Dollars And Sense: Satellite Radio–Getting Plenty Of Static

by Armand Musey

Recently, there has been a great deal of concern about the financial viability of the two satellite radio companies, Sirius and XM Radio. We maintain our long-term thesis that satellite radio has the potential to be a broadly accepted consumer offering, and ultimately offers investors a very attractive business model. Satellite radio’s initial funding costs are high, as upfront investment is significant and operating losses will be heavy in the initial years of service. However, once the satellite radio companies build out their subscriber bases sufficiently to cover their fixed operating costs, they should be able to capitalize upon their national distribution capabilities and relatively low variable costs. Likewise, returns on capital invested in new subscribers will rise to very attractive levels, and margins and cash flow should rapidly expand.

In the meantime the questions are how do we get there from here, and does the long-term process make these companies attractive investments at their current distressed levels? The answer is not simple, and we would caution investors to keep three factors in mind before investing in the satellite radio companies. First, ultimately the success of satellite radio depends on the distribution support of the automobile manufacturers. Second, even if the automobile manufacturers can deliver the subscribers, the satellite radio companies must rely on the capital markets funding operations and subscriber acquisition costs until they reach break even, which is not expected for both companies until late 2004 or early 2005 under current projections. Finally, the current players are both burdened by excessive leverage in their capital structure and one or the other, or both, may not survive in their existing form.

We believe the initial indications that automobile manufacturer support for satellite radio is strong, particularly GM’s support for XM Radio. If XM Radio becomes a popular option on GM cars, the other manufacturers are sure to follow its lead by strengthening their efforts to highlight satellite radio as an option for new car buyers. This is critical because aftermarket distribution will never generate sufficient subscribers for satellite radio to become economically viable. We project aftermarket sales will account for less than 20 percent of new satellite radio subscribers once all channels of distribution are fully online. The current consensus is for total subscribers to exceed 20 million by 2006. New car and truck sales are expected to be roughly in the 17 million-range by 2006, implying satellite radio will need about a 20 percent market penetration of new vehicle sales, which we think is an aggressive, but not unrealistic outlook.

The question of continued capital market support is harder to resolve. Currently neither company has significant revenues and both have fixed cost bases of approximately $135- $150 million per year, plus heavy sales and marketing and subscriber acquisition costs. Both companies, by their own admissions, will each need at least $600 million in incremental funding before they break even. More importantly, at current cash burn rates both companies only have enough cash on their balance sheets to fund operation through early 2003. Both companies are also projecting funding deficits of $200-$300 million for 2003 alone. Investors will have to foot this bill. Right now it is not clear to us that they will be willing to do so.

All this means the satellite radio companies are between a rock and a hard place, particularly Sirius, which has managed to squander a significant headstart over XM Radio and continues to miss milestones and reset expectations for its initial year of subscriber growth.

This leads us to the conclusion that the current players may not survive in their existing form. We believe the next critical step for satellite radio will be the level of success of XM Radio’s introduction in GM 2003 model cars. If this introduction goes poorly, all bets are off for the industry, as neither company is likely to find support for its next round of financing. However, if it does go well it will likely be sufficient to allow XM Radio to secure its next round of funding, although how attractive the terms of this deal would be is hard to say. One might think a successful GM rollout of XM Radio would have positive implications for Sirius. But, actually, we suspect it may put the final nail in Sirius’ coffin. The reason: investors wishing to bet on demand for satellite radio are more likely to back XM Radio thinking it is the clear winner rather than continue to spread their risk across both companies. This could potentially throw Sirius into bankruptcy, which would leave current shareholders with nothing.

Armand Musey is a satellite communications analyst at Salomon Smith Barney (SSB). Part of the information provided herein includes excerpts, abstracts, and other summary material derived from research reports or notes published by Musey as a member of SSB’s Equity Research Department. For a copy of the full research reports or notes from which such information is derived, please contact an SSB salesperson . To view the research-report disclosure required by the NYSE and NASD rules relating to analyst independence and conflicts of interests, private-client investors may visit SSB’s disclosure Web site at http://www.ssbaccess.com and institutional investors may visit the SSB’s disclosure Web site at http://www.ssbgeo.com, or contact an SSB sales person. In addition, valuation methodologies and associated risks pertaining to price targets, as well as other important disclosures, are contained in research reports and notes published on or after July 8, 2002. Salomon Smith Barney or its affiliates has received compensation for investment banking services provided within the last 12 months from XM Satellite Radio, Inc.