On February 19, Sirius Satellite Radio and XM Satellite Radio announced that they had entered into a definitive agreement to merge in a $13 billion transaction. Although portrayed as a merger of equals, Sirius shareholders would end up with slightly more than half the equity in the combined company. The announcement of the deal did not catch Wall Street by surprise. It was something that had been expected by many for some time.

As to the reason for the merger, simply put, the two companies have been competing so fiercely with one another that costs at both have skyrocketed to unsustainable levels. In 2006 alone, Sirius and XM had combined losses of just over $1.8 billion.

The huge losses can be traced to Sirius and XM spending billions to compete with each other for talent, distribution and subscribers, not to mention the ongoing costs that both must incur for the highly capital-intensive, infrastructural build-out and upkeep of their respective systems. At the rate they’ve been spending and losing money, there has been a fear among some industry followers that one or both companies could be on the verge of going under. I am not so pessimistic. Moreover, I believe that if regulators approve the deal, the prospects for the combined company will, in fact, be quite promising.

As evidenced by the downward movement in the price of both companies’ shares since the merger was announced, Wall Street seems to be betting that regulators (the Department of Justice and the Federal Communications Commission, to be precise) will not approve the deal. The Street’s pessimism represents, in my opinion, an excellent opportunity to accumulate a position in one or the other company’s shares (I prefer Sirius, the reasons for which I will explain later).

Wall Street is concerned that the DOJ and FCC will turn down the deal because the satellite licenses awarded to Sirius and XM were never supposed to be controlled by just one company, the fear being that such concentration would stifle competition in the satellite radio industry. I believe it was a valid concern more than a decade ago when the first licenses were granted, but less so today. With the subsequent advent since then of internet radio, high definition radio, iPods, streaming music on cell phones, and music-only cable TV channels, not to mention the continued viability of terrestrial radio, there is little chance that a combined Sirius/XM would be in a position to threaten the competitive characteristics of the more broadly defined “audio entertainment” market.

Given the competitive landscape, the fact that Sirius and XM have been experiencing unsustainable losses, and the further fact that the government would ultimately rather have one successful satellite radio operator than two that are potentially teetering on the verge of collapse, I tend to think the regulatory powers-that-be will, in the end, choose to define the market more broadly and approve the deal. (One possible scenario is that the government requires the merged company to relinquish one of its licenses at some pre-determined point in the future in order to secure approval of the deal.)

If, as I anticipate, the deal is approved, the upside potential is substantial, with the resulting company well-positioned to become a powerhouse provider of audio entertainment. Listed below are some of the attractive characteristics from which such a company would benefit:

1. Economies of scale – The merged company would have a dramatically reduced cost structure, as the fierce competition currently besieging both companies for talent, distribution and subscribers would disappear, as would a fair amount of their respective capital spending requirements – if not immediately, then at some point in the not-too-distant future. Wall Street analysts have published estimates of the net present value of these savings ranging from $3 billion on the low end to as much as $7 billion on the high end. Even at the lower end of the range, the cost efficiencies are striking.
2. Strong market position – While there may be many alternatives to satellite radio, the company will clearly be in a dominant position with respect to its core business for the foreseeable future. Moreover, the established programming infrastructure and talent that Sirius and XM have developed will position the merged company extremely well for moves into other developing segments of the audio entertainment industry (e.g., internet radio).
3. High barriers to entry – Given the high costs involved in building and maintaining a robust satellite radio service, it is unlikely that a serious competitor will emerge anytime soon to challenge the merged company’s dominance in satellite radio.
4. Large and rapidly growing customer base – With approximately $1.5 billion in 2006 revenues, approximately 14 million subscribers and growth that, while down somewhat from previous levels, is still robust by any standard measurement, the merged company will have the type of critical mass and growth rate that virtually all companies strive for, but few ever achieve.
5. Excellent management – You don’t want to bet against radio industry icon Mel Karmazin.

All-in-all, a merger of Sirius and XM will, in my opinion, result in the type of company that Wall Street rewards handsomely, offering great potential upside to investors willing to take a chance that regulators will approve the deal. However, even if the deal does not win approval, I believe the downside risk is mitigated by the fact that Sirius and XM will ultimately be successful entities, even if not individually to the same degree as if combined. They will each still have millions of subscribers, high growth rates, recurring revenues, a relatively low churn rate, and an attractive, reasonably priced product offering. Of course, the level of success, and the speed at which it can be achieved, would be greatly enhanced if the merger is allowed to go forward.

Further, I see each of them benefiting from the fact that there is practically nothing on traditional radio these days for baby boomers, still the largest and most affluent segment of society. Reaching out to these consumers should keep satellite radio’s subscriber base growing at rates well above normal for many years to come.

I bought shares of Sirius this week for my own account. I chose it over XM because I’m a big fan of Karmazin and I like the fact that Sirius achieved positive free cash flow in the fourth quarter of 2006 – two attributes which I believe make it better positioned than XM in the event the merger is quashed by the government. I also like the fact that it’s currently trading at around its 52-week low.

R.A. Dorfman
March 15, 2007