Lehman Brothers analysts Vijay Jayant and James Ratcliffe issued detailed reports today on Sirius and XM. The analysts carry price targets for Sirius and XM of $4.90 and $19.00 respectively.

SIRIUS REPORT EXCERPTS

Change of Price Target Updating Model, Focus on Merger Prospect

Investment Conclusion

Updating standalone SIRI model to reflect revised OEM production volumes, delayed timing of modeled price increases. Believe share performance likely to continue to be driven by merger prospects, not underlying business fundamentals. Adjusting price tgt to $4.90 to reflect subscriber and margin estimate changes, retain 1:OW rating.

Summary

Lowering auto production forecasts, although higher Sirius install rate partially offsets subscriber impact. Raising music royalties forecast to reflect CRB decision, which was modestly more costly than we had expected. 4Q07 estimates now include impact from CRB decision (true-up payment), although cash pmt not expected until 1Q08E. Key 4Q07 ests: 654k net adds (already announced), $100 SAC, $10.13 ARPU, $271MM rev, ($160)MM adj. EBITDA, $76MM FCF, does not include CRB true-up payment.

We are updating our Sirius model to reflect evolving conditions in the OEM and retail markets, as well as higher content expenses (due to the recent Copyright Royalty Board decision). We continue to believe that the fundamental story of the satellite radio industry is driven by the auto OEM business. In the near term, however, satellite radio stock performance is likely to be driven by the market’s perception of the likelihood (and timing) of the approval (by the FCC and DOJ) of the XM-Sirius merger. We expect Sirius shares to continue to be volatile in the near term, until the merger question is resolved. We are lowering our standalone price target on SIRI to $4.90 from $5.40, reflecting lower revenues due to delayed price increases in a standalone scenario. We retain our 1:OW rating.

Auto OEMs –

Adjusting Production and Subscribership Forecasts. We are lowering our overall vehicle production forecasts, reflecting revised expectations for the overall US vehicle market and macroeconomic environment. Overall, we are lowering our cumulative 2008-2013E estimates for OEM vehicle production by approximately 17%. While our absolute unit production numbers are lower, this is partially offset by an increase in our expected Sirius radio installation rates, as automakers increase their commitment to deploying satellite radio as more of a standard product in vehicles. By 2011E, for example, we now expect Sirius’s OEM partners to install satellite radios in approximately 81% of their expected vehicle production, up from 80% in our previous forecast. On net, our expectations for Sirius unit installations declines somewhat; we now expect 2011E unit volumes of 5.0MM Sirius-equipped cars, down from our prior 6.0MM forecast.

Our lower satellite-radio equipped vehicle forecasts drive somewhat lower Sirius OEM subscriber forecasts. We now expect 14.3MM Sirius OEM subscribers by 2013E, down from our prior 16.8MM forecast. This reflects 57% of the expected population of Sirius-equipped vehicles, down from our prior expectation that 61% of Sirius-equipped vehicles would be active customers by YE 2013E, due also to the increasing share of the market taken up by customers whose Sirius-equipped vehicles do not include bundled subscriptions.

Adjusting Margins to Reflect CRB Ruling –

True-Up Included in 4Q07 Estimates. We are adjusting our future cash flow margins to reflect the December ruling of the Copyright Royalty Board (CRB) on the appropriate royalty payments for satellite radio to make for the right to broadcast musical performances (for further detail on the CRB process, please see our 1/8/07 report Paying the Piper: SatRadio Music Fees). While we had expected the arbitrator’s ruling to include an increase in the royalty payments (as a percentage of revenue), the CRB’s decision was modestly more favorable to the recording industry than we had anticipated, and we are therefore increasing our estimate for long-term royalty payments above our prior forecast. In the past, Sirius had been paying, on net, approximately 4.5% of revenue for both recording and songwriting (ASCAP, BMI) royalties. We had expected this to rise to approximately 8.5% with the new agreement. We had also expected an escalator which would take total fees to approximately 9% of revenue by 2013E. Per the arbitrator’s decision, however, the total royalty appears likely to rise to approximately 11% of revenue by 2013E. We have incorporated this higher forecast for royalty payments in our model going forward.

In addition to the going-forward impact of the increased royalty fees discussed above, the CRB’s decision has a short-term impact on Sirius’s earnings and cash flow. The CRB’s decision is retroactive to the expiration of the previous agreement at the end of 2006. The satellite radio industry had been continuing to pay royalties to SoundExchange over the course of 2007 on the terms of the expired agreement, with the understanding that, once the arbitrator made its decision, the industry and SoundExchange would “true up” for the period since the end of 2006, with satellite radio making an additional payment if the terms of the arbitration resulted in a royalty increase, and the industry getting a rebate should the arbitrator actually reduce the royalty level. Since the royalty level was in fact increased, the satellite radio industry owes a one-time “true-up” payment. We expect Sirius to expense this payment in 4Q07, although the actual cash will not be paid until 1Q08. We expect Sirius’s one-time payment to be approximately $30MM, equal to the difference between a full year at 4.5% ($39MM) and a full year at 8% of revenue ($70MM).

