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Monday, February 19, 2007

XM/Sirius - a Consolidation Misstep

News of the XM and Sirius satellite radio merger sent tremors through both the business and media world. But at this early stage the jury seems confused, if not out, on whether this is a good idea.

Certainly from a business perspective, the saving of $7 billion annually is a good start to pulling this business back from the brink of disaster. And placing Mel Karmazin in control is another good move since Mel's proven his prowess at goosing his media enterprises with operational effectiveness.

But what of the consumer? Is a monopoly such as the one potentially created by this merger good for the consumer?

The topic of a satellite radio sector merger has been floating around for months and Bridge Ratings has conducted some preliminary research on what effect such a merger would have on the satellite radio consumer both current and prospective.

1. The "why" factor

Over 90% of those currently subscribing to either or both services had no opinion on a proposed merger other than what such a merger would do for them.
  • Will it mean that they have to get new equipment?
  • Will their current radio work with the 'other' service
  • Will prices go up or down now that there is no competition?
  • 56% of both current and prospective satellite radio subscribers are confident that monthly subscription prices will increase - certainly for new subscribers and likely for current subscribers when their current contracts expire.

67% of current subscribers don't understand or appreciate the business reasons why such a merger would take place. That's left to those who understand Profit and Loss statements and subscriber attrition reports. Most consumers don't understand why such a merger would be necessary so soon. Many of those we surveyed perceive the satellite radio business as new, vibrant and exciting. Unaware of their financial difficulties, most current and prospective subscribers can't rationalize why such a combination of two strong companies is necessary at such an early stage of the industry's development. For many consumers, satellite radio is still perceived as a brand new technology and service.

2. Subscriptions

In three different studies conducted between August 2006 and January 2007, it was confirmed that a combined entity of a singular satellite radio business would not garner as many total subscribers as two distinct competitive entities over the first two years of the enterprise. The reasons are many, but primarily the culprit is the elimination of consumer choice in the manner these services have been sold. The previous combined impact of two companies heavily marketing their benefits to the masses tends to generate increasing market awareness and interest. Marketing budgets will likely be trimmed - this is one of consolidation's nasty little secrets. However, reducing marketing is not in the best interest of satellite radio at this time. In fact, among those consumers who have expressed interest in satellite radio but who have yet to subscribe, 62% need a better reason to purchase. As yet, they have not been 'sold', 'convinced' or 'motivated' by the marketing to make that purchase decision. Marketing is a key to sustained subscriber growth.

As of this writing, Bridge Ratings has re-evaluated its growth projections for the satellite radio industry. Should the merger proceed and be completed by the end of 2007 (an unlikely event), we see 2008 subscriber counts for the combined entity to be 8% lower than if both companies were to continue operating separately.

3. The Monopoly Model

The creation of one superSat company provides some new opportunities for Mel Karmazin and the new combo's shareholders and Wall Street watchers. One is monopoly power. Monopoly power is usually defined as the ability of a firm to earn high profits by raising and keeping the prices of its products substantially above the levels at which those products would be priced in competitive markets. That is, a firm with monopoly power can charge high prices and get away with it - the market will not punish it for doing so. In a competitive industry, in contrast, the market will punish a high-price firm by the loss of its customers to rivals with lower prices.

Karmazin has hinted at subscription price hikes long before this latest wrinkle and now has the power to do just that despite the fact that the new merged company is considering a tiered pricing model with an a la cart approach for the consumer. But monopoly power is undesirable for several reasons, some of them obvious:
  • High prices reduce the wealth of consumers. The use of monopoly power is obviously undesirable to consumers because no one likes to pay high prices. Such higher prices may make the firm with monopoly power rich and make the consumers of its products poor. These effects on the distribution of wealth are generally considered undesirable. Even the current subscription rate of $12.95 per month has had most consumers think twice about why they need satellite radio.
  • High prices lead to resource allocation. Economists give greater emphasis to a second undesirable effect of prices that exceed the competitive level. Such prices tend to reduce quantities of the products that consumers demand. Allocation of profits is not necessarily guaranteed to be in the public interest.
  • Monopoly power creates an obstacle to efficiency and innovation. A company with monopoly power is one that does not face much effective competition - and consequently it does not have much reason to fear loss of business to others. Where this is so in the satellite radio business, there be less incentive for management to make the effort to produce efficiently with a minimum of waste or to undertake the expense and risks of innovation such as was experienced during the two company's competitive battles. The result is that the coming product from a merged satellite radio business may be of poorer quality than it would if the company possessed no monopoly power.
While this is not intended as a class on economics, the point is that in many instances, monopoly power has provided a solution to struggling businesses and has inevitably been a disservice to the consumer.

4. Programming & Culture

In research Bridge Ratings has conducted, XM has consistently been considered the service with the better original programming. Satellite radio is a music medium and in the opinion of thousands of consumers studied by Bridge Ratings, no one does a better job at it than XM. What will happen to the creative structure in place at XM once Mel begins with the consolidation scythe? After all, as with terrestrial radio, consolidation of these two satellite radio companies should save billions a year. Those cost savings will have some bearing on the quality of the product much like personnel and resource cuts have negatively impacted terrestrial radio in the last ten years.

No, it seems to me that once again the American consumer will get a front row view of where they stand in the eyes of U.S. regulatory agencies. This proposed merger must pass muster with the FCC, the DOJ and others. And when one looks at the business end of this deal, and how government bail-outs have been common, clearing regulatory hurdles is a safe bet to save the failure of another space venture.

5. The Balance Sheet

The balance sheets represent the biggest problem for these companies.

Sirius has almost $1.1 billion in long-term debt. At XM that number is over $1.3 billion. Sirius has cash and securities of $350 million. XM has $285 million. So, combined debt would be $2.4 billion against about $600 million in cash. Payables and accrued expenses of the combined company would be over $500 million. To have a significant value to shareholders, the combined business would have to pay down at least $200 million in debt per year. None of the debt is due until 2009, but the majority is due by 2013. The combined company would be able to partially use cash on hand and could go to the capital markets with a new debt issue with the sole purpose of refinancing that amount due in 2009 (and with convertible debt if they were smart and/or able). All of this if revenue growth can continue at 10% quarter over previous quarter and expense growth can be held to 5%.

Mel Karmazin is a smart, strategic business operator. He will find a way to make this work. Wall Street and investors - even the government - will see the immediate benefits of such a joint-relationship. What will take more time will be confirmation of whether such a merger is in the public interest.

1 comment:

Alessandro said...

Excellent info, I liked it.