Benjamin Swinburne of Morgan Stanley issued a report on XM's Q4 and full year operations.


XM Satellite Holdings

Updating Model for Lower OEM Outlook, Higher Royalty

What's Changed - FY08E Net Adds From 1.33 mm to 1.29 mm - FY08E Revenue From $1.42 bn to $1.38 bn

Pushing Out FCF Breakeven: We are modestly reducing our subscriber estimate for FY08. We base our reductions on our more modest assumptions for XMSR’s OEM partners due to continued domestic retail weakness, and we assume OEM net additions will contribute roughly 98% of net additions in FY08E. The impact of the lowered sub estimates as well as the increased music royalty rate delays our FCF breakeven estimate until 2012 compared to 2011 previously. We continue to assume the benefit of a $1 monthly rate increase; however, given commentary on the pending merger, we have pushed back the date of the assumed increase to 2009.

4Q07 Results Broadly In-Line: XMSR reported broadly in-line results marked by better than expected subscriber net additions and reported ARPU of 460K and $10.14 respectively. Pre-marketing EBITDA margins were 31% after adjusting one-time items versus our estimate of 27%. Modest reduction to OEM forecast: We have decreased our OEM gross additions by 110K and net additions by roughly 40K, implying nearly 60% and 10% YoY growth, respectively. XM stated that it currently penetrates roughly 40% of its OEM partners production and expects this to grow to 70% by MY10E vehicles.

Retail Estimates Unchanged: Despite a modest rebound in retail net additions in 4Q07, we continue to believe the channel will actually lose subscribers in FY08 compared to adding 185K net additions in FY07. 4Q07 retail net additions of 99K represented a 63% decline versus 4Q06, while net additions actually swung negative in 3Q07, representing a 125% decline from 3Q06.

•Elusive FCF Breakeven Appears Further Away. Neither XMSR nor SIRI has generated annual FCF.Our current estimates imply that XMSR will reach FCF (CFFO less capex) breakeven in 2012E compared to 2011E in our previous estimates. Our estimates include the benefit of a $1 monthly rate increase assumed in ’09. As, shown in Exhibit 2, should XMSRnot implement a rate increase this year, FCF breakeven would not arrive until 2013 if we were to exclude the benefit from working capital.

•OEM Expected to Reach Near 100% of FY08 Net Additions DARS industry subscriber growth now almost completely relies on its OEM channels. XMSR’s OEM channel accounted for over 75% of net additions in 4Q07 and we believe this % will ramp to 98% by YE08E. The company stated that its OEM partners have indicated that they intend for XM radios to penetrate roughly 70% of their total production compared to 40% today. Given improving OEM conversion rates, as seen in 4Q07, we believe OEM additions could be a significant source for long-term subscriber growth. We currently look for roughly 4.15mm and 1.37 mm OEM gross and net OEM additions in FY08, representing 60% and 10% YoY growth, respectively.

FY08E Outlook

•We have lowered our revenue and adjusted EBITDA loss estimates for FY08E from $1.42 bn and $56 mm to $1.38 bn and $116 mm, respectively. Our lowered estimates result from our reduced subscriber estimate for the year. We now look for FY08E pre-marketing EBITDA margins of 31% compared to 33% previously.

•We have reduced our FY08E subscriber net addition estimate to 1.29 mm compared to 1.33 mm previously.Our lowered subscriber estimate reflects our reduced OEM expectation for the industry due to continued domestic auto weakness. Our revised subscriber expectations assume XMSR adding 1.27 mm OEM net additions and losing approximately 12K retail additions in FY08E.

•We look for FY08E SAC and reported ARPU of $60 and $10.52 compared to our previous $57 and $10.78, respectively. We have kept our full-year churn estimate broadly unchanged at 2.12%. 4Q07 Results vs Morgan Stanley Estimates XMSR reported solid 4Q07 results this morning compared to our fairly conservative estimates for the quarter. XM net additions of 460K came in approximately 72K ahead of our estimate led by better than expected monthly churn of 1.72% compared to our 2.18% estimate. Net additions growth from both the OEM and retail channel came in ahead of expectations. While retail additions beat our estimates for the quarter gross and net retail additions declined 33% and 63%versus our 38% and 76% estimates, respectively. ReportedARPU of $10.14 came in broadly in-line with our estimate, while SAC of $87 came in $4 above our expectation for the quarter. Like competitor SIRI, XMSR failed to provide anyFY08 guidance in its release this morning.

4Q07 revenue and adjusted EBITDA loss of $307.7 mm and $116.9 mm compared to our $310.4 mm and $79.8 mm, respectively. While subscriber and consolidated revenues came in broadly in-line with our expectations for the quarter,higher revenue share and royalties drove adjusted EBITDA roughly $38 mm below our estimate. Similarly to SIRI, higher revenue and royalties payments in the quarter were likely due to accrued royalty payments from satellite radio’s increased royalty agreement announced in December ‘07. On the subscriber side, both OEM and retail net additions of 351K and 99K came in ahead of our 323K and 65K estimates. OEM net additions also benefited from the sequential and YoY uptick in conversion rate to 53.9% from 52.5% in 3Q07 and 52.4% in4Q06.

Tiered Offering Impact Unknown We believe proposed programming tiers could potentially benefit subscriber growth by providing a wider array of content at more attractive price points, but its impact to the merged company falls dependent on consumer take-rates of the various offerings. The merged company would continue to offer subscribers their current programming packages at the existing $12.95 price, but would also offer a la carte bundles starting at $6.99 for a 50- channel package. The company would also offer family targeted packages starting at $11.95 as well as 50 channel music and talk specific packages priced at $9.99.

Potential for Overhead Reductions from Merger - We believe the merger of the XMSR and SIRI platforms would likely allow for the reduction of dual G&A, R&D, and variable content and programming expense buckets resulting in roughly $1.4 bn of merger synergies. While larger on-air talent contracts such as Howard Stern would likely have to be renegotiated upwards due to larger listening audiences, we believe the merger would provide more negotiating leverage with the platforms’ condensed programming talent. The current sports (i.e. MLB, NBA, NASCAR) contracts would remain in-place until the contracts reached their expiration dates which are not due for several years. In addition, we believe the current revenue share agreements with OEM partners would also remain in place given the ever-increasing importance of the OEM channel to subscriber growth. Reductions in R&D channel would likely come only after near term technology needs related to the interoperability of both platforms were addressed.

SAC/ CPGA Reductions Could Result from Merger We believe the early value produced from a merger would result from reductions in the marketing and commission components of CPGA. Reductions in radio subsidies would likely take longer to emerge as new, interoperable radios would likely be more expensive than the current stand-alone radios and thus require greater subsidies. We believe reductions in commission and promotion expenses would result from increased bargaining power with the retailers and from the more attractive programming lineups of the merged company. It is also important to note that we believe subscriber growth would be unaffected by the company’s more modest marketing campaign.

Incremental Sub Growth Could Result from Improved Conversion Ratios - We believe a XMSR and SIRI merger could drive incremental subscriber growth from both slower retail gross additions declines as well as improved OEM conversion rates. We estimate that retail gross adds would improve approximately 5% annually and that roughly 10- 15% of subscribers who would have typically disconnected service after the promo period decide to stay on. We note that both our retail and OEM estimates could be conservative.

Improved OEM conversion rates are particularly beneficial as they carry significantly higher contribution margins as the initial CPGA has already been incurred. We estimate the improved rates could add approximately 4 mm new OEM subs by YE17E, which would add roughly $4 bn of incremental revenues through the forecast period (’08E- ‘17E).

Tyler Savery Position - Long Sirius, Long XM