Despite a slow start last year, New York-based Sirius Satellite Radio [Nasdaq: SIRI] is gaining ground on its U.S. rival XM Satellite Radio [Nasdaq: XMSR].

Sirius expects to raise $168.875 million through a convertible notes offering in order to fund its operating needs through cash flow break-even. The company also is preparing to flex its marketplace muscle by introducing plug-and-play units to drive retail sales.

Sirius has gained momentum since its $1.2 billion recapitalization in March. The latest infusion will address a funding shortfall of roughly $100 million that Sirius management acknowledged still existed after the March financing was completed.

The company’s improved financial and operating outlook spurred Marc Nabi, a satellite and broadcasting analyst at Merrill Lynch, to upgrade his “sell” recommendation on Sirius to a “neutral” rating. He previously had been one of most skeptical Wall Street analysts on the prospects for Sirius and satellite radio overall.

“At our July 2002 downgrade to sell, we believed an incorrect capital structure without fundamental catalysts did not justify the high-risk exposure,” Nabi wrote May 22. Sirius’ risk/reward position appears improved following the recent capital raising, good first-quarter subscriber results and a positive shift in its financial fundamentals, he added.

The new financing is “proactive” and opportunistic in unpredictable markets, Nabi said. Despite the financing and Sirius’ successful first quarter recapitalization, he disagreed with Sirius management’s forecast that the company now is funded to reach free cash flow break-even by early 2005.

Nabi is forecasting that Sirius will not hit that break-even mark until 2006 and will need $175 million in additional funding by then. Sirius officials reiterated their more optimistic break-even forecast after Nabi’s latest research note was released.

“Our business model shows that we can be cash flow break-even with 2 million subscribers in the first half of 2005,” said Jim Collins, Sirius’ vice president of corporate communications.

Morgan Stanley is the “book running manager” for Sirius’ new offering of 3.5 percent convertible notes due 2008, while UBS Warburg serves as co-manager. Sirius granted the underwriters an option to purchase up to an additional $26.25 million of the notes in a deal that is expected to close any day.

The company said it would use net proceeds to eliminate its “funding gap” and for general corporate purposes. The notes are convertible into Sirius’ common stock at the option of the holder for a conversion rate of 724.6377 shares per $1,000 principal amount, or $1.38 per share. Sirius cannot buy back the notes until the 2008 maturity date.

Plug-and-Play

The new plug-and-play units built by Kenwood and Audiovox [Nasdaq: VOXX] are priced at $99.99 for a receiver, $69.99 for car docking kit and $69.99 to $89.99 for the in-building docking kit. The combined cost approaches the $200 price point that consumer electronics retailers find products need to fall under to gain mass market acceptance, according to a research note by SG Cowen. The Sirius plug-and-play units are “substantially superior” to the first-generation plug-and-play unit built by Sony [NYSE: SNE] for XM, SG Cowen’s satellite analysts wrote.

The new plug-and-play units will hit store shelves just in time for Father’s Day, June 15, Sirius officials said.

The new portable Sirius plug-and-play units allow subscribers to use the same equipment in their car, home, office, and boat for a $12.95 a month subscription price. Sirius also offers a “preferred” subscription plan that charges $6.99 a month for each additional unit ordered by the same customer.

Listeners of the Kenwood plug-and-play unit can observe what is playing on other Sirius streams by song title or artist name. An additional feature of Kenwood’s Here2Anywhere is a memory and recall option that allows a listener to save up to 24 song titles and associated artist names while they are listening. The feature lets the listener call up those song titles or artist names in the future by touching a button.

The Audiovox Satellite Radio Shuttle unit has two unique features, Sirius officials said. First, the unit uses an FM transmitter with four frequency adjustments incorporated into the docking station for a wireless connection to virtually any vehicle radio. The Audiovox receiver unit also is the first satellite radio device to include a feature called S-Seek that allows a listener to save up to 10 favorite songs and to receive notification as soon as one of those songs is played on any of Sirius’ 60 music channels. With the touch of a button, the unit can be tuned to that stream to allow a listener to hear his or her favorite songs, Sirius officials said.

Sirius’ Collins said his company’s new plug-and-play features have a number of advantages over the comparable model offered by rival XM.

Both the Kenwood and Audiovox units have more channel presets than XM offers for a listener to find his or her favorite audio streams quickly.

“Our plug-and-play models will be very popular. Our retail partners are telling us that our in-dash units already are selling quite well, compared to XM,” Collins said.

If XM’s SKYFi plug-and-play units also are countered, it should significantly increase Sirius’ market share, he added.

Sirius has plans to offer a boom box unit to compete with the hot-selling XM SKYFi unit by year-end, Collins said. The SKYFi is an attractive device because it offers the versatility to work in a car, home or as a portable boom box.

