The merger of Sirius Satellite Radio and XM Satellite Radio is necessary for so many reasons that the executives that announced the deal this week were duty bound to go ahead with it, despite regulatory concerns.
It has happened far earlier than most analysts expected, but we said it back in January, this was a merger that investors would insist on. And an administration that could find little wrong with the merger of SBC, AT&T and Bellsouth will eventually find a way to get itself comfortable with what is a simple salvage exercise for investors stuck with a problem.
Unlike the two veritable stones, tying them together to see if they float, this is a merger of necessity, that is likely to work. Neither one of these companies had a future on their own, despite all of the hype and investor sentiment that once had them valued at over $12 billion collectively.
Today they are valued together at $9.5 billion, going down, and the reason for the descent is that both of them have missed anticipated subscription numbers, as the market virtually saturates and they both knock lumps out of each other paying small fortunes to attract the best talent in the entire live entertainment market.
The two will merge say the companies with each of the shareholding groups ending with 50% of the combined company, which will have around $600 million in the bank and long term debt of around $2.4 billion, a net debt situation of around $1.8 billion based on their last published figures. Combined annual revenues are likely to be initially around $1.6 billion, and both companies have reported that they have achieved or are near cash break even.
Together the two companies have convinced around 14 million people to throw away their old car radios, and for some his includes their iPods and MP3 portable music players, and instead take between 120 and 150 channel satellite radio services. Once they overcome the hurdles to a tricky merger they will be able to offer what is probably less content overall, cutting their content bill dramatically, but this would still be more than the current number of radio channels that either one of them currently offers separately.
There are many reasons that we are negative about the prospects of the separated companies, but in truth we are not much more optimistic about the merged entity.
On the plus side although the operation is likely to remain loss making, it could be cash positive from day one, and getting more profitable each quarter and able to drive more cash back into the coffers, initially at least.
The big costs for these two groups are not broken out in exactly the same manner, but marketing to get new customers and the subsidies of the players and the incentives to their partners cost around $280 million a quarter while content alone is eating another $120 million.
With 14 million customers the merged group just has to manage churn and continue grow customer numbers slightly in order to please investors, so expect a huge hole in the marketing and subscriber acquisition numbers costs. Satellite rental and technology (apart from subsidizing players) is not a big contributor to costs so there are no savings to be made there.
With an average subscription fee of $12.95 that many customers gives rise to a gentle move towards over $2 billion in revenues without much effort. The best strategy going forwards is to cut $400 to $500 million in costs out of its budgets, push up Average Revenue Per User by adding new services and drive cash into the bank, pay down debt and prepare itself for a future with is fraught with challenges.
But the challenges are considerable. The two operators use slightly different radio modulations, and say they will develop players that will receive both. That will be a considerable cost and they will retain costs in merged devices for two demodulators, two sets of codecs and two players and two DRMs, as well as doubling up on patent royalties at the same time. When we wrote our last piece we were inundated with readers saying that satellite radios are cheap, but they forgot that they are subsidized by the subscription costs and only appear, like mobile handsets, cheap to consumers.
But the biggest problem is the arrival of more fierce competition from HD radio, as 13,000 local US radio stations gradually adopt a digital radio strategy, which will radically improve traditional radio, at the same time as the iPhone hits the world with all of the music that offers, at the same time that mobile TV in the form of MediaFLO in the US, is ramping up customers.
The iPhone is supposed to sell 10 million in its first year, while mobile TV in the US will include up to 20 TV channels, 80 Clipcasting services and perhaps another 20 audio channels and yet is expected to cost less to consumers than satellite radio. Not only that, but the costs to the operators are barely more than the provision of its existing handsets, with no new network costs. Under these conditions it is likely that mobile TV will hit 10 million customers mid-way through 2009, creating a head to head between the merged satellite company and the marketing power of Cingular (AT&T) and Verizon Wireless.
One of the only way to respond to this will be the upgrade of the two satellite services to provide video, rather like mobile TV. Already they offer some video services, mostly for kids in the back seat of cars which have the players installed.
Over the next two years there are very little consumer equipment cost savings for the merged satellite radio operation. It needs to replace all of its customer devices so they can receive both types of satellite signals, and that is likely to take around 3 years. Some time in the middle of that costly exercise, video service might become a necessity, with another potential equipment change.
At present Sirius broadcasts using 12.5 MHz of the S band between 2,320 and 2,332.5 MHz. XM uses the next 12.5 MHz between up to 2,345 MHz.
Sirius audio channels are compressed using a proprietary Lucent codec and encrypted with a proprietary conditional access system.
One thing that will be immediately resolved will be the RIAA suit against XM Satellite Radio, because Sirius already has a deal with the record labels which means it pays slightly more for content which includes the right to allow radio customers to store music they hear on the radio. Our view was that Sirius, having agreed to pay more for that right, had to ensure that XM also paid the same, and would have been the main driving force to take XM to task. Now that pressure evaporates.
Another point is that advertising has been virtually banned from both companies’ services, and at some key point in the future the two businesses will both need a reason to allow it back in, wholesale. One way to do this is to orchestrate tiered radio services, with tiered pricing, which would also help the rate of customer acquisition. They couldn’t do that separately because they wouldn’t have had enough spectrum, now they might explore this. So we might see the very best loved content being either preserved as advertising free, or the reverse might happen, that advertising finds its way only onto the content that people will not stop listening too.
Whatever approach it takes this is key to the merged entity being able to fight off rival services by slowly lowering its monthly charge to reduce churn, and relying instead, in some part, on advertising revenues.
The US has some 13,000 radio stations and these are either being devalued, going quietly bankrupt or simply suffering leaner times, as a direct result of the arrival of these two huge footprint radio services. If they also began to take advertising, then they have a difficulty in taking advertising for local markets (they don’t have enough spectrum for that) but they might further kill off the bulk of terrestrial radio before it has a chance to enliven itself with higher quality digital signals.
A merger will still require antitrust approval from the Justice Department and under their existing licenses, XM and Sirius were prohibited from ever owning each other’s license. The FCC has said it would consider waiving this rule. Both are likely to be achieved now, but after the Bush administration this would have been a lot harder deal to get through.
Under the terms of the deal that has been struck, XM shareholders get 4.6 shares of Sirius stock for each share they own and the Sirius CEO Mel Karmazin would end up as the CEO of the merged company, likely to still be called Sirius we suspect. Gary Parsons, currently Chairman of XM, will become chairman of the combined company. The deal is not expected to complete until late in 2007 early 2008.
In the end, any service which is purely a broadcast system, delivering schedule entertainment of any type, is going to have difficulties in the future. People are getting more used, every day, to experiencing content in a non-linear fashion. The idea of storing music makes the satellite players more like a digital music recorder, analogous to a DVR and it might have the feel of an iTunes, and that goes some way to making it less like a broadcast only linear service. But it would be better still of the company had the ambition to create a MoD (music on demand) or even content on demand service with a two way service perhaps using an iTunes style model over the internet, additional to the satellite distribution.
It is too much to hope that the spectrum that Sirius and XM hold could ever be a two way network, offering a rudimentary broadband download service. However the equivalent of a large EPG style piece of client software might make it possible to click on all the pieces of music a customer wants to store on his satellite receiver and for the device to remember to record it when it is next played. Then it really would become a genuine iTunes rival.