Citi issued a report on XM’s Q4 and full year operations.


XM Satellite Radio Holdings Inc (XMSR)

No Real Surprises in 4Q07 – Merger Remains Stock Driver

? Fate of XM Still Depends on Merger — We estimate XM price reflects a roughly 25% probability of merger approval, but we still believe it’s more likely than not, Maint. Buy (1S) rating w/new, probability weighted target of $17, based on lower downside potential on lower estimates. XM still has a favorable risk/reward with 41% ETR to target, vs (20%) downside potential

? In Line Subs, Positive Net Add Growth, OEM Still Driving Bus — XM had in line 4Q subs of 9M w/ better OEM weaker Retail. Still, XM drove the 2ndqtr of Y/Ynet add growth at 4%, the second time since 1Q06.

? Conversion Rate and Churn Look Good — Conversion rate rose to 53.9%,best in 6 qtrs and good in light of heightened penetration. XM also kept self pay churn low at 1.72% w/focus on customer care. But better customer care came at a cost w/customer care exp in 4Q as % of revs rising to 27% (vs. 15% last yr).

? SAC/CPGA/Royalty Going Up — FY 07 SAC of $75 was 18% higher than FY06 at$65, but if we account for cars on lots related to already spent SAC, it would be lower at $63. Mix shift to OEM also pressures CPGA rising to $140 in 4Q, but ex Starbucks exp, CPGA wd be a more modest $120 closer to recent qtrs, but still above historical rates due to bigger OEM mix. Higher royalties also hikes expense profile, w/royalty exp as % of rev likely up 400bps+/yr and rising. ? 4Q07 Mixed Bag —Revs of $308, +20%, beat est. w/ better than est. ARPU. But offsetting better revs and lower int exp. was more royalties, cust. care exp.and non-cash comp w/led to deeper EPS loss of ($0.78) vs ($0.68) est.

Believe XMSR Stock Continues to be Driven by Merger Prospects XMSR shares have rallied 14% over the past 1 1/2 months on increased optimism, as we see it, regarding the possibility of getting regulatory approval for its pending merger with Sirius Satellite. Looked at another way, the stock is roughly flat since the start of the year, compared with the radio group down (21%) and the S&P 500 down (7%). Any way you slice it, we believe XMSR has seen stock outperformance driven in large part by the hopes that it will achieve merger approval. We note that assuming PV of synergies at $7 billion (which is above consensus), the stock currently reflects a roughly 25% probability of merger success. Even if we use a more modest consensus synergy number of $4 billion, the stock price reflects a 33% probability of success, which is too low, in our view. Specifically, we continue to feel a merger remains more likely than not, although our view is not without risk particularly as the merger approval process continues to drag out. On a fundamental basis, after accounting for recent changes in XMSR’s royalty structure, higher customer care costs, and greater than expected stock based comp, the company is plugging along roughly in line with our expectations. However, we have had to trim estimates given the large increase in royalties and stock based comp. Based on our new estimates, we arrive at a new probability weighted price target of $17, down from $19.50, which assumes a 60% probability that the merger will be approved. Our new price target implies a 41% estimated total return, making our Buy (1S) rating still appropriate.

In Line 4Q Subs, Same Old Story, OEM Good, Retail Weakening Subs XM reported ending subscribers for 4Q07 of 9.03 million subs, which was in line with our estimate, and at the low end of its guidance of 9 to 9.2 million (but which guidance was set long ago). Specifically, both OEM subscribers and Retail subscribers came in where we expected at 3.59M and 4.52M, respectively. Overall, XM delivered 460K net subscriber additions (361K OEM and 99K Retail) which translated into 4% Y/Y growth in Net Adds, only the 2ndquarter to show positive growth in Net Adds in the last 7 quarters. Breaking this down further we seen Net Add growth was fueled by the OEM channel up 87%, and dragged down by Retail which saw a (63.5%) decline in Y/Y Net adds. However, on a positive note, Retail Net Adds were actually positive, in comparison to actually turning negative for the first time back in 3Q07. On a Gross Add basis, XM reported 1.13M in total gross adds, up 6% Y/Y, the third consecutive quarter of positive gross add growth. Retail Gross Adds were down (33%) while OEM Gross Adds increased 46%.