Price Increases –

Assuming in 2H08 in the Absence of a Merger. We continue to believe that price elasticity in the satellite radio sector is somewhat limited, even with two players in the sector, and that Sirius had been planning on increasing prices, a price increase that the current merger talks has put on hold. Should the deal not go through, we would expect the company to go through with a price increase. Given the delay in merger decision, we have pushed this expected standalone price increase out to mid-year 2008. Our full year ARPU estimate for 2008E declines from $11.78 to $10.50, reflecting the delayed price increase. As a result, our 2008E revenue estimate declines to $1.26BN from $1.50BN, due to the lower expected ARPU in 1H08.

Estimate Revisions.

We are adjusting both our near-term and long-term estimates for Sirius, reflecting the factors discussed above.

Subscribers. Our YE 2007E subscriber estimate is slightly higher at 8.32MM, up from 8.28MM, and now reflects 654k 4Q07 net additions, in line with the company’s announcements. For 2008, we now expect 2.03MM net additions, down from our prior 2.72MM forecast due to lower OEM and retail sales.

SAC and CPGA. Our 4Q07E SAC is up modestly at $100 vs. $103 in 4Q06, reflecting auto OEM ramp-up costs. For 2008E, we expect SAC of $95, down (8.2)% YoY.

Revenue. Our full-year 07E revenue estimate is down slightly at $944MM, due to a change in subscriber acquisition timing, while our 2008E estimate declines to $1.26BN from $1.50BN, due primarily to lower ARPU resulting from the delay in price increases mentioned above.

EBITDA. We now expect a 4Q07E EBITDA loss (excluding stock compensation) of $(160)MM, up from our previous $(120)MM estimate due primarily to the one-time CRB true-up payment. For 2008E, we expect a loss (excluding stock compensation) of $(228)MM, up from our prior $(61)MM estimate due primarily to lower revenue.

Free Cash Flow. We expect a 4Q07E FCF gain of $76MM, up from $36MM in 4Q06. Our estimate does not include any cash outlay for the CRB true-up. For 2008E, we now expect a $(360)MM loss, up from our prior $(103)MM loss, due primarily to the larger forecast EBITDA loss. We continue to expect positive free cash flow for 2009E.

Valuation. Our revised YE 2008E price target of $4.90 (down from $5.40 due to lower long term forecasts) is based on a stand-alone Discounted Cash Flow (DCF) valuation. Our key assumptions include risk free rate of 5.0%, an equity risk premium of 4.8%, levered beta of 1.0, cost of debt at 8.5%, target debt-to-capital of 40%, and unlevered free cash flow (FCF) growth rate in perpetuity of 3.0%, yielding a 7.9% weighted average cost of capital (WACC) and 21x multiple on terminal year unlevered FCF.

XM REPORT EXCERPTS

Mkt Focused on M&A -

Investment Conclusion

Updating standalone model to reflect OEM and retail market conditions, CRB decision, timing of expected price increases. Believe investor focus remains on outcome of merger approval process rather than underlying fundamentals of satellite radio business. Recent credit line covenant changes positive indicator of mgmt assessment of deal success probability. Adjusting price tgt to $19 to reflect subscriber and margin estimate changes, retain 1:OW rating.

Summary

Lowering auto production forecasts, but increasing XM install rates to reflect greater standardization of XM into vehicles - now expect XM in 66% of partner vehicle production by 2013E. Raising music royalties forecast to reflect CRB decision, which was modestly more costly than we had expected. 4Q07 estimates now include impact from CRB decision (true-up payment), Starbucks resolution. Key 4Q07 ests: 458k net adds, $81 SAC, $152 CPGA, $10.16 ARPU, $299MM rev, ($133)MMadj. EBITDA, ($98)MM FCF including royalty true-up payment.

We are updating our XM model to reflect evolving conditions in the OEM and retail markets, as well as higher content expenses (due to the recent Copyright Royalty Board decision). We continue to believe that the fundamental story of the satellite radio industry is driven by the auto OEM business. In the near term, however, satellite radio stock performance is likely to be driven by the market’s perception of the likelihood (and timing) of the approval (by the FCC and DOJ) of the XM-Sirius merger. We expect XM shares to continue to be volatile in the near term, until the merger question is resolved. The company’s recent agreement to change the covenants on $400MM in undrawn lines appears to be a vote of confidence in the transaction’s success, as the benefit (the ability of the lines to survive a transaction) would have no value were the deal not to be successful. We are lowering our standalone price target on XMSR to $19 from $20, reflecting higher operating costs. We retain our 1:OW rating

Recent Credit Line Covenant Changes Imply Management Optimism About Deal Success.

