Tuesday, January 23, 2007

Kit Springs Weighs In on XM Law Suit and Merger

January 23, 2007

Stifel analyst Kit Spring has issued a note on XM Satellite Radio in reference to the RIIA suit. Springs doubts that the suit will have a negative impact on the enterprise value of XM.

Report Excerpts:

- XMSR lost round one as a defendant in a lawsuit by the recording industry: Last May, the recording industry (RIAA) filed a lawsuit against XM alleging copyright infringements, essentially saying new radios with recording functions are like iPods, which require a higher licensing fee. XM believes these devices are legal based on the Audio Home Recording Act of 1992, similar to TiVo. The RIAA seeks $150k per song or $35B - 5 times the enterprise value of XMSR, an amount that seems completely divorced from economic reality. Last Friday, judge Deborah Batts ruled against XM's dismissal request. She will hear the case. See our Stifel regulatory team's note this a.m. for more detail

Springs sates, "We doubt the liability will be material to XMSR's enterprise value for
the following reasons::

- Based on our analysis of NPD data and other retail channels, these devices haven't been very popular. To date, we estimate XM has sold only about 125k radios (vs.7.7MM subs) with the advanced recording features in question (Pioneer Inno and Samsung Helix allow for disaggregation of shadow recoding).

- Unlike an iPod, you can't take songs off these devices, so maximum economic damage is likely limited to both the number of devices and the average useful life of the devices, perhaps 3.5 years. These qualities lead to enormous differences in the economic damage relative to Internet file sharing, which has a viral/exponential effect. We'd also point out that the number of songs downloaded on iTunes per iPod is only about 20, another statistic that points to limited economic damage.

- Sirius negotiated separate licenses with the record companies for their recording capabilities, which we believe were around $9 per radio upon manufacture for recording consistent with the AHRA and$25 per radio (incremental $16) for advanced recording features. Sirius was the
manufacturer of its advanced recording radios. We believe XM/Pioneer/Samsung are paying only the$9. If XM settled for 5 times what Sirius is paying, that equates to damages of $10MM, an immaterial amount, in our view

- In our view, the RIAA is incentivized to improve its economics versus XM, but at the same time not to materially harm the company. Satellite radio pays a total of7% of its revenues to record companies and artists combined, versus3% from terrestrial radio. So, record companies should prefer that satellite radio takes off, unless they conclude that radio in general (both satellite and terrestrial) is bad for record sales.

- Advanced recording will likely remain a niche product until manufacturing costs plummet: Looked at another way, we believe an incremental $16 fee for future radios with advanced recording features would be a slight detriment to adoption if manufacturers tried to pass all of the cost to consumers. If XM had to bear the full cost of advanced recording, as opposed to sharing it with manufacturers and/or consumers, this would represent a reduction to the economics per sub with advance recording features. If XM wanted advanced recording for every radio and fully subsidized it, we estimate this would cost XM an incremental $25 in SAC/CPGA (42%/25% increase). We doubt that XM will need to do this because competing technologies will also be restricted in terms of what they can offer. We believe that advanced recording features will remain a niche product for consumers that want to pay the extra $9-25, until manufacturing costs plummet. We do not belive the Street has baked in high assumptions for recording products.

Maintain Buy rating on XMSR: We continue to believe long-term forecasts for satellite radio are achievable based on the projected ramp of new car installations (from about 20% of new cars today to70% by decade end) and relatively high-take rates in new cars today (55%). We think SIRI and XMSR will attempt a merger in 2007 and see $7B of merger synergies. Of course, there is also a possibility that no merger occurs. Our $18 target is derived from a DCF, which assumes 9x 2011 EBITDA and a 10.5% WACC.

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1/23/2007 01:02:00 PM

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