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So Where's That XM-Sirius Merger?

Robert Holmes

Strong subscriber growth in the fourth quarter may temper losses for Sirius (SIRI Quote - Cramer on SIRI - Stock Picks) and XM Satellite Radio (XMSR Quote - Cramer on XMSR - Stock Picks), but the delayed merger between the two and woes in the auto sector could dampen the 2008 outlook for the satellite radio providers.

Analysts currently expect Sirius, which is set to report fourth-quarter results on Tuesday, to post a loss of 13 cents a share, according to a Thomson First Call survey. XM should lose 64 cents a share, if Wall Street is correct, when it reports on Thursday.

While earnings will take center stage this week, many are still awaiting a resolution to the long, drawn-out merger between XM and Sirius, one that has driven negative sentiment and remains a key risk going forward as unsubstantiated rumors of approval from the Federal Communications Commission and Department of Justice continue to swirl.

Since the potential blockbuster deal was announced a year ago, XM shares have tumbled nearly 20% and Sirius has lost 23%.

"There's one thing that everyone is focused on, and that's the arbitrage spread for the potential deal tightening," said David Bank, analyst with RBC Capital Markets. "That's what people really care about."

Stifel Nicolaus analyst Kit Spring pins the probability of an FCC and DOJ merger approval at 55%, as slowing sales of satellite radio products makes the monopoly argument less compelling.

"We see increased volatility for Sirius and XM absent a merger, given the potential liquidity events," warns Spring, who expects both Sirius and XM to require debt financing in 2009 if the deal isn't completed. "It would seem investors have generally interpreted the delays in decision making at the DOJ and FCC as negative signals."

Bank says there's a better probability than not that the deal will go through. "The synergies are very real, and the leverage that the two companies will have as one will be really powerful. However, our concerns are about the fundamentals in the core business, which have been decelerating, and we don't necessarily see a turn," he said.

Goldman Sachs analyst Mark Wienkes wrote in a research note that the valuations of XM and Sirius will likely realign with more realistic long-term cash flows, regardless of whether the deal comes to fruition.

"Longer term, merged or unmerged, our outlook for satellite radio is cautious given our view of unrealistic cash flow expectations, and hence valuation risk," he said. "In the event the merger is approved ... we would likely still see the longer-term risk-reward profile as effectively having almost fully priced in the synergies, leading to a continued cautious view."

With no resolution on the immediate horizon, investors will instead bide their time examining the health of the satellite radio providers through the earnings results. Subscriber growth, a favorite measure among analysts for each company's performance, will be a key factor, as most observers expect a weak holiday period. Ending net subscribers for 2007 should top 8.3 million and 9 million for Sirius and XM, respectively, both near the low end of guidance.

Spring said that even with rising total net subscriber additions, an increasing monthly churn rate -- the number of subscribers that quit the service -- as well as the economic slowdown in the U.S., could prompt both to deliver murky forecasts.

"We expect both to suggest that slowing consumer spending and U.S. auto industry woes will negatively affect satellite radio in 2008," Spring said in a research note. He adds that automakers General Motors (GM Quote - Cramer on GM - Stock Picks), Ford (F Quote - Cramer on F - Stock Picks) and Chrysler have seen significant declines in volume, diminishing the impact of satellite radio.

RBC's Bank adds that the excitement over the earnings reports will depend on something "really material changing about the underlying business plans, whether it be the conversation rate or the churn rate spiking.

"Hopefully we'll see some encouraging news on the retail side, but it's probable we won't get a positive tone," he continued. "There will certainly be chatter about the trade-off between the weakness in sales and increased penetration of [original-equipment-manufacturer] partnerships. If the number of cars being manufactured is shrinking but it isn't outpacing penetration, it'll certainly temper the weakness."