XM recently entered into an agreement to modify the covenants on two as-yet-undrawn credit lines totaling $400MM in available capacity.The lenders have agreed to waive a provision that could have led to a default event if the merger is completed; in exchange, XM agreed to place restrictions on the company’s ability to drawn on the lines in early 2009 if the company does not achieve certain pre-marketing cash flow targets in 2008. We view this agreement as an indicator that management continues to believe the deal is likely to be approved. If management did not believe this, then the company would be agreeing to restrictions on its credit lines and getting nothing of value in return. We don’t believe the restrictions are particularly onerous – if the company believed that its ability to access its credit lines would be materially affected by the restrictions, we believe it would have had to note this fact in the SEC filing, and it did not. Even so, the restrictions have some value, so we think the company believes it’s getting something of value in exchange. Since the provision waiver only has value should the deal go through, we view the fact that the company found it worthwhile to obtain it as a sign of management’s confidence in deal approval.

Auto OEMs – Adjusting Production and Subscribership Forecasts.

We are lowering our overall vehicle production forecasts, reflecting revised expectations for the overall US vehicle market and macroeconomic environment. Overall, we are lowering our cumulative 2008-2013E estimates for OEM vehicle production by approximately11%. While our absolute unit production numbers are lower, this is offset by an increase in our expected XM radio installation rates, as automakers increase their commitment to deploying satellite radio as more of a standard product in vehicles. By 2011E, for example, we now expect XM’s OEM partners to install satellite radios in approximately 61% of their expected vehicle production, up from 50% in our previous forecast. As a result, our longer term expectations for satellite radio installation volumes are actually up – we now expect 2011E unit volumes of 6.3MM XM-equipped cars, up from our prior 5.6MM forecast.

Our higher satellite radio-equipped production volumes drive modestly higher OEM subscriber forecasts. We now expect 15.5MM XM OEM subscribers by 2013E, up from our prior 13.6MM forecast. This reflects 48% of the expected population of XM-equipped vehicles, up from our prior expectation that 46% of XM-equipped vehicles would be active customers by YE 2013E.

Adjusting Margins to Reflect CRB Ruling – True-Up Included in 4Q07 Estimates.

We are adjusting our future cash flow margins to reflect the December ruling of the Copyright Royalty Board (CRB) on the appropriate royalty payments for satellite radio to make for the right to broadcast musical performances (for further detail on the CRB process, please see our 1/8/07 report Paying the Piper: SatRadio Music Fees). While we had expected the arbitrator’s ruling to include an increase in the royalty payments (as a percentage of revenue), the CRB’s decision was modestly more favorable to the recording industry than we had anticipated, and we are therefore increasing our estimate for long-term royalty payments above our prior forecast. In the past, XM had been paying, on net, approximately 4.5% of revenue for both recording and songwriting (ASCAP, BMI) royalties. We had expected this to rise to approximately 8% with the new agreement. We had also expected an escalator which would take total fees to approximately 9.5% of revenue by 2013E. Per the arbitrator’s decision, however, the total royalty appears likely to rise to approximately 8.5% of revenue for 2008, and 11% of revenue by 2013E. We have incorporated this higher forecast for royalty payments in our model going forward.

In addition to the going-forward impact of the increased royalty fees discussed above, the CRB’s decision has a short-term impact on XM’s earnings and cash flow. The CRB’s decision is retroactive to the expiration of the previous agreement at the end of 2006. The satellite radio industry had been continuing to pay royalties to SoundExchange over the course of 2007 on the terms of the expired agreement, with the understanding that, once the arbitrator made its decision, the industry and SoundExchange would “true up” for the period since the end of 2006, with satellite radio making an additional payment if the terms of the arbitration resulted in a royalty increase, and the industry getting a rebate should the arbitrator actually reduce the royalty level. Since the royalty level was in fact increased, the satellite radio industry owes a one-time “true-up” payment. We expect this payment to be expensed in 4Q07, although the actual cash may not be paid until 1Q08. We are booking the cash in our 4Q07 forecasts, for the sake of conservatism. We expect XM’s one-time payment to beapproximately $42MM, equal to the difference between a full year at 4.5% ($51MM) and a full year at 8% of revenue ($93MM).

