Two analysts issued reports today regarding the satellite radio merger. One bearish and the other bullish. The reports were issued by Bear Stearns and Bank of America. As should already be expected, the bearish report is from Bank of America's Jonathan Jacoby, and the bullish report from Bear Stearns' Robert Peck. Some sector watchers who are positive on the odds of merger approval may feel that both reports are bullish....Peck being bullish on the merger outlook, and Jacoby being full of bull.
Bank of America Excerpts:
Sat Radio Regulatory Update: FCC Request & Maytag Man Doesn’t Fix Sat Radio
We Remain Cautious on the Sat Radio Group – Hurdles Abound
We remain cautious on the satellite radio group. We are less optimistic on merger approval (<30%) than many and believe that the longer-term sub economics continue to deteriorate. Several points:
The Street DOJ focus seems to now be on the Maytag/Whirlpool merger –but we note there are differences between appliances and satellite radio. As Thomas Barnett, the Asst Attorney General for Anti-Trust, pointed out in the appliance merger, “largest appliance retailers, have alternatives available to help them resist an attempt by the merged entity to raise prices.” Sat Radio has no alternatives. Similar to Whole Foods (which was the prior argument for the “merger” bulls) – appliances have competitors with exact (similar) products and a relatively low barrier to entry. This is not the case of satellite radio – the sat radio merger requires a market re-definition and to prove that the raising of subscription prices would drive people to other forms of audio entertainment. Furthermore, our contacts believe that if the staff does recommend to block the deal, Thomas Barnett will most likely follow their recommendation in this case (as opposed to Maytag), as this would imply from a straight anti-trust analysis there is merit for a case. It does appear that the DOJ process is winding up, and our contacts believe there is the possibility that the DOJ will announce before Thanksgiving.
The FCC announced today that it is requesting more info from the merger hopefuls – which indicates to our contacts that the FCC isn’t as “in the bag” as many on the Street believe. Late Friday, the FCC requested a significant amount of specific information (7 pages for each company) from the merger hopefuls (see inside – we have attached the request). Some may argue that this is a positive – it requires a quick turn-around (11/16), and the data may be required in the case of approval (to appease the NAB, etc). HOWEVER, our contacts believe that the timing of the request is a problem and possibly indicates that the FCC is far from reaching a decision. Furthermore, the FCC is in the midst of its own “firestorm” due to Chairman Martin’s attempt to review the media ownership consolidation rules by mid-December. Congress has announced that they will hold more oversight hearings, and this could become another impediment for the XM/SIRI merger.
Investment thoughts – we recommend caution (or to invest for a widening of the spread). Recent data points continue to appear negative for merger approval – our contacts do not believe it is normal for this type of FCC filing to come this late in the process. To be fair, they note that the FCC will require this info to approve (or deny) a deal, but the timing and amount of requested data is a concern in their eyes. Furthermore, our contacts do not believe that the FCC would be putting out this request if it had the internal word that the DOJ was about to approve the merger. Lastly, longer-term sub economics continue to deteriorate.
Sector View: Audience erosion will continue to cap top-line growth for terrestrial radio over the next decade, whether radio "goes Google" or not.
Portfolio Managers’ Summary Our 12-month thesis on the sector.
2007 will be the transition year from a retail driven model to an OEM-driven subscriber model. Going forward, we expect OEM gross adds to be greater than retail gross adds in every quarter - including the traditionally retail-heavy fourth quarter. We expect new cars with factory-installed radios to account for 60% of new subscribers in '07 (or 4.9M new activations), up from 48% in '06 (or 3.6M new activations) and 39% in '05 (or 2.6M new activations).
Our call today in a nutshell. We remain cautious on the satellite radio names. We believe there is limited upside to these names - even if the deal is approved. Furthermore, we remain cautious on the deal receiving approval, as the DOJ process is more complex than many investors believe and the FCC may struggle to delineate between easing rules for satellite radio and maintaining ownership rules for terrestrial radio. Furthermore, as investors are concerned solely with the deal, fundamental issues are being ignored.
Risks to our call. Subs accelerate, churn rates improve, or merger is swiftly approved.