Great Expectations

“We believe that the plug-and-play product will be very well received at the retail level,” Collins said. “It is one thing that we were missing in our retail product portfolio. We also believe there will be a strong demand for devices that can be integrated into your in-home entertainment center, and we plan to introduce those units in the fall.”

In the third quarter of 2003, Audiovox also plans to introduce a boom box, according to SG Cowen. JVC and Sanyo [Nasdaq: SANYY] are expected to unveil plug- and-play units late in the year, SG Cowen’s satellite analysts added.

Chance Patterson, XM’s vice president of corporate affairs, said the introduction of his company’s Delphi [NYSE: DPH]-manufactured SKYFi unit has proven to be a boon. That product accounts for the lion’s share of all new retail satellite receivers industry-wide, he explained.

“The SKYFi boom box has been a big seller for us,” Patterson said. “In fact, we can’t keep them on the shelves.”

When XM may have a next-generation plug-and-play unit to match or exceed the new features offered by the Sirius plug-and-play units is unclear.

“We, as a matter of course, don’t go into a lot of detail about planned products,” Patterson said. “As we approach the fall, XM will have a broader array of consumer products at retail.”

To that end, XM will continue to “leverage off” its technology advantage to give consumers products that they want to buy, Patterson said. Product development and executing the company’s business plan for growing subscribers are keys for XM, he added.

Despite the new financing and the plug-and-play product rollout by XM, Sirius only has roughly 50,000 subscribers, compared to more than 500,000 for XM, Patterson noted.

“Effectively, Sirius is just launching its business,” Patterson said. Hard-earned lessons about training sales personnel, product distribution and point-of purchase learning already have been picked up by XM. Sirius now faces those same challenges as it ramps up, he added.

With XM projecting to have more than 1.2 million subscribers by year-end and Sirius expecting to amass roughly 300,000 by the same time, XM will finish the year with an 80 percent market share, Patterson said.

Market Forecast

“We will be excited to have an 80 percent market share of a year-end, industry-wide 1.5 million subscriber base,” Patterson said.

As far as comparing the new Sirius plug-and-play units to XM, Patterson said both have similar functionality. In his view, the Sirius products, especially the Audiovox unit, are “a bit bulkier.”

“The bottom-line is we’re going to execute our business plan as we always have done, regardless of what product Sirius rolls out,” Patterson said. “We will be well-positioned in the marketplace.”

The latest financing arranged by Sirius, combined with additional financing obtained by Sirius and XM earlier in the year, is a “positive development” for the industry, Patterson said. The “financing risk” that previously had dogged both companies now has been minimized, he added.

Both companies also are gaining traction in the OEM sales arena as more automobile manufacturers add the equipment to their new vehicles.

“We will be available in more than 70 car models by this fall,” Patterson said. Aside from XM investor General Motors [NYSE: GM], Honda [NYSE: HMC], Acura, Nissan [Nasdaq: NSANY] and Infiniti all will be offering the service this year. “We have accelerated the growth of this OEM category in a very short amount of time,” he said.

XM is projected to reach cash-flow break even by late next year.

“From there, we will have a business with a huge upside,” Patterson said. “More and more people will be interested in XM as customers and investors. The one million-subscriber mark, a milestone that XM projects to reach later during 2003, would be meaningful from both an investor standpoint and from a consumer and marketing standpoint, he added.

“We expect that as we exceed that number in the coming months, many more people will join the current fans of satellite radio,” Patterson said.

XM’s research suggests there are nearly three listeners for each subscriber, so the fan base already could be higher than the subscriber counts reflect, Patterson said. With both XM and Sirius offering discounts for families to add additional subscriptions, that overall customer count could gain additional lift.

Sirius should gain traction with its new product introduction.

“It is very important to get below that $200 price point for broad consumer acceptance,” said Bruce Leichtman, president and principal analyst of Durham, N.H.-based Leichtman Research Group.

Now that the price point has fallen to a level that will not be a barrier, the next business side challenge is for Sirius to boost its customer awareness, Leichtman said.

“I still think there is great opportunity out there for both companies,” Leichtman said. “While the cumulative subscriber numbers between the two companies are improving, there still is a huge untapped potential.”

With roughly 200 million automobiles on the road in the United States, only 20 million of them, or 10 percent, would need to have satellite radio to create a big business, Leichtman said. With a lower price point and heightened awareness, that total industry-wide subscriber goal is “easily attainable,” Leichtman said. “I think there is an opportunity for a rising tide to lift both companies’ boats.”

Prior to the rollout of its plug-and-play units, Sirius had faced some product limitations that hurt its growth, said Leichtman, whose firm conducts market research and analysis for the satellite, cable and broadband industries.

–Paul Dykewicz

(Marc Nabi, Merrill Lynch, 212/449-2468; Jim Collins, Sirius Satellite Radio, 212/901-6422; Chance Patterson, XM Satellite Radio, 202/380-4318; Bruce Leichtman, Leichtman Research Group, 603/397-5400; Tom Watts, SG Cowen, 212/278-4260)