Renewal/Refinancing of Existing Debt Likely to be Required.

Our forecasts for XM indicate that the company is likely to need to refinance the bulk of a $400MM convertible bond coming due in 2009 in order to reach cash flow breakeven. We expect bondholders to elect to receive cash, rather than stock, since the bonds have a $50/share conversion price, a level we very much doubt XM equity will attain by 2009. In addition, the company will need to obtain extensions or refinancings of the company’s two as yet undrawn credit lines, which expire in 2009, in order to reach cash flow breakeven. We estimate total incremental cash needs to reach FCF breakeven at approximately $300MM.

We believe that, by the time the refinancings are required, XM is likely to be on a clear path to FCF-positive, with breakeven cash from operations and predictable (and declining) capital expenditure needs. In that environment, we would expect the company to be able to renew its credit lines and refinance the convertible bonds when they come due. This is, of course, entirely dependent on credit market conditions at that point. For our modeling and valuation purposes, we assume that the company can in fact refinance its maturing debt, albeit at significantly higher rates (12%, approximately equal to the YTM on the company’s existing bonds, vs. the 1.75% the company is currently paying on the convertible bonds).

Price Increases – Assuming in 2H08 in the Absence of a Merger.

We continue to believe that price elasticity in the satellite radio sector is somewhat limited, even with two players in the sector, and that XM had been planning on increasing prices, a price increase that the current merger talks has put on hold. Should the deal not go through, wewould expect the company to go through with a price increase. Given the delay in merger decision, we have pushed this expectedstandalone price increase out to mid-year 2008. Our full year ARPU estimate for 2008E declines from $11.39 to $10.49, reflecting the delayed price increase. As a result, our 2008E revenue estimate declines to $1.4BN from $1.5BN, due to the lower expected ARPU in 1H08.

Starbucks Exit Should Have Minimal Impact – Relationship Benefits Had Been Limited, at Best.

XM’s relationship with Starbucks, which had initially appeared promising, has turned out a disappointment, in our view, so we viewed the announcement that the relationship was being dissolved as neutral to modestly positive. The exit payment made by XM, of $22MM in stock, is recognized in our advertising and marketing expense line. We expect the one-time, non-cash stock payment to increase CPGA by $19 in 4Q07.

Estimate Revisions.

We are adjusting both our near-term and long-term estimates for XM, reflecting the factors discussed above.

Subscribers. Our YE 2007E subscriber estimate is slightly lower at 9.03MM, down from 9.12MM, and now reflects 458k 4Q07 net additions. For 2008, we now expect 1.63MM net additions, up slightly from our prior 1.52MM forecast driven by strong OEM growth, offset by weaker retail growth – we now expect just 80k retail net adds in 2008E, down from 276k in 2007E and our prior 250k estimate.

SAC and CPGA. Our 4Q07E SAC is essentially unchanged at $81, while our CPGA rises to $152 from $128, reflecting primarily the Starbucks settlement. We note that we are currently applying the settlement costs to advertising and marketing, which affects CPGA, but not SAC. Should any of the settlement costs be attributable to SAC, SAC could be above our forecast. For 2008E, we expect SAC of $67 and CPGA of $102.

Revenue. Our full-year 07E revenue estimate is essentially unchanged at $1.13BN, while our 2008E estimate declines to$1.39BN from $1.51BN, due primarily to lower ARPU resulting from the delay in price increases mentioned above.

EBITDA. We now expect a 4Q07E EBITDA loss (excluding stock compensation) of $(133)MM, up from our previous $(104)MM estimate due to the one-time CRB true-up payment. For 2008E, we expect a loss (excluding stock compensation) of $(132)MM, up from our prior $(39)MM estimate due primarily to lower revenue.

Free Cash Flow. We expect a 4Q07E FCF loss of $(98)MM, up from our prior $(69)MM estimate due to the CRB payment. For 2008E, we now expect a $(137)MM loss, up from our prior $(25)MM loss, due primarily to the larger forecast EBITDA loss. We expect positive cash from operations for full year 2009E, although we don’t expect positive full-year FCF until 2011E.

Valuation. Our YE08 price target of $19 (down from $20 to reflect lower near-term revenue due to delayed price increases and lower long-term profitability due to higher music royalties) is based on a Discounted Cash Flow stand-alone valuation. Our key assumptions include risk free rate of 4.8%, equity risk premium of 5%, levered beta of 1.0, cost of debt at 10%, target debt-to-capital of 40%, and unlevered free cash flow growth rate in perpetuity of 3.0%, yielding an 8.3% weighted average cost of capital and 19x multiple on terminal year unlevered FCF.

Tyler Savery Position - Long sirius, Long XM