JP Morgan Note On Merger of Sirius and XM

Report Excerpts:

- As outlined in a separate industry note published this morning, we believe that recent rhetoric from XM and Sirius executives clearly indicate that they would like to merge the companies. Both sides have argued for substantial synergies, and that regulators could find grounds to approve a combination. We believe that the comments by managements at both XM and Sirius are likely trial balloons, making us conclude that a more formal merger proposal is possible before year-end.

- We see the most likely proposal as a stock-based merger of equals providing both companies' shareholders an equal stake in the new company, consistent with the market’s current valuation of both companies, which are trading near firm value parity. A merger of equals would also be consistent with our view that at this early stage the companies must be seen as near parity in total value, with XM holding a lead in Asian automaker distribution deals and current total subscribers (although we have Sirius with a lead by 2010), and Sirius leading in retail sales, brand, and better cash flow economics for its Ford and Chrysler deals relative to XM's GM deal. If executed, we see combined savings from a merger near $344m per year, based on 1) 30% reduction in combined G&A, 2) 20% reduction in combined subsidies and distribution and sales and marketing costs, and 3) a 10% reduction in programming costs.

- We believe that both XM and Sirius would continue to operate separate physical networks for many years (i.e., we are not assuming physical network consolidation) since XM and Sirius use different encoding technologies and have large installed bases of radios built into cars. The cost of swapping these radios out we believe would be prohibitive, so we believe if they merged the companies would continue to broadcast via separate satellite fleets (although there could be some consolidation of terrestrial repeater networks). However, we believe XM and Sirius could consolidate programming so that both systems beam identical best-of-breed content, putting, for instance, football and baseball and Howard Stern on both systems, as well as Oprah and Martha Stewart. The companies, however, could consolidate programming staff for music channels, which are largely duplicative. If we capitalize these $344m yearly savings at a 10x multiple, they would be worth $3.4b. If we provide 50% of this value each to XM and Sirius, it would be worth a quarter to a third of each company’s current share price, or $1.14 for Sirius and $5.24 for XM.

- The question mark is regulator approval, which we put at a 50/50 coin toss. Both Justice and the FCC would weigh in, but standard practice is for the FCC to defer to Justice on questions of antitrust, which we believe would be the principal issue. The deciding factor will be how Justice defines the market (subscription radio or in-car music and entertainment). Precedent (DirecTV/Echostar) suggests that Justice would view it as subscription radio, which would prompt a ruling against a merger. However, the trend we believe is for regulators to take a more expansive view of new media markets, which would tend to support approval of a deal. FCC policy, which has specifically called for two satellite radio systems as part of the spectrum licenses, is another problem. However, that could be dealt with potentially by putting licenses in separate companies, while consolidating content and operations, and thus complying with ownership restrictions but still achieving operating and financial efficiencies, like LMAs for terrestrial broadcasters.