William Kidd of Wedbush issued a detailed note today on the satellite radio sector, pricing, and the merger.
New Pricing Plan: a Positive Step in the Merger Process
• New post-merger pricing schemes should alleviate some regulator merger concerns. Additionally, there is no denying that a lower price point is a consumer friendly concession.
Among a bevy of new XM and Sirius pricing plans that are contingent on the proposed merger’s regulatory approval, we viewed two plans to be especially positive. One plan allows subscribers to chose up to 50 channels from their existing service provider for $6.99/mo, cheaper than the roughly $13/mo subscribers of XM and Sirius generally pay for 150 channels. The other plan which will cost $14.99/mo would allow subscribers to pick up to 100 channels, though subscribers would be limited to roughly 10 channels from XM if they were a Sirius subscriber or 10 channels from Sirius if they were an XM subscriber. This plan demonstrates the increased choice made possible by the merger, which would hopefully give Sirius subscribers access to baseball and XM subscribers access to Howard Stern. Both à la carte plans should be politically popular as Congress has been trying for years to push a reluctant cable industry towards a comparable pricing scheme. One caveat is that these à la carte programming plans will only be available for subscribers using new radios, which will be developed following approval of the merger. Both companies were keen to point out that the new price points as well as the à la carte plans were contingent on the proposed merger’s approval.
• The new pricing scheme is not a consumer cure all—it does not address every pricing circumstance.
We see two areas in which the companies could have furthered its interests in the eyes of regulators, but instead they chose not to: (1) although the new proposal helps to ensure that at least some price points will be lower at the time the merger is approved, it does not ensure that prices will be kept low. Clearly, if our collective experience with cable rates is any lesson to regulators, a monopoly’s ability to raise rates is as important, if not more important, than what the rates are day one. This also was an area where various Congress members sought assurances from the companies (such as a few years stay on price hikes) in the companies’ initial Capital Hill testimonies, but received none. Although Congress is not responsible for approving the proposed merger, we believe this point has merit and that regulators would likely see some assurance in comparable protections. (2) the à la carte plans are not as flexible as what the term normally implies. It basically allows an existing XM or Sirius subscriber to pick from and obtain up to 10 channels of the other service, which is clearly not the same as being able to pick from roughly 100 channels of the other provider. We realize that most of the channels between the two services are essentially the same. And at this point, neither company is able to assure regulators or consumers exactly what channels from the other service will be available, since they still have to negotiate with their content providers for such flexibility. However, Sirius did inform us that Howard Stern would be available to XM subscribers. But what about the NFL, MLB, Oprah, NASCAR, and Opie & Anthony? We would imagine that some years later a full à la carte plan would be possible, allowing subscribers access to all of the content on both systems. However, such a plan would either require an interoperable receiver, which is not the same as the newly proposed receiver required for these à la carte plans or full service integration (meaning that the new merger company would operate as one service not two).
• The new pricing scheme does come with its costs to value.
We suspect that many subscribers would find the $6.99/month price point compelling, since much of the rationale to take satellite radio is narrowcasting (meaning subscribers rationalize the service by a few channels that appeal to them, and not the 100-plus channels that they potentially can listen to). Consequently, the lower price point could lead to lower revenues and subscriber valuations. A second aspect of the new pricing proposal that ultimately would have to be resolved is programming economics. Today, much of the programming for satellite radio is either a fixed cost or based on an advertising revenue share, which contrasts with more variable rate programming schemes (e.g. dollars or cents per subscriber) used in the pay television word. Except for some of the more recent landmark transactions, like Howard Stern, MLB, and Oprah, we suspect the older content agreements are struck under far more favorable pricing terms. With lower subscription price points, we suspect the new merger company would ultimately need to move to more traditional television contract terms (meaning variable agreements based on subscribers or audience share), since it would not make sense to have the same cost structure (excluding advertising revenue shares) for a $6.99/mo sub and a $14.99/mo sub. By the same token, it is probably unrealistic for the new merger company to think that the terms of favorable programming contracts, struck long ago, will last forever. Our point is that the company is proposing a new variable rate revenue model though its current cost structure is more fixed than variable.
• The merger’s potential impact on vendors/suppliers is still an area that could draw regulatory criticism.
While most of the merger talk focuses around the consumer, the merger will clearly have an impact on automakers and programmers. Much of the synergies that are in our analysis as well as our competitors relate to being able to lower costs. Given that much of the potential to theoretically lower cost are the result of an absence of competition, we suspect that regulators are not going to skip over this issue lightly.
• In spite of our view that regulators are still more likely than not to deny the proposed merger, we believe that the transaction would be favorable to shareholders, and in many respects, to subscribers as well.
Clearly, it is up to regulators to weigh if the consumer benefits are worth allowing an entity monopoly power. This could be used to extract monopoly rents from subscribers and potentially vendors. That said, there is no denying that more services could be clearly delivered by a merged satellite radio company, given the ability to eliminate redundant capacity and provide what is now exclusive content across the board. Therefore, we believe a merger could improve the consumer value proposition, since subscribers would theoretically receive more content (or at least more of the content they want) at a comparable price point. The challenge for this transaction is not to list all the theoretical competitors, like iPods, the Internet, and free radio, so that the new company does not appear to be operating as a monopoly. Accordingly, we believe a key regulatory question that remains is whether or not these theoretical competitors are capable of restraining a monopoly’s pricing power. If such competition does impact satellite radio subscription rates, we suspect that regulators can and would conclude that vibrant competition is possible even with just one nationwide, mobile subscription radio platform. However, we suspect proving that free radio and iPods have impacted satellite radio’s pricing proposals is going to be difficult, which is why believe this transaction’s approval remains quite speculative. From the beginning, everyone saw that this transaction would boil down to market definitions and whether consumers and suppliers benefited by more than they theoretically could be exploited. From our perspective, although there have been positive steps by the companies such as this pricing proposal, most of the challenges remain the same. Secondly, without competition, content providers and automakers would likely see their contracts reduced as they are renewed from what they would have been otherwise with competition. Accordingly, this is an area that will undoubtedly see further regulatory attention.
• We reiterate BUY on Sirius and HOLD on XM based on our DCF analysis.
Note that both company valuations do not incorporate any merger premium/benefit, consistent with our view that the transaction has less than a 50% likelihood of approval and thus, will likely be denied within 12 months.
• Risks to attainment of our share price targets include shortfalls in subscriber growth; increased competition whether from XM; AM/FM radio, HD Radio, or streaming-media services; satellite anomalies; new/increased government regulation; a prolonged and/or failed merger attempt; an inability to renew key content and OEM contracts; and an unfavorable outcome in the ongoing arbitration process with record labels over royalty rates.
Position - Long Sirius, Long XM