Behind Goldman's XM-Sirius Slam

The sour note on satellite radio halted a nascent rally, but other analysts say the report could ensure FCC approval for the merger

by Olga Kharif

Just when you thought it was safe to get bullish on satellite radio, along comes a bearish Wall Street report. Days after a top U.S. regulator pledged to give a long-awaited green light to a merger of XM Satellite Radio (XMSR) and Sirius Satellite Radio (SIRI), an analyst at Goldman Sachs (GS) reiterated its dreaded "sell" ratings on the companies' shares.

In a research note dated June 18, Goldman Sachs analyst Mark Wienkes wrote that his team considers it "unlikely that the industry can generate returns sufficient to justify the current valuation." The analyst, who declined to comment for this story, also reduced his six-month share-price target for XM and Sirius. Uh-oh.

Wienkes' report revived investors' concerns over prospects for the satellite-radio industry, which is being buffeted by competition from rivals such as Apple (AAPL) as well as declining sales of autos, many of which come with satellite-radio receivers preinstalled. The dour prognosis also cut short a share rally that ensued when Federal Communications Commission Chairman Kevin Martin said he will recommend that his five-person commission give its assent to the deal (BusinessWeek.com, 6/17/08). The planned merger has been held up for more than a year as regulators have deliberated whether it would thwart competition and result in higher prices for consumers.

When the deal does go forward, assuming Martin gets support from at least two other commissioners, XM and Sirius may need to raise as much as an additional $1 billion in capital, a move that could dilute the value of existing shares, added Wienkes, who slashed his target for Sirius to 1.75 a share from 2.25 and for XM to 6.50 from 11.50. The Goldman Sachs team also cites reports suggesting that demand for satellite radio is falling among younger listeners. XM shares have plummeted 24%, to 8.14, since the report was released. Sirius' stock has tumbled 23%, to 1.93.

Proceed With Caution

Even an analyst who says investors are overreacting to the report remains cautious. "Growth is there, but it's decelerating," says Tuna Amobi, an analyst at Standard & Poor's which, like BusinessWeek.com, is owned by The McGraw-Hill Companies (MHP). "The fundamentals have deteriorated significantly since the deal was announced" more than a year ago, he notes. That slowdown emanates in part from "uncertainty" whether the deal will proceed and in part from the economic slump, Amobi says. What's more, the expected $3 billion in cost savings and revenue gains from the deal are beginning to sound "optimistic," he says. The companies will incur more expenses and may need to sacrifice revenue as they meet regulators' conditions designed to ensure that the deal doesn't harm consumers, he adds. "You have to comply with regulatory conditions while going on this steep climb to get to free cash [flow]."

As steep as the climb may be, it's not insurmountable, says Amobi, who believes investors are getting carried away. On June 20, Amobi upgraded Sirius' stock to a "buy," with a 2.50-a-share target. He had upped XM's rating to "hold" several days previously. After sliding more than 30% since May, the stocks are cheap. "This [price drop] is mind-boggling, like nothing that we've ever seen, so you have to wonder how much more downside there is," Amobi notes. Cowen & Co. analyst Tom Watts also begs to differ from Goldman. "We disagree with a competitor's negative view," Watts wrote in a note.

Negative Report, Positive Effect?

In fact, the competitive pressures outlined in Goldman's report could even ensure that XM and Sirius get a green light from the FCC, some analysts say. "This is a fundamentally pro-merger analysis," says Blair Levin, an analyst at Stifel Nicolaus & Co. and a former FCC official. "As the FCC looks at this, I suspect if people were on the fence, this is the kind of thing that makes you more nervous about saying no to the merger."

XM and Sirius are also likely to spur growth if, as expected, they release a receiver that can pick up transmissions from either service. Even falling demand for cars may not have as bad an impact on the enlarged company as some expect, Amobi says. While car sales may fall, more cars that do get sold will feature built-in satellite radios. XM expects its penetration rate among carmakers to rise from the current 40% to 70% in the next few years, offsetting the sales declines. Sirius will make that jump in Ford's (F) 2009 models.

Some of the conditions imposed on the deal may well spur demand for satellite radio, says Ross Rubin, an analyst at consultant NPD Group. The FCC is likely to insist that XM and Sirius offer channels on an à la carte basis. Packages selling for $7 or $8 a month, compared with the current $12.95 a month, "definitely have the potential to bring in a group of consumers that might be on the fence today," Rubin says.

Kharif is a senior writer for BusinessWeek.com in Portland, Ore.