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No. of Recommendations: 46

Hi Fools,

This is my first post on this message board - or anywhere on this website. But, as an investment writer myself (see I have had the opportunity to judge the Fools' work as both an investor, a writer and a competitor.

I was surprised they choose to short Sirius - because as I think I can show you clearly, the obvious greater risk is XM. Regardless of whether the technology catches on with the public, there's almost no way that XM shareholders can profit because of horrible, off-balance sheet obligations that XM owes to GM.

Wall Street currently values XM at $1.14 billion. The competition garners a measly market value of about half that, $512 million. XM's much higher price comes from the strength of its “first mover advantage” and its relatively clean balance sheet -- two things the Fools pointed out.

But the strengths of XM are just a mirage.

Nobody knows for sure how fast subscribers will sign up for satellite radio. But I'm willing to bet it's faster than Wall Street expects, so in the spreadsheets I've drawn up to construct estimates for revenues, I'm assuming impressive growth: 100,000 subscribers by the end of this year, 250,000 by the end of 2003, half a million by 2004 and a million by 2005. After that I have big, but declining subscriber growth rates plugged in: 70%, 50%, 30% down to 20% per year growth starting in 2009 and continuing from there. My estimates, which I'd describe as aggressive, call for nearly four million subscribers by 2009, which as you'll see, is an important year for XM Radio Holdings.

Next, to estimate revenues, I went looking for similar subscription/ad businesses. I took Adelphia Cable's revenues for my model. Adelphia earns a couple of billion dollars on 2.1 million subscribers, or $456 per year, per subscriber. Again, nobody knows how much revenue XM Satellite will be able to generate, but I'm going to assume that they'll earn 30% as much as Adelphia. And I think that's pretty generous — Adelphia operates as a monopoly in most markets and they sell high priced network services in addition to broadcast content. Adelphia has also spent years perfecting its ad sales business. XM will be starting from scratch in an unproven medium.

As with all such models, you can move my numbers around and produce strikingly different results. But here's the thing: even if you assume that XM can achieve the ambitious targets I'm suggesting here, the company still won't make any money.

Wall Street firms touting XM are quick to remind you that the firm is relatively debt free, especially when compared to Sirius, which has nearly twice as much debt as equity on its balance sheet. And that's true — when you're looking at a balance sheet comparison.

But my dear and gentle Fools, these days, on Wall Street, the devil isn't in the details — it's hidden off the balance sheet.

You see, XM Satellite Radio Holdings has promised to pay General Motors $35 million by 2005 and an additional $400 million dollars by 2009, in exchange for being the exclusive satellite radio service for all GM factory cars.

That's a giant promise. According to my model, which assumed rapid subscriber growth and high per subscriber revenues, XM Radio's sales will only total $1 billion cumulatively through 2009. We don't know what profit margins will look like, but we do know that XM will have to pay 4-6% royalties to the RIAA (Radio Industry Association of America) for its music licenses. We know it will have to reimburse General Motors and several radio manufacturers for their investment in new radios and we know that it has promised GM a percentage of its gross receipts from the radios that GM installs.

Nevertheless, let's pretend that XM Satellite Radio is a radically efficient business and that it's able to generate 25% profit margins — roughly three times those of more established businesses. Even then it will have only garnered — in total — $249.5 million dollars in profits by 2009.

That won't be enough to pay off General Motors.

And that's why I suspect that General Motors — which is already a large equity owner in the company — will eventually assume control of the company. My guess is that GM will do its best to get the rest of the company on the cheap, which is bad news for today's shareholders.

If you're gonna short one of these stocks, shouldn't it be XM?

Thinking independently of the Fools, let's consider that “debt-laden” competition, Sirius Satellite Radio (NASDAQ: SIRI, $9.65).

Sirius has several competitive advantages over XM.

First, unlike XM which will host advertising on all channels, Sirius promises to only host ads on its talk radio channels. The 50 music channels it will begin broadcasting on February 14th will be completely free of advertising. That's enough of a difference for me right there. I can either spend $10 per month and get ads with XM or spend $12 per month and get no ads on Sirius.

Which would you chose?

