Thursday, March 01, 2007

Wedbush On Merger Hearings

March 1, 2007

report excerpts:

Sirius CEO Karmazin saw more flak than fanfare at yesterday’s Congressional antitrust hearing on the proposed merger with XM Satellite.
Karmazin was one of five witnesses. Two witnesses, counting Karmazin,were in favor of the merger; two were opposed, including the NAB’s President Rehr; and one, a regulatory lawyer who outlined the process, was essentially neutral. Karmazin made it clear that if concessions are necessary to get the deal through, then concessions will be made. He also said that the merger plan from the beginning was to share a significant portion of the merger synergies with consumers, which we interpreted as vis-à-vis mergerconcessions as opposed to benevolent goodwill. Karmazin stressed to the forum that he is willing to agree to aservice price freeze. However, when asked to be specific on a time frame and whether he would agree to a 4-year stay on price hikes, Karmazin avoided the specific question and replied that he was willing to consider some time“between 2 weeks to 4 years,” later adding that he would work with regulators to determine the appropriate time frame. Karmazin then mentioned that he would negotiate with exclusive content providers on both networks toprovide consumers with an elevated level of channel choices—giving Sirius and XM subscribers access to both NFL and MLB programming amongst others.

• Market definitions were at the center of the debate:
critics of the merger argued that much of satellite radio’s content is not available anywhere other than satellite, making it hard to argue that satellite radiocompetes with terrestrial radio, let alone iPods. Several Representatives, as well as witness Mark Cooper fromthe Consumer Federation of America, differentiated satellite radio from local radio and the rest of the audio market. They asserted that satellite radio is a national, mobile, and unrestricted medium that provides exclusive content andad-free music, which has no direct competitive counterpart. However, Cooper took the definition further, explainingin detail how satellite radio does not compete with local radio. He put forth that satellite radio has the capacity to aggregate on a national basis, small, scattered local demand for content, whether it be an out-of-market sports feedor 60’s hits. In this way, satellite radio did not compete with the local broadcaster. An example of his position is as follows: while a local radio broadcaster in Boston may do well broadcasting their local team, there is not enoughlocal demand for that same broadcaster to broadcast a Seattle team feed for instance. Satellite radio is able to aggregate these small pockets of localized demand and serve them on a national basis with content that is not available on or viable to local radio. Thus, “one-way competition” is created whereby local radio competes with satellite radio, but satellite radio does not compete with local. In the hearing, other arguments were made that satellite radio providers do not compete with anything other than satellite radio. Poignant questions to Karmazinincluded why his company website only featured competitive comparisons with “Brand X”, which he acknowledged represents XM, if it competes with so many other services. The company’s service price, which is essentially identical to XM, was also another source of contention, since most agree that the chief way to determine ifsubstitutes such as local radio and iPods are competitors is if they impact service pricing.

Supporters of broader market definitions claimed that market dynamics have changed considerably overthe past 10 years.
Karmazin, in concert with at least two supportive Representatives, argued since the FCC awarded satellite radio licenses ten years ago, other significant competitors have emerged—notably HD radio,Internet radio, iPods, etc., all of which compete for a listener’s time. And with such new players, supporters for abroad market definition led by Mel Karmazin, claim that competition today cannot be viewed in relation tostatements made over 10 years ago regarding the necessity of two separate competing satellite providers. A favorable pro-merger argument was made by New York’s Representative Anthony Weiner, who also put forth that radio offers exactly what local radio does: talk and music. Representative Weiner also stressed thatsatellite radio was not an essential service to consumers, implying that consumers did not need protection for services they did not need. As an aside, Rep Rick Boucher (D-VA) was the other proponent of the merger and hesimply stated that with concessions, the merger should be approved since it serves the public interest. At thehearing, Karmazin also consistently disputed the position that he was operating in a duopoly. At one point, whenRepresentative Sensenbrenner (R-WI) compared the merger’s outcome to creating a regulated utility monopoly, Karmazin responded, “We are not a monopoly,” to which Sensenbrenner retorted, “You are a monopoly!”

The hearing only reinforced our view that the proposed transaction could only be approved with some form of price control or assurance.
Gigi Sohn, a consumer advocate and hearing witness, suggested concessions as part of her formal testimony. She asserted that a merger should only be approved if:
1. à la carte programming choices are available

2. 5% of capacity is allocated to non-commercial educational and informational programming over which the combined company has no editorial control

3. The company agrees not to raise prices for three years after merger approval.

Sohn testified that subject to these conditions, the proposed merger would be in the consumer’sbest interest. We believe regulators are likely to also embrace the idea of à la carte programming, not because itreally matters in the context of satellite radio, but because they want leverage and market examples for their battlewith cable operators.

The NAB and some representatives challenged the trustworthiness of both satellite radio providers giventheir regulatory track record; this could be problematic if the FCC views the two companies in a similar light. NAB President Rehr was the first to raise the question as to whether or not regulators and the pubic couldtrust the satellite radio providers with monopoly powers, citing what he alleged to be a poor record of regulatory compliance. He claimed that the companies have had compliance issues with repeaters and receivers and in somecases have made false reports on those items, referring a repeater in one instance that was 67 miles away fromwhere he said company documents claimed it was. Some Representatives seem to agree with Rehr’s position,namely around the continued absence of an interoperable receiver, which is an FCC license requirement. Karmazin responded by saying he has the design for such an interoperable receiver at his office in New York, but no receiver manufacturer wants to make it since it would cost $700 without subsidies. This claim by Karmazin drew the ire of atleast one witness and some representatives because the FCC intent was likely to have such a radio in the marketplace, and not merely to have the designs resting in a desk drawer in New York.

• The merger is an opportunity, not a last resort.
Karmazin made it clear to regulators that the merger proposal was a not a failing company proposal, saying that they are not suggesting the companies need to merge to continue to exist. Needless to say, both Sirius and XM probably don't want to portend that their services are doing overly well, which is probably why both were fairly shy, in terms of guidance on cash flow improvements in 2007.

• Reiterate BUY on Sirius and HOLD on XM based on our DCF analysis.
We believe Sirius offers a more favorable risk/reward tradeoff than XM. Naturally, if regulators approve the company’s proposed merger withSirius, we would expect XM to outperform Sirius due to the premium embedded in the fixed share exchange ratio. Nevertheless, we perceive downside risk from current price levels if regulators deny the transaction. Converselywith Sirius, we perceive a potential to outperform, irrespective of the merger’s outcome. Both company valuationsare based on DCF analysis that does not incorporate any merger premium/benefit, consistent with our view that thetransaction has less than a 50% likelihood of approval and thus, will likely be denied within 12 months.

• Risks to attainment of our share price targets include shortfalls in subscriber growth;
increased competition whether from XM; AM/FM radio, HD Radio, or streaming-media services; satellite anomalies; new/increased government regulation; a prolonged and/or failed merger attempt; an inability to renew key content and OEM contracts; and anunfavorable outcome in the ongoing arbitration process with record labels over royalty rates.

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3/01/2007 12:20:00 PM

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