Thoughts on Sirius-XM Merger

There was a lot less discussion of the Sirius Satellite (SIRI) - XM Satellite (XMSR) merger announcement on Real Money, Street Insight andother business news sources than I expected. I suppose that is because it was a long rumored and well analyzed potential deal and analysts feel that the odds of FCC and Department of Justice approval are less than 50%.

Yesterday, SIRI rose 6% while XMSR gained 10%. Both stocks closed near their lows for the day, however, pulling back by 3-5% from daily highs reached close to the open.

I see a couple of relevant investment themes from the SIRI-XMSR deal.....

First, if the government approves the deal, it will have taken a step toward redefining the media landscape in the internet age. Approval will only occur if the companies can convince the government that satellite radio competes in a broader market including iPods, internet radio, HD radio and other new delivery systems for audio content. If the government says yes, a precedent will have been sent that should impact future acquisitions in the TV, radio, newspaper, cable, satellite, and entertainment industries. That would be bullish as it would encourage more acquisitions and merger which would support valuation multiples.

Second, approval of the deal will indicate the government is willing to let failing companies with self-inflicted wounds merge their way out of trouble. The failure here is mostly financial as 14 million subscribers is a pretty sizable business. I am not sure if investors could translate this "fail and merge" strategy to other deals but it is something worth watching on a deal-by-deal basis. Current merger discussions in the auto and airline industries would be the types of deals where a "fail and merge" precedent would have implications.

Third, as a media analyst, I am interested in whether a merger SIRI-XMSR will be a more formidable competitor to the traditional radio industry. The answer would have to be yes as placing all the content available on SIRI and XMSR today on a single service seems likely to attract some additional subscribers. However, I think that the slowing subscriber growth for satellite radio is a function of poor marketing. The message is muddled with potential subscribers not getting a clear message as to why satellite radio is superior. In particular, I think the lack of emphasis on how it is a superior music and talk radio service does not get through. Tell us why satellite is better than terrestrial -- no ads on music channels, more and better content suited to anyone's tastes, no loss of signal when traveling outside of city specific geographic areas. A merger alone won’t solve the poor marketing so I don’t think the near-term impact on traditional radio will mean much.

Finally, as a Sirius subscriber since 2003 I just hope that my favorite channel, JamOn 17, survives the merger. JamOn gets about 90% of my listening even though I have more than 100 channels to choose from. Of course, my son listens only to Jazz and Classical and my daughter listens only to indie rock. I guess our family represents the marketing message that I fell is missing.

Radio Industry Should Boost Dividends

Credit Suisse had an interesting report earlier this week about the radio industry that has broader implications. The thesis was that radio operators should establish signficant quarterly dividends as the best use of still substantial, if no longer growing, free cash flow. Dividends were preferred relative to share repurchases or just holding cash.

Among the reasons that Credit Suisse believes that dividends are the best use of radio industry free cash flow is that (1) it is a mature industry similar to others that offer high dividends, (2) there is empirical evidence that dividend paying stocks perform better, and (3) as baby boomers age and begin to shift toward more conservative asset allocations, the attractiveness of high dividend paying stocks will increase.

But most interesting is that Credit Suisse believes that high annual dividends will prevent "overinvestment" in the radio business....

Radio is a no growth industry facing secular competitive challenges that undercut the base business model. Reinvestment opportunities are limited and arguably just make the situation worse by raising the expense structure, dampening margins, and possibly undercutting product/advertising pricing. Unlike, say telecom services there is no imperative to reinvest to protect market share. There is nothing radio can do in its base business similar to replacing copper with fiber, for example.

Radio is not the only mature industry with limited growth prospects and secular challenges. Yet, it is not very often that you see industry observers, including insiders such as management, analysts, and bankers, acknowledge that further investment is not a good idea. Why throw good money away, money belonging to shareholders, instead of returning it in a fashion that reinforces long-term capital discipline? A fairly high quarterly dividend prioritizes capital allocation over the long-term, something that a share repurchase or leveraged recapitalization does not.

Clear Channel Sale Overwhelms Earnings News

Buyout news makes the 3Q06 report this morning from Clear Channel (CCU) pretty irrelevant as far as the stock price is concerned. Nevertheless, as a leading media industry company, the results are worth reviewing.

Overall, the company reported results that were largely in line with analyst estimates with revenues rising 7% to $1.8 billion. EPS of 38 cents slightly exceeded the consensus estimate of 37 cents.

The most important detail for CCU investors is the health of the radio business. For the past year, CCU has been out of sync with the industry because the company took the lead in a goal to reduce advertising inventory and switch from 60 second to 30 second spots. The goal is to firm pricing through tighter inventory and receive a premium on 30 second spots.

When CCU first put the plan in place, its own revenues vastly underperformed the industry as its competitors made no adjustments to their own as selling strategies. Some even added spots to soak up demand foregone by CCU. During 2006, the situation has reversed as CCU has faced easy comps against the implementation of its new strategy. Consequently, CCU's 3Q06 radio revenue gain of 5% compares to flat or slightly negative trends industrywide.....

While CCU's strategy makes sense, it has run up against an acceleration in market share loss for radio relative to other advertising media. Thus, instead of CCU reporting high single digit revenue gains with margin expansion, the company is reporting mid-single digit gains with limited margin gains. As radio has lost share, CCU, along with its peers, have all had to invest more in content and promotion to try to keep listening levels up.