OEM Conversion Rate Rises – A Positive XM reported an impressive 53.9% OEM conversion rate, up from last year at 52.4% and up from 3Q07 at 52.5%. XMSR’s conversion rate in 4Q07 is the best we’ve seen in the last 6 quarters, and all in the face of ramping penetration at OEM partners. While there continues to be fluctuation in this metric, over the past 2 years, we believe XMSR should be given credit for maintaining conversion rate in a fairly narrow band of 52% to 54% at the same time that penetration rates have soared. Looking ahead, XM seemed fairly confident that given the steps they’ve taken (like better dealer engagement, channel presets, etc.) to maintain/improve conversion rates that they would be able to keep conversion rates in the low 50%’s range, which given increasing penetration is a positive in our view. Longer term, we continue to think conversion rates will come down as penetration moves from luxury cars to lower end vehicles where consumers are likely to be more cost conscious. Specifically, we anticipate that as XM’s penetration into partners such as Nissan, Hyundai, Toyota and GM increases, the conversion rate is likely to decline from the current 54% to the low 40% (on average) ten years out.

Self Paying Churn Stays Low – A Positive XM reports self paying sub churn (both OEM and aftermarket Retail) of 1.72%, which is down from the 1.79% churn one year ago, and a tad up from 3Qchurn of 1.69%. To put XM’s churn in perspective, 4Q07 results were a strong improvement over the 1.8% to 1.85% range for churn that XM saw in the 5 quarters from 2Q06 to 2Q07. XM’s ability to sustain its recently dropped churn number is a significant positive and an increased vote of confidence by subscribers in the satellite radio product. Its ability to maintain low churn is also a testament to XM’s focus on customer service. Although XM does not disclose the exact split between OEM and retail self paying churn, but we continue to estimate that Retail churn is running at roughly 2% per month while OEM is at a lesser 1.4%. However, all this focus on customer care to improve conversion rates and churn also came at a cost, with 4Q07 customer care as a percentage of revenues rising to 27% in 4Q07 versus 15% of revenues in 4Q06.

Not a Surprise, Expense Profile Changes with Heightened Royalties Not surprisingly, XM’s Royalty and Revenue share expenses increased in large part to the increased fees it has agreed to pay as determined by the Copyright Royalty Board back in December of 2007. This increase in royalties is magnified by the fact that XMSR charged the entire 2007 royalty increase in 4Q07 of $37 million. There was also a $13 million settlement for recording label law suits. The net effect was a 146% Y/Y increase to $107M, or 35% of total revenues. Looking forward, however, by spreading royalty fees over the year, we expect total Royalty and Revenue share expenses to hover around 22% of total revenues in 2008 increasing by 50 basis points a year for several years. There was also pressure in this line item due to mix shift to OEMs which caused an increase OEM revenue share expense that is not present with regard to a Retail sub. Looking ahead as the business model continues to shift to OEM, we expect the Royalty and Revenue share expenses to represent a large portion of the company’s expense profile, which has now increased.

SAC/CPGA Continues to Move Higher Due to Shift to OEM While we continue to like the growth prospects of the OEM channel there is a near term cost in the form of increased SAC and CPGA. XM’s subscriber acquisition cost (SAC) came in at $87, a 25% increase, due in large part to the shift to OEMs including increased factory installation costs from relatively new OEM partners. Specifically, the company has already outlayed the SAC costs, but will not be able in many cases to record the gross add until the car is sold, or they become a paying subscriber. The company noted that if they included cars on the lot not yet sold as gross adds, their FY 2007 SAC would actually have been $63 (instead of $75) which would have been an improvement over 2006 FY sac of $65. Similarly, when looking at CPGA (which has SAC as a component), the shift toward OEM has increased this metric to $140 in 4Q07, up from $128 last year, and higher than our $118 estimate. But we would note, if we exclude the $22 million Starbuck settlement included in marketing, this would have cut CPGA down by $20 to $120 in 4Q07 and more in line with our expectations, and an improvement from last year. Longer term we continue to expect mix shift to OEM will pressure the SAC and CPGA metric.

Revisions to Estimates and Price Target Change While XMSR is not issuing guidance for 2008 until greater clarity on whether or not the merger will be approved, we have still made an attempt at forward estimates. We have opted to keep or revenue estimate intact at $1.3 billion. However, with a much higher royalty and revenue share expense profile, coupled with what we expect could be higher customer care costs, SAC and CPGA costs than we initially expected, our expense forecast increases, leading to 2008 adjusted EBITDA loss of ($230). Our EPS also falls to a loss of ($1.96) versus our prior estimate of a ($1.87) per share loss. Using a probability weighted analysis on whether or not the proposed XM/SIRI merger will close, we assume a 20% downside risk to the price if the deal does not close (to $10), and assuming a PV of $7.2 billion in synergies, and assuming a 60% probability that the deal goes through, we arrive at our new $17 price target, down from $19.50 previously.

4Q07 Recap: In Line Subs, Better Revs, But Higher Costs XMSR delivered better than expected revenues of $307.7 up 21% and 7% higher than our estimate. 4Q revenue results were based on in line subs suggesting better than expected subscription ARPU of $10.14. In terms of expenses, SAC came higher than expected at $87 (vs. our $80 estimate) due in large part to the switch in mix toward OEM. Similarly, CPGA came in higher at $140 (vs our $118 estimate). But perhaps most notable was the very large increase in the revenue and royalty line, due in large part to the CRB settlement which increased royalties paid out. The result of this was magnified by the fact the XM took this increased royalty charge of $37 which applied to full year 2007 all in 4Q07. The net result was the Royalty Revenue Share line item was up 146% to $107M, which was $52M above our estimate which had not yet been adjusted for the royalty ruling. With also higher than expected stock based comp, despite solid revenues, EPS fell a dime short at a loss of ($0.78) per share.

Investment strategy We rate the shares of XM Satellite Radio Holdings Inc Buy/ Speculative (1S). In our view, satellite radio still remains one of the few areas within the media sector that offers attractive secular growth. Still, with a proposed merger with Sirius Satellite in the works and a high level of uncertainty as to the outcome, merger-related news flow will likely be the key stock driver for now. We continue to feel there is greater than currently expected potential upside if the merger goes through, and that there is a greater probability that the deal is consummated than currently reflected in the stock. Understanding the strictly binary potential paths for XM stock on whether the deal is approved or not, for investors with a greater risk tolerance, we think the risk-reward in XM favors investment in XM stock.

Valuation Our $17 price target is based on a probability weighted analysis on whether or not the proposed XM/SIRI merger will gain governmental approval and be closed. Specifically, assuming a 20% downside risk to the price if the deal does not close (to $10), and assuming a PV of $7.2 billion in synergies, and assuming a 60% probability that the deal goes through, we arrive at our $17 price target. Further, our analysis assumes a Cost of Equity in deriving the present value of synergies of 8.9% a risk free rate (in accordance with CIR recommendations) of 4.09%, an equity risk premium (in accordance with CIR recommendations) of 4.18%, and beta of 1.2 which translates into a terminal year multiple of 13.5x (based on a long-term free cash flow growth rate estimate of 1.5%).

Risks We have assigned a Speculative Risk rating to XM Satellite due primarily to strong stock impact up or down from the binary decision on whether or not XMSR and SIRI’s proposed merger is approved. Other risks also include the fact that XM is still in the early stage of its business cycle and thus still operating with quarterly net income loses. Furthermore, if Retail subscriber growth slows faster than expected, or OEM growth accelerates more slowly than expected, XM may have difficulty reaching our current subscriber estimates. Furthermore, if there is a greater than expected increase in music industry royalties, XM may have trouble reaching our current estimates.

Tyler Savery Position – Long Sirius, Long XM