Investment Considerations FCC Request Appears to be More of a Negative than a Potential Positive Our contacts believe that it will be difficult for the FCC to render a decision before year-end. They are skeptical regarding the FCC information request, as they do not view this type (of a detailed request) as “normal” so late in the review process. The 7-page request by the FCC for additional information is, they believe, an indication that the staff hasn't reached a substantive decision (or certainly not a positive one), and has not yet written up a draft item to circulate up to the Commissioners. A decision by year-end could prove to be difficult. These are many of the same staffers that are also working on the changes to ownership rules (which is expected in mid-December). Not only is the request substantial in volume, our contacts point out the context of the questionnaire is enough to raise a few eyebrows. The FCC has now opened the door for a full examination of a lot of issues that it could probably have dealt with quickly (vertical integration of hardware contracts, illegal terrestrial repeaters), and has now brought these issues into the merger approval process.
Our contacts do not believe that the FCC would be putting out this request if it had the internal word that the DOJ was about to approve the merger. Some interesting background observations to the filing (we have attached the filing at the end of this report): This questionnaire is being characterized as an "Initial Information and Document Request." This is a bit strange to label the request “initial” nearly 7 months into the process. And the FCC is just now asking for initial information. We would have expected this request back in June, or possibly early August after XM/SIRIUS put forth their economic showings. The FCC expects all documents to be "Bate Stamped" (sequential page numbering), and color coded, with a separate cover letter "in each box” organization in this manner must imply a substantial amount of information will be submitted. And will require time to get organized and filed properly. The XM and SIRI requests are nearly identical, but for the programming contracts specific to each. The FCC in the cover letter expects the applicants to "amend the consolidated application to reflect such responses." We find it interesting that the FCC is ordering for the application be amended. The cover letter also brings to light the overuse of "copying prohibited" [documents] "has emerged as a problem recently," and "frustrates the Commission's goals." The FCC is in a very tough position, in that if it grants the merger based in large part on confidential information, then there is a much higher likelihood of reversal by the Court of Appeals because then there is a much higher likelihood of reversal by the Court of Appeals because the FCC hasn't give commenters the chance to view the basis of the decision and comment upon it.
More detailed points:
Section 1A – corporate documents: Provide any and all agreements and like documents relating to the Transaction, including, but not limited to, the Merger Agreement and any and all attachments, appendices, side or separate letter agreements and like documents by and between the Applicants - our contacts found this a bit surprising as we would expect the FCC to have this information already.
Section 1B: This set of requests appears to directly address the questions raised by U.S. Electronics about hardware and agreements (the vertical integration of hardware issue). Our contacts were surprised to see the FCC interested in this.
Section 2: This section is entitled Data, Studies and Analyses, which is a request for essentially all underlying data from the studies, which our contacts believe will further delay the decision.
Section 3: Technical Information. This is an interesting request as MOST, if not all, of this information should be in the FCC's hands as part of the Enforcement Bureau's investigation of the illegal repeaters. We believe this section is the FCC's way around having to abide by the FOIA request, by having XM and SIRIUS turn over the information voluntarily. Should this information prove to be worse than feared, in particular - the allegations about XM and SIRIUS knowingly supplying specifications for radios that would interfere with the non-commercial FM band, this may provide a strong argument in opposition of the congressmen who have backed the merger. In addition, in parts C and D of this section, the subject of interoperability is tested here. The appropriate responses to each question might contradict each other: ease of migration to interoperable radios vs. a la carte programming. In other words, if the merger hopefuls argue that the migration to interoperability will be easy, then the FCC can hammer them for having taken so long. If they state issues with interoperability, then the FCC can ignore the a la carte programming. Interoperability is further questioned in the next section as well.
Section 4: Claimed Public Interest Benefits: We pay particular attention to C – should the merger hopefuls renegotiate contracts post-merger, programming costs could potentially increase, to the detriment of the consumer (again, our checks indicate that sports programming fees will increase for the combined entity initially post-merger). In addition: explain why the proposed billing credit for subscribers who do not elect adult programming is a merger-specific benefit. In addition, address whether the Company would offer such a credit in the absence of merger approval – this raises the question of why the companies are only offering a credit if the merger goes through.
The Bank of America report was predictable in that Jacoby's "DC Contact" appears to relish in a contrarian view of each and every aspect of this merger process. There has not been one point in this merger where the "DC Contact" has viewed anything in what would be a positive merger light, and the only point at which something positive could have been insinuated was when the "DC Contact" indicated a magical September 10th date, which if eclipsed without a clock stoppage would increase the merger odds to above 50%. It is my belief that the "DC Contact" and Jacoby believed that the FCC clock would indeed be stopped, and got caught in a quandary when a clock stoppage did not happen.