For most of the industry this has meant that 2006 has witnessed flat revenue trends and declining margins. Since CCU is lapping the first year of its new strategy where the company took one for the industry, it is showing decent financial results. However, if industry trends don’t improve, the outperformance versus industry trends won’t last into 2007.

The willingness of the Mays family to sell CCU along with the continuing strong performance of the company's Outdoor division (40% of revenue, 37% of EBITDA in 3Q) suggests that a deal is likely to get done. CCU is the dominant player in radio and unlike newspapers where the McClatchy-Knight Ridder deal has not produced returns for shareholders, there aren’t any big recent negative precedents to scare away potential private equity buyers.

I don’t expect a big premium to the current trading value of CCU, however. With radio under secular attack from iPods, satellite radio, and the internet, I don’t see private equity firms willing to pay historical buyout multiples in the low teens. This limits upside to the upper $30s.

Should the deal fall apart, CCU shares would head back to the $20s as 2007 will prove much more difficult for the company as its own comps toughen and industry trends continue to falter. I think the Mays family is very aware of the downside and will accept an offer in the $36-38 range. The just reported 3Q and guidance or pacings for 4Q are extremely unlikely to change the approach of the Mays family of the potential buyers.

Nothing But Static in Radio Stocks

The New York Times and Goldman Sachs were both out recently with analysis of the radio industr. Commentary in both reports was generally negative, noting the lack of advertising growth and the loss of usage share to other media such as the Internet radio and iPods.

The Goldman Sachs report had some very interesting data. First, as noted elsewhere, Goldman points out that recent studies show that time spent listening to radio is falling at a 2% annual rate. This is an acceleration in the rate of loss from a decades long decline at a 0.20% rate. Interestingly, Goldman says that time spent listening in cars is up (primarily due to longer commutes), with all the loss coming from listening at home and at work. Both these areas are more accessible for iPods and Internet radio. Even worse for the radio industry, the bulk of the share loss is in the 12-17 and 18-34 demographics. Other trends noted by Goldman include news and talk gaining share at the expense of music stations and women more rapidly abandoning the medium than men.

Overall, this presents a bleak picture and clearly explains the significant declines in almost all radio stocks this year.....

Multiples have contracted and cash flow is barely growing. With younger listeners leading the exodus to iPods and Internet radio, there is reason to expect the market share loss is permanent and could accelerate. Furthermore, Apple Computer's (AAPL) deal to put fully integrated iPod docks in the bulk of the 2007 car models and continued subscriber gains for satellite radio could overwhelm the longer commute times.

As for the stocks, the negative fundamental trends are well known. Lots of assets are for sale, and there have been a few transactions at premiums to current public market values. It is possible the stocks will stabilize or even have a small bounce as sentiment is so negative. However, I think it would be tricky to play any radio stock from the long side against such weak long-term fundamentals. Further, the New York Times article speculates that Clear Channel (CCU) will be selling stations. This could lead to excess supply of stations for sale and remove any premium in private market values.

The bottom line is that radio stands with newspapers as having the worst fundamentals in traditional media. Everything gets cheap enough to warrant looking at from the long side, but with both groups looking at low single-digit revenue growth at best, there is no reason for anyone with a time horizon beyond a short-term trader to be long.

Satellite Radio Stocks Crumble But Don't Buy Terrestrial

I am not a fan of the satellite radio stocks although I am an extremely happy and enthusiastic Sirius subscriber. I never listen to CDs or the radio in my car since getting Sirius two years ago.

My issue with the satellite radio stocks has been valuation relative to the cost of obtaining and maintaining subscribers over the long-term. Despite the recent shortfall at XM, I think subscriber growth will meet long-term goals at near current monthly pricing. Satellite raid is a far superior product to terrestrial radio and there is no chance that terrestrial can fight back because their music stations will always be an ad-supported business. Listen to whatever music genre you prefer on Sirius or XM for an hour or two and you will never want to hear a commercial on your favorite FM radio station again.

As for the terrestrial radio stocks, I don’t think they are a good investment....

Public market values are still at a big premium to other media sectors and private market activity has not yet been robust. Emmis is attempting to go private but there is no big premium there to public values and the stock did run to a big premium to the buyout price. This indicates to me that there isn’t a lot of money, strategic or financial, in the wings waiting to flood the sector with buyout deals.

It is easy to see why. Fundamentals are under severe long-term pressure and only a big rebound in traditional advertising growth rates could help. Like newspapers, radio is losing market share of advertising dollars as advertisers move money to the internet. As marginal dollars continue to drift away from traditional media, radio will find it tough to produce anything better than low single-digit revenue growth. Facing the need to invest intheir stations to face the compeititve threat of iPods, Sirius, and XM, this leaves the industry without operating leverage and stick in a low growth environment at best. If that is the case I see no reason to pay 9-11 times EBITDA for radio when newspapers trade at 8 times EBITDA, diversified media trades at 8-9 times EBITDA, and cable trades at 6-7 times EBITDA. The only thing radio offers relative to other media is extremely capital intensity which helps free cash flow and supports buyout speculation.

An oversold rally from a horribly acting group is possible but I wouldn’t look at terrestrial radio for long-term capital gains.