Don't Bet On Howard By ANDREW BARY ALL THE HYPE SURROUNDING HOWARD STERN'S MOVE to Sirius Satellite Radio and his outsized $600 million, five-year contract has lifted the profile of an industry that barely existed just three years ago. Much has been written about the King of All Media's departure from floundering terrestrial radio to the uninhibited world of satellite radio, and his raunchy Sirius debut on Jan. 9. Yet there hasn't been a lot said about the economics and financial prospects of Sirius and its only direct rival, XM Satellite Radio. Wall Street actually hasn't been swept up in the Stern hoopla; investors seem to be taking a cautious view of the two as they change from speculative "story stocks" valued largely on subscriber growth to ones that are being judged more on such traditional financial measurement as profits and free cash flow. "The stocks are discounting a lot of good news, and they have large valuations," says JPMorgan satellite-radio analyst Barton Crockett. For companies with modest revenues and still-sizable losses, XM (ticker: XMSR) and Sirius (SIRI) have nontrivial stock-market values -- $10 billion for Sirius, $9 billion for XM. These figures are based on fully diluted share counts for both companies that include convertible debt and other equity-linked securities. Sirius and XM shares are up more than 10-fold from lows reached in late 2002 and early 2003, when the Street questioned their financial viability. Yet the stocks have come under pressure during the past year, despite a doubling in their combined subscriber numbers to more than nine million. Market-leader XM, which began its service in 2001, about a year ahead of Sirius, now has six million subscribers, while Sirius has 3.3 million. So far, the shock jock is paying dividends for Sirius. In anticipation of his debut this month, many of his fans signed up for subscriptions. The chief investor concerns are the path to profitability and the ultimate size of the satellite-radio market. Will satellite-radio subscribers top out at 20 million, 30 million or 50 million? There now are more than 200 million listeners to conventional AM and FM radio. Perhaps the more important questions are: Will incremental satellite subscribers prove more costly to obtain, and will currently high customer loyalty begin to decline as the services become mass-market products, resulting in increased -- and expensive -- customer churn? XM was hurt by recent news of weak fourth-quarter growth in new radio subscribers from its automotive partners, primarily General Motors (GM). This raised some questions about the growth rate for satellite radio in the critical vehicle market. Sirius shares, at around $6.30, are below a peak of $9 hit in late 2004 and a recent high of almost $8 at the height of the pre-Stern enthusiasm last month. XM, at around $28, is near its 52-week low of $26, and well below its record of $40 reached in December 2004. Sirius bottomed at 40 cents in early 2003, and XM hit a low of under $2 in 2002. Investors are wondering whether it's worth taking the risk involved with satellite radio operators, which aren't expected to produce significant profits until 2009. There are plenty of investment alternatives in the depressed media, satellite-TV and cable-TV sectors. Companies like Time Warner, Gannett and CBS have substantial current profits and free-cash-flow yields of 5% to 8%, based on estimated 2006 earnings. "I think this is a classic case of investing in companies during the romance phase and avoiding them in the reality phase," says Rob Lutts, chief investment officer at Cabot Money Management. "Let's see the first dollar of profits before we start talking about billions." Lutts isn't fazed by richly valued companies, but he'd much rather own Google (GOOG), which is producing ample profits now, than the satellite radio duo. Looking out a few years, new and competing technologies, like wireless-music services offered by cellular-phone companies, potentially could challenge satellite radio. The current financials of XM and Sirius aren't pretty. Sirius last year likely had revenue of less than $250 million, an operating loss of more than $800 million -- and a loss of 65 cents a share. XM probably produced revenue of $550 million, an operating deficit of $500 million and a loss of almost $3 a share. Contrast this with Clear Channel Communications (CCU), the leading terrestrial-radio operator, which probably had $9 billion of revenue and almost $1 billion in free cash flow last year. Clear Channel's equity value is $17 billion. The good news is that both XM and Sirius have ample cash that they say is sufficient to take them to cash-flow breakeven. Barron's has written periodically on satellite radio, including a bullish cover story three years ago ("A Sound Idea," Feb. 17, 2003), when XM and Sirius were a fraction of their current prices. We've consistently favored XM over Sirius, and we still do, despite Sirius' strides in the past 18 months. In addition to snagging Stern, Sirius hired Mel Karmazin, a veteran radio executive and former president of Viacom, as its CEO in late 2004. "Satellite radio is one of the few secular-growth stories in media and industry in the early innings of growth," says Eileen Furukawa, the satellite analyst at Citigroup. She likes both companies, but says XM stock is the better value. Here's why XM looks more attractive than Sirius: XM and Sirius have market values that aren't too far apart, but XM has almost double the number of subscribers. XM is likely to maintain its lead in the coming years because it has a stronger stable of automotive partners than Sirius, including all of the major Japanese car makers, starting in 2007. XM's partners control about 60% of the U.S. auto market. "It's a significant disappointment to us that our market cap is lower than that of our competitor," says Gary Parsons, XM's chairman. "We have more subscribers, and we add them at a fraction of the cost." XM's cost per acquiring a subscriber is roughly $100, versus about $200 for Sirius, although Sirius aims to bring down those costs. "Investors at this point don't seem to be valuing that we're twice as large and twice as efficient" as Sirius, Parsons says. The similar market values of Sirius and XM could reflect the momentum that Sirius received from the Howard Stern launch and the vastly different shareholder bases of the two companies. XM is the institutional favorite. Sirius counts a huge number of retail investors and limited institutional ownership. Sirius typically is one of the most active Nasdaq stocks, sometimes trading more than 100 