merrill lynchMerrill Lynch analyst Glen Campbell initiated coverage on Sirius with a sell rating citing that it is too early for investors to step into the equity. The analyst places a $2.30 price target on Sirius, and while he does see merger synergies, he also sees many uncertainties going forward. The lack of any real company guidance can make it difficult for analysts to project performance. This could lead to more conservative stances. While such stances may be frustrating for longs, they will become very beneficial if indeed the merged company can outperform and over deliver. The issue however is that there is little concrete evidence to go on in assuming the merged company can hit the ground running.

REPORT EXCERPTS

Prospects improved by merger, but a tough road near-term

We are initiating coverage of Sirius with a Sell rating and a fair value estimate of $2.30/share, a 20% discount to our YE2008E per-share DCF value of $2.89 pro forma the pending XM merger. The merger is likely to generate tremendous long-term cost and revenue synergies, in our view, worth $6.5bn in NPV terms. The share price is broadly reasonable in relation to our base case DCF value. However, top line expectations for 2008-09 continue to slide and still look too high. Refinancing the XM balance sheet at the merger closing will be costly, with substantial equity dilution possible. We believe it’s too early to buy the stock.

Post-merger base case looks OK but very uncertain

The long-term market potential for satellite radio is the key to valuation – but is highly uncertain. Our base case DCF valuation of $2.89/share assumes growth from 17mn subs at YE2007 (5.6% of the US population) to 40mn subs (12%) in 10 years; our valuation drops $1/share at 30mn subs and rises $1/share at 50mn subs. Substitutes (notably the iPod) have reduced the addressable market and will continue to do so, we believe. But the merger should help to offset this pressure with expanded content, tiered pricing and a simpler marketing message. So should the continuing growth in the rate of satellite radio pre-installation by car makers. With deep post-merger cost-cuts, EBITDA should turn positive next year, with margins nearing 40% by 2017E.

The near term looks tough

We expect subscriber growth to remain soft in a tough economy. For the two companies, we forecast 2.8mn subscriber additions for 2008 (653K for 1Q08). We believe our estimates are substantially below consensus.

Summary

We are initiating coverage on Sirius Satellite Radio with a Sell rating and a theoretical fair value estimate of $2.30/share. There are no reasonable comparable companies, in our view, so we have used a DCF-based valuation. The pending merger with XM Satellite Radio has received DoJ approval (on 24 March) but is still awaiting FCC approval, expected within weeks and considered very likely. Our base case post-merger YE2008E DCF value is $2.89 per share. We have applied a 20% public market discount to this valuation, which reflects

  1. the high level of uncertainty about the long term market size;
  2. our view that near-term expectations for revenues and subscriber growth are still too high; and
  3. the challenges of refinancing the XM balance sheet and the possibility of equity dilution.

We note too that FCC transaction approval is believed to be likely, but is not certain. We project substantial (50%+) downside in the share price if the transaction is not approved. We model positive EBITDA starting in 2009 and positive FCF starting in 2011. The basis for our valuation and our sensitivity analysis is set out beginning on page 20.Please note that our valuation is based on our projections pro forma the XM merger, not the stand alone financials shown on pages 1 and 2 of this report.

Position - Long Sirius, XM.