates and they were fighting each other, but that since that time, none of them are, making the reach of the combined networks mostly additive rather than duplicated.
The idea of offering different services on terrestrial repeaters is perfectly possible and forms the basis of the Ancillary Terrestrial Component (ATC) that mobile satellite service providers use to delivery mobile services from a satellite and supporting terrestrial network.
This would be a perfect nightmare for local broadcasters, and the FCC has been beset by broadcasters, radio station owners, and even cable operators, trying to insist that the terrestrial repeaters must repeat the identical satellite signal, because any localization of these signals means that far more free to air services could be created to compete with local radio stations.
Sirius XM will certainly have a fight on its hands over this terrestrial capability, and the FCC is currently conducting a rulemaking proceeding to establish rules for terrestrial repeater transmitters of the merged satellite radio operator. Currently satellite repeaters are only allowed under a special temporary license, which could be removed as part of the merger conditions.
The National Association of Broadcasters, Wireless Communications Service licensees, Multipoint Distribution Service licensees, and Instructional Television Fixed Service licensees have all asked the FCC to put road blocks in the way of increased use of the terrestrial repeaters. They want reduced power limits, a limit to the number of repeaters in any given area, they want plans to be made public by Sirius XM on how it plans to use this capability and even asks that every repeater bears a separate license.
Again it goes against the habits of how this FCC behaves to think terrestrial repeaters are going to be regulated as part of the permission to merge. Either way we have to consider the potential for more radical steps by the merged satellite entity once it is away from the detailed scrutiny of all the powers that be.
It might suddenly find itself separate spectrum, such as that 5 MHz of spectrum in 1.6 GHz L-Band which was leased by Crown Castle last year to Telcom Ventures and Columbia Capital, which are known to have had financial interests in XM. Such a deal would cost around $13 million a year because that’s what the VC firms paid, and could give it an existing set of repeaters throughout the New York area, saving it several $100 millions of build out there, and giving it the spectrum license for other repeater networks, which might support both L-Band and S-band spectrum.
The same L-Band spectrum could even by offered eventually by one of the ultra modern satellites that both Sirius and XM have on order from Loral and Boeing, to give increased capacity either for more radio, more free to air radio, or more video. Last summer Sirius launched its Backseat branded seatback TV with channel from Nickelodeon, Disney and the Cartoon Network, so we know it has its eyes on video.
So very simply there will be more advertising. There will be more free to air services somewhere in the combined company’s future strategy, and it actually says so in each of their filings at the SEC. So we can expect last year’s advertising revenues of $34 million at Sirius and $38 million at XM, so $72 million combined to double this year and next, and grow into a thriving $300 million or more chunk of repeatable revenue. One of the main reasons for NOT offering advertising was to distinguish the services from terrestrial radio, but between the two services there will be enough spectrum to do both, and for them to survive without quite such a strict adherence to advert free programming.
While we are on that Backseat service, it is clear that post merger this can be offered to both sets of customers and through both sets of automobile partners. In fact it will have to be otherwise the ICO MIM system being brought to market now, based on the Alcatel DVB-SH technology, might prove irresistible to some of those manufacturers.
And while we are on the subject of extra L Band spectrum, a number of the Mobile Satellite Service providers would be in a position to help out, with available satellite offerings, some in S-Band, some in L-Band, and too many of them chasing the same markets. Take for instance the interest that EchoStar, freshly released from ownership of the Dish network, has in Terrestar, and how it has already donated its L-band spectrum to that group. A partnership might be easily struck here to make use of that old Modeo spectrum also, or for the two to partner on other services.
In fact EchoStar’s attitude to the merged company is important. It might easily buy many of their satellites (around a dozen including some old ones in the air which XM use for emergencies and two that are still on the ground) and lease capacity back, leaving EchoStar plenty of spare capacity to bring to market for other players or its Dish sister company’s mobile TV system. A move of that type would amply drive down debt in the combined company. On the other hand EchoStar may do the opposite and new enable rivals to Sirius XM, though we think that’s unlikely, after all the money that they have spent building a brand.
So again simply put, there will be more advertising, more video services, the benefits of a merged route to market through car makers, and more spectrum, and potentially some sweeping moves in debt reduction, a coordinated and reduced fleet and a substantial reduction in programming costs.
Could Mel Karmazin make the merged entity cash generative overnight? Well to us it looks like his merger plan already provides for that, but the answer must be a big YES, driving up the corporate value, and making room for new initiatives.
This puts us in mind of the freshly merged Comcast, when it bought AT&T Broadband to be come the biggest cable operator in the world back in 2001. It took two years for the financial markets to see all the benefits and during that time Comcast kept its customers base roughly flat at 21.5 million homes (it has since risen, but only by acquisition) and it added entertainment services like VoD, DVRs, gaming and music, drove down the combined programming costs, invested in its delivery capacity to make it entirely digital, and then turned its service into a pure IP based triple play. ARPU has risen constantly from the date of that merger. It has since savaged its debt, and began acquiring rivals. Although investors have recently called for the head of Comcast’s CEO Brian Roberts, that’s only because after almost 8 years of share price gains, the company insists on continual capex build out to keep up its pace of change.
Make no mistake there are the same operational gains that Comcast had available at Sirius XM, and Karmazin is the just the man make them happen swiftly given his exceptional track record while running Viacom.
The parallels at Sirius XM are the cost reductions we have discussed, a continued rise in total customers, many in the US as it attacks the 240 million registered vehicles in the US and the 16 million new cars each year (even if they slow in the recession), but also at the fledgling Canadian operations; the addition of a DVR in Comcast has already happened iin satellite radio, and customers can save tracks to both Sirius and XM devices for replay later. It could also cut a deal with one of the many music services such as Napster or iTunes for its customers to acquire music directly from these services. iTunes music store capability is already built into some HD radios, so why not iTunes tag satellite music?
XM has already managed to raise average monthly subscription revenue from $10.09 in 2006 to $10.15 in 2007, but while Subscriber Acquisition Costs (SAC) have continued to rise it makes a nonsense out of these two companies operating separately. SAC rose from $65 in 2006 to $75 in 2007 at XM, and there were similar numbers for Sirius. In a merged company which is already break even, expect the ARPU to double its rate of increase and SAC to stabilize or begin to fall after a brief rise to cope with new equipment R&D and design.
As for new services, all you have to do is ask what is it exactly that these devices don’t currently do? Well they don’t play games, and not all of them can show video, only a few of them can attach to Wi-Fi networks and even fewer simply search the internet or offer VoIP phone calls. Most of the new satellites radios have rudimentary GPS and mapping services so they are already location aware, but the list of location aware applications that might apply to these devices will increase rapidly as such systems are developed for newly GPS aware mobile handsets. And finally in this age of merged devices, why shouldn’t the satellite radio and the cellular handset merge in some kind of unholy alliance, if a handset maker or an operator can be convinced it will drive their revenues.
Some of that is unlikely, but not that much, not over the next five years, not over the 8 year time frame during which Comcast worked the financial levers of being the biggest at what it does. So expect Sirius XM to at least attempt all that is possible in this list, and to achieve immediately all of the steps that are easy.
The upshot of all this is that while the companies are still healthily valued, at something like 4 times revenues, as soon as there is no longer any reason to discount their value due to continued uncertainty, it will be a signal to unveil some of the company’s future plans, and any series of good news announcements that ensue are likely to grant the investors which have stood by both companies a huge sigh of relief