Second, unlike XM, which has two satellites in a geostationary orbit above North America, Sirius has three birds in a geosynchronous orbit. The satellites follow a figure eight path from the equator across North America and back again, leaving at least two birds over North America at all times. However, the widely different angles of the satellites helps to create continuous line-of-sight connections to the earth bound radios, almost regardless of ground clutter. Both Sirius and XM will build ground repeater stations to broadcast in tunnels and in the middle of core urban areas where skyscraper canyons make line-of-sight connections nearly impossible. But, Sirius will produce much better reception with its technology in a broader area and will require fewer repeater stations, making for lower overall network costs.

Third, coming later to this market will prove to be a boon, not a disadvantage. It will take some time for consumers to learn about the new service, see it demonstrated and develop a desire for it. It's true that in network applications being the first mover and establishing a standard is incredibly valuable. But this isn't a network application. It's a broadcast application. And, in any case, the FCC has mandated that both companies' radios be able to receive either company's transmissions.

In other words, there's no first mover advantage here. But there was a huge first mover cost — for XM.

(By the way, the FCC's requirement that the competing systems be interoperable didn't arise until early 2000, nearly two years after the spectrum sale. Talk about changing the terms on a deal. That's like me selling you a house and then, two years later, making you invite your neighbors for dinner every night. There isn't a deadline currently for interoperability and it's plainly bad for both businesses. It's my hope that the FCC drops this demand or that it is thrown out in court).

XM wanted to be first, so they've been spending too much all along the way, starting with the FCC license. XM paid $89 million. Sirius paid $83 million. XM has spent around $900 million so far to build its technology and establish operations. Sirius, just $444 million, or about half as much.

Most importantly, by demanding to be first, XM set up Sirius to garner most of the new car market on the cheap. When XM signed an exclusive deal with GM, it forced the other car makers — Ford, DaimlerChrysler and BMW — to sign with Sirius. And while it cost XM nearly $500 million plus a % of sales to land GM, Sirius got deals with everyone else for no money upfront. In fact, DaimlerChrysler even bought $100 million worth of Sirius for $43.00 per share as part of its agreement. Now, if Sirius is successful, the car companies will get paid — in stock. They each have warrants for 4 million shares with strike prices that start at $30 per share. But these warrants aren't exercisable unless they've installed at least 4 million Sirius radios in their cars. GM, on the other hand, isn't even under any obligation to install the radios at all.

So...what's the downside? Well Sirius does owe a lot of money to both Loral Space Systems for its satellites ($50 million) and a lot of money to Lehman Brothers ($150 million). It also has convertible bonds that come due starting in 2007 that prevent it from raising more money in the debt markets. Out of all of the debts, the Lehman Brothers loan is probably the most dangerous. However, payment on the note doesn't begin in earnest until March 2005, when 22.5% of the principle must be repaid.

I'm not that concerned about the debt because Sirius will have radios installed in 44% of the new cars made in America by then — that's 4 million potential subscribers each year. And these subscribers will be driving Mercedes, BMWs, Volvos and Jaguars. That's exactly who is most likely to purchase a premium radio service — not your GM buyer going for the $2002 rebate on his new Chevy Cavalier.

One more thing I like about Sirius' technology: the company can cut off your radio's ability to receive the satellite signal remotely if you don't pay your bill.

Sirius recently raised another $158 million, pricing shares at $9.85. That will give the company, according to my calculations, nearly $400 million in cash. The company says that should be enough to see it through 2003, by which time, having proved its business model will work, it can raise more money at a higher share price.

I don't expect the company to be profitable until 2005 — at the earliest. Remember: these kinds of broadcast networks require enormous fixed costs to build and establish, after which time they can deliver years of very profitable operations.

Today you have the opportunity to invest in Sirius Radio for book value. Judging from its competitive advantages over XM (better reception, sold in better cars and no advertising), Sirius radio will become the standard satellite radio of choice. Despite what the Fools say.


"...the differences between the conservative and the radical seem to spring mainly from their attitude toward the future. Fear of the future causes us to lean against and cling to the present, while faith in the
future renders us receptive to change."
-- Eric Hoffer

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