Tuesday, February 20, 2007

Color on SIRI/XMSR merger

Several firms are out commenting on XM Satellite (NASDAQ:XMSR) and Sirius Satellite (NASDAQ:SIRI) merger:

- BofA notes XM shareholders will receive 4.6 shares of Sirius stock for each share of XM - implying an XM share value of $17.02 (based on Friday's close) and a total combined enterprise value of ~$13B.

Firm's contacts in D.C. maintain that procedural hurdles could stop a deal from getting through the FCC - we estimate the probability of obtaining regulatory approvals before end of 1Q08 at less than 50%. As the firm has stated previously, the Achilles heel for sat radio could prove to be the existence of a rule that prohibits the two providers from merging. The FCC might not be able to simply waive this rule; it might have to formally change this rule. This could take time and the window to get approval before the '08 elections is narrow. In addition, a lobby group like the NAB (National Association of Broadcasters) could seek a legislative 'solution' to prevent a merger.

Fukk realization of synergies could take several years, making value estimates more uncertain. Firm estimates that an XM/Sirius marriage would create $5B of value, but mot cost savings wouldn't be realized until the end of the decade.

Investment thoughts - they wouldn't chase these names and remain Neutral on the shares of both XMSR and SIRI. Firm's expect SIRI to open slightly higher on 2/20, perhaps near $4 - implying an opening price for XMSR of ~$18, based on the 4.6x exchange ratio. But they think that further appreciation potential from these levels is limited. Assuming $5B of synergies AND certain FCC approval, the firm estimates that Sirius and XM stock would be worth ~$4.25 and ~$19.50.

- Goldman Sachs notes that in their view, merging platforms could deliver significant operational, financial, and strategic benefits, likely exceeding $4 billion, though mostly years away. That said, they continue to believe that that the merger is unlikely to pass muster with the FCC, DOJ, and investors, assuming current terms. Finally, the firm cautions that some investors might view the
emergence of the merger proposal as a lack of confidence in the fundamental business outlook as stand-alone competitors.

The ~18% EV discount XMSR trades at relative to SIRI should be cut by 2/3 upon the open. Assuming SIRI shares trade toward $4 implies $18.40 per XMSR share, less an estimated net 5%-6% arb discount (10%-12% gross spread less rebate) yields XMSR shares around $17.40, or a 24% increase from Friday's close. This is close to the almost 22% premium assigned to XMSR shares via the proposed 4.6:1 fixed-exchange ratio.

- Wachovia has probably the best note on the subject saying they believe there is a 25% chance or less of obtaining regulatory approval with the deal in its current form and a 50% chance or less in any form. It is interesting how times have changed in the sat radio space as two years ago the sat radio industry was dubbed Coke and Pepsi and cable without the competition, yet today the expectation is that they will be allowed to merge. Recall their belief that a deal would not be approved is based on an FCC rule prohibiting the merger of the two players, no compelling reason to change that rule amidst likely aggressive opposition of the powerful broadcast lobby. Likelihood is further reduced by the fact that in most of the cars in the U.S. over the next five years, there are only likely to be two pay radio providers (XM and Sirius), which would be reduced to one by this deal. Over the long term, they believe more competition will emerge in the car, but as of today widely available factory install alternatives simply do not exist. Firm believes the sat radio players' strategy is get approval from the DOJ and hope that this will put pressure on the FCC not to vote against a deal.

For 2006, they estimate the combined companies generated $1.5B in revenue, yet some have publicly surmised there are $7B in synergies from the proposed merger. This level of potential synergies is extremely unrealistic, in firm's opinion.

Firm notes their historic caution on the sat radio stocks has been driven primarily by belief that results would continue to weaken amidst a rich industry valuation. This merger attempt despite long odds would seem to validate this belief that results for the industry are likely to continue to be
worse than expectation, which should be highlighted by weak '07 guidance for both players. Despite a likely move higher in the shares today, they believe even at current valuation levels assuming a deal is approved as is, the implied valuation of the combined company is rich. After a pop amidst potential merger/synergy euphoria these stocks again are likely to trade on weak fundamentals, regulatory milestones (or lack of milestones), and valuation.

Notablecalls: There will surely be a pop in both stocks as investors greet the news of a merger. It had long been my personal view that merging was one of the best ways for these two to generate some shareholder value. However, the odds of getting the merger done are not so favorable. The main hope here seems to be that Karmazin knows what he is doing. After all, he's the king of radio mergers. So, currently it looks like XMSR is a short around the $17.30-$17.50 level. Have no feel for SIRI but it sure looks like $4 is the line in the sand.