BEAR STEARNS EXCERPTS:
FCC Request NOT Incrementally Negative
• Net-Net: We Expect a Decision Shortly. Given the very specific questions, we wouldn’t be surprised if the FCC were close to finalizing its order on the merger. In addition, the FCC has given XM and Sirius only two weeks to respond while not stopping the clock (yesterday was Day 150 of the 180-day clock), which we think is also a positive as it suggests a degree of urgency on the part of the FCC. The third inference is that the DOJ likely is close to allowing the deal, which would necessitate the FCC to expeditiously complete the documentation process. If the DOJ were close to denying the deal, the need for such detailed information would not have arisen in the first place. In that case, all the FCC would have to do is to deny the merger on the grounds that it cannot be allowed under Rule 25.118 which disallows merger of the two satellite radio operators.
• FCC Request is Extremely Detailed. The FCC issued a request for information on Nov 2 seeking a significant amount of detail pertaining to the merger as well as business operations during the past two years. The requests are extremely detailed and structured around four broad topics (i) corporate documents and agreements, (ii) data, studies and analyses, (iii) technical information, and (iv) claimed public interest benefits. A whole section, for example, is devoted to interoperable radios, where the FCC has a requested information under 10 sub-heads. The FCC wants both the companies to respond to the request “no later than November 16, 2007.”
• We Recently Quantified Synergies at $5 Billion. In our note “After Deal Closes, New Pricing Schema Actually Accretive to Model” dated Oct 15, we revised our synergies estimate based on the new pricing schema to $5 billion, which implies Sirius could be worth about $5.50/share and XM $23.50/share at YE2008. Sirius and XM shareholders vote on Nov 13;along with the 180-day FCC “clock” which ends on Dec 6, this likely has accelerated the regulatory process.
WE CONTINUE TO BELIEVE THE MERGER WILL PASS
FCC Request is Extremely Detailed. The FCC issued a request for information and documents to both XM and Sirius on Friday, November 2, 2007. While the two requests are virtually identical, the FCC has sought a significant amount of detail pertaining to the merger as well as business operations during the past two years. The requests, one of which we have reproduced in this note, are extremely detailed and structured around four broad topics (i) corporate documents and agreements, (ii) data, studies and analyses, (iii) technical information, and (iv) claimed public interest benefits. A whole section, for example, is devoted to interoperable radios, where the FCC has a requested information under 10 sub-heads. The FCC wants both the companies to respond to the request “no later than November 16, 2007.”
Our Takeaway: NOT Incrementally Negative.
Given the very specific questions, we wouldn’t be surprised if the FCC were close to finalizing its order on the merger. In addition, the FCC has given XM and Sirius only two weeks to respond while not stopping the clock (yesterday was Day 150 of the internal 180-day timeline), which we think is also a positive as it suggests a degree of urgency on the part of the FCC. The third inference is that the DOJ likely is close to allowing the deal, which would necessitate the FCC to complete the documentation process on its side on an expeditious basis. If the DOJ were close to denying the deal, the need for such detailed information would not have arisen in the first place. In that case, all the FCC would have to do is to deny the merger on the grounds that it cannot be allowed under Rule 25.118 which disallows merger of the two satellite radio operators.
We Recently Quantified Synergies at $5 Billion. In our note “After Deal Closes, New Pricing Schema Actually Accretive to Model” dated October 15, 2007, we revised our synergies estimate based on the new pricing schema to $5 billion, which implies Sirius could be worth about $5.50/share and XM $23.50/share at 2008 year-end. The Street appears to be increasingly coming around to our view that the merger is likely to muster approval of both the DOJ and the FCC, and is likely to be close before year-end. The clock for the DOJ started on September 4, 2007 when both Sirius and XM certified to the DOJ their “substantial compliance” with the DOJ’s second request. The FCC continues to evaluate the merger within its 180-day timeline, which ends in early December, and has not stopped the “clock” even once during the process. Sirius and XM shareholders vote on the merger on November 13, 2007; along with the 180-day FCC “clock” which ends on December 6, 2007, this likely has accelerated the regulatory process.
Peck has been an accurate predictor of this sector for quite some time. His thought process seems to be in alignment with Watts of Cowen, who himself has been well on top of issues surrounding the merger. My take is that I would offer more weight to the analysis of Peck than I would to Jacoby. Peck's analysis has reflected the ebbs and flows of the merger process, while jacoby's has seemed to be a pure "devils advocate" contrarian on each issue.
Tyler Savery Position - Long Sirius, Long XM