Banc of America Analyst Jonathan Jacoby has downgraded XM Satellite Radio to neutral from buy. According to Jacoby there is limited upside potential and significant downside if the firm does not merge with rival Sirius Satellite Radio. Jacoby also states that even in the event of a merger, many of the cost savings would not materialize until 2010, citing that the systems are not interoperable.

- A merger attempt appears more likely given recent commentary by managements and numerous press articles, and the value of synergies could be huge - $5B by our estimate. Recent comments made by managements for XM and Sirius at investor conferences suggest that both would be interested in pursuing a combination, though an agreement on pro forma ownership and newco management could remain elusive (both companies have expressed a need for their shareholders to have a majority stake in the newco). Our view is that a merger would have to be announced in the next 4-8 weeks if there is to be a reasonable chance of clearing regulatory hurdles before the '08 elections.

- BUT several factors suggest that the upside potential for XMSR stock is now limited, and if no merger occurs XM & Sirius have significant downside risk:

- Consensus subscriber estimates need to be reduced – suggesting that the intrinsic value of each standalone company is lower than perceived. We have revised our subscriber estimates lower for both companies. Our new yearend ’07 sub est for XM is 9.2M (from 9.7M). For Sirius, our new year-end ’07 subscriber estimate is 8.2M (from 8.7M). Our new standalone equity share ests. for XM & SIRI are $13.50 (from $17) and $2.50 (from $3.50), respectively.

- Full realization of synergies could take several years (making value estimates more uncertain), and current stock prices appear to have "baked in" much of this potential value. Most cost savings wouldn't be realized until the end of the decade.

- Our contacts in D.C. suggest that procedural hurdles could stop a deal from getting through the FCC. On competitive grounds, a merger probably would pass. BUT the Achilles heel for sat radio could prove to be the existence of a regulation that requires two satellite radio operators. The FCC might not be able to simply waive this, it seems that might have to be formally changed. This potential procedural hurdle + general FCC inertia reduces the probability of approval before 08 to something less than 50%, in our view.

- We estimate that XM stock is worth ~$19 if a merger deal with Sirius is closed, suggesting little potential upside remains; SIRI would be worth $4. If the newco equity is split 50/50, we estimate that XM shares would be worth ~$19. Although more bullish sentiment might cause both stocks to trade higher following an official announcement, we believe that investors should be cautious as underlying fundamentals continue to weaken and synergies will take years to materialize.

- We have downgraded our rating on XMSR to Neutral from Buy, but we still prefer XMSR to SIRI. Our price targets for XMSR and SIRI are unchanged at $17 and $3.50, respectively. In our view, SIRI still has less upside potential AND more downside risk than XMSR (attributable to its relative valuation premium). "