Wednesday, January 31, 2007

Deutsche Bank Weighs In On Satellite Radio Merger

January 31, 2007

Just as the buzz around a merger between Sirius and XM seemed to have calmed down a bit, a new report has been issued. This report from James Dix of Deutsche Bank, was quite extensive (40 pages), and details various aspects of a merger including the possibility of it happening and the regulatory hurdles that may be faced.

Report Excerpt:

Audio Signals

Cloudy crystal ball on regulators at this time hurts the risk/reward

Based on our review of the legal landscape and current developments in mobile audio, we conclude that there is a reasonable risk that the regulators would not approve a merger between Sirius and XM, or would approve one only with substantial conditions including potential spectrum divestiture. We continue to recommend investors substantially discount the prospect of a merger, but maintain our Buy ratings based on longer-term fundamentals.

Be quick, but don't hurry

We believe investors may underestimate the practical difficulties the satellite radio companies would face in winning timely regulatory approval. In its order in DirecTV-EchoStar, the FCC repeatedly noted that the merging companies had not met the burden of making their case. If Sirius and XM have to rush to file a merger proposal due to potential changes to the FCC in the 2008 election cycle, they may have less ability to make their own case. We have reviewed the satellite radio license grants, the 2002 FCC ruling in the DirecTV-EchoStar proceeding, and 1997 and 2006 DOJ/FTC guidance on horizontal mergers. We base much of our assessment of the competitive landscape, central to determining the relevant market and competitive impact of a merger, on takeaways from our four days at CES earlier this month and discussions with DB's wireless equipment team.

Keys: defining relevant market and gauging timing/impact of new entrants

While satellite radio faces substantial competition for the consumer's attention and entertainment dollar from a host of products and services that did not exist 10 years ago, such competition by itself might not justify allowing Sirius and XM to merge. Rather, we believe that regulators would focus on the incremental impact on competition in the relevant market from a potential satellite radio merger, and would have to handicap the timing and impact of the rollout of potential new products like HD radio, smart phones, auto consumer electronics, 3G and WiMax.

Will there be a 2007 rate increase?

Sirius' prior public statements on the potential for a rate increase suggest that it does not currently feel substantially constrained even by competition with XM from being able to raise rates. However, we wonder whether the potential for a merger makes it less likely that either company raises rates this year. The ability to increase prices without substantial churn might suggest to the FCC that the relevant market for assessing a merger is satellite radio, not something broader.

Maintain Buy ratings, with 12-month TPs of $20 on XM and $5.75 on Sirius

There are obviously other legal analyses and facts that could determine a regulatory decision in this case than the ones we present here, and we are not offering a legal opinion on what any regulator might decide. We use a DCF through 2020, WACC of 13-14%, and TVG of 4% to support our target prices. Risks to our investment theses and TPs include changing market risk tolerance for tech-driven businesses, subscriber growth volatility, competing technologies, rising costs, deal risk and adverse regulatory developments.

As we here at SSG have expressed before, the definition of the market is a key element for these companies should they decide to attempt a merger. With the advent of new competition from the MP3 market, cell phones with audio capability, HD Radio, and internet radio, it becomes important for Sirius and XM to demonstrate that the marketplace is substantially broader than it was only 6 or 7 years ago.

Labels: deutsche bank, merger, sirius, xm