million shares a day. Jim Cramer, the host of CNBC's Mad Money, has been a Sirius fan. XM and Sirius have demonstrated that large numbers of Americans will pay for something that they used to get free. Both charge $12.95 a month or $142 a year for 125-plus channels of commercial-free music, news, talk and personalities like Stern. One misconception is that Sirius and XM share programming. Looking ahead to 2010, a significant chunk of the estimated 17 million vehicles expected to be sold in the U.S. could have satellite radio as standard equipment. Both XM and Sirius may add three million subscribers annually in the next few years. Commercial radio helped create the opportunity for XM and Sirius, as the industry alienated listeners by adopting homogenized formats in the 1990s and barraging them with as many as 20 minutes an hour of commercials. XM and Sirius recognized that there was a broad national audience for jazz, classical, blues and folk music -- even if those genres couldn't support commercial stations at the profit margins demanded by Clear Channel or CBS Radio. At a time when Oldies stations are disappearing from the air -- New York's WCBS-FM, for example, switched to a more eclectic "Jack" format in the hope of drawing a younger audience -- XM's 'Seventies station draws almost two million listeners a week, which would make it one of the country's largest individual radio stations. Bob Dylan now has a radio show on XM, while Sirius has Eminem. THERE'S TALK ABOUT COMMERCIAL RADIO blunting the appeal of satellite radio by creating niche channels using emerging digital technology. Don't bet on it. Radio titans, like CBS chairman Sumner Redstone, still don't view satellite as a major threat. The financial beauty of XM and Sirius is that they can just as easily serve 50 million subscribers as nine million with their satellites. Compare the duopoly in satellite radio with the looming free-for-all as satellite TV, cable TV and the Baby Bells fight for video and voice customers in a battle that the Street fears nobody will win. Stern isn't to everyone's liking, but one of the benefits of satellite radio is that there are more than 100 other channels from which to choose. Sirius not only gave Stern a morning show, but two channels to program. Among the features are Tissue Time with Heidi Cortez, a phone-sex maven; Crack Whore View; and Meet the Sterns, featuring Stern's parents. Because Sirius is pay-radio, Stern likely will not be subject to the same indecency scrutiny from the Federal Communications Commission that bedeviled him at Viacom, his former employer. So far, Stern is paying dividends for Sirius. Prior to his signing in October 2004, Sirius was a weak No. 2 to XM. In the latest quarter, Sirius added more subscribers than XM for the first time, thanks to satellite-radio purchases by Stern's fans. Stern needed to generate one million incremental subscribers for Sirius to break even on his contract, and it looks as though he has delivered. But those Stern groupies will have to stay with Sirius for Stern to pay off over the five-year life of his contract. One of the risks with Stern is that his pull will wane because his Sirius audience is far smaller than the one he enjoyed in conventional radio. And Sirius hasn't been helped recently by Stern's early decision to file for the potential sale of the 34 million shares that the company granted to him and his agent as part of his outsized contract. It's not known whether he has unloaded any stock, but the filing prompted some fans of the company to accuse Stern of potentially pursuing a "pump and dump" strategy after relentlessly promoting Sirius in recent months. There are prudent reasons for Stern to sell some Sirius stock, because he will owe taxes on the entire $200 million stock grant this year. Back in 2003, both XM and Sirius projected that they would hit cash-flow breakeven with two million to three million subscribers, but XM and Sirius may not hit cash-flow breakeven until 2007, when their combined subscribers should top 15 million. One of the chief culprits had been a bidding war for programming. Sirius snared a seven-year contract with the NFL for $232 million, while XM paid $650 million for an 11-year deal for Major League Baseball. David Frear, Sirius' chief financial officer, says programming costs are likely to be contained, and he sees continued low customer churn, given the high satisfaction with satellite radio. "We don't see any blockbuster pieces of programming to do, now that all of the major sports properties are spoken for and the preeminent talk-radio personality is spoken for." Sirius will gain Nascar in 2007, when it leaves XM, while XM will add the National Hockey League, which should help the company as it expands into Canada. XM talks about achieving cash-flow breakeven in 2006, but most analysts assume that won't happen until 2007, using a conservative measure of free cash flow that includes capital expenditures. The table nearby shows estimates from JPMorgan's Crockett. He sees XM producing free-cash flow of $188 million in 2007, $528 million in 2008, $923 million in 2009 and $1.4 billion in 2010. Cash-flow estimates from Street analysts are all over map, reflecting the inherent difficulties of making financial projections four years out. Citigroup's Furukawa sees XM generating about $900 million of free cash in 2010, $500 million less than Crockett. XM's Parsons says the company believes that it can generate $100 million of annual free cash flow for every million subscribers above financial breakeven. This implies that XM could have more than $1 billion of free cash flow in 2010, when it expects to have 20 million subscribers. With a current market value of $9 billion, XM trades at a 10%-plus free-cash-flow yield based on potential 2010 results. If XM trades in 2010 at a 5% cash-flow yield, it suggests that its stock could double by then. Sirius' cash flow is expected to trail XM's because it's growing from a smaller subscriber base. JPMorgan's Crockett sees Sirius generating $622 million of free cash in 2010, while Citigroup's Furukawa projects $643 million. These projections suggest less upside potential for Sirius shares. XM's automotive-contracts edge is significant: Car makers are ramping up production of vehicles that are factory-equipped with satellite radios, and consumers prefer buying cars that can be immediately driven off the lot with them, rather than having dealers install the radios. XM also has ancillary data services, such as NavTraffic, which integrates live traffic reports into the navigation systems of the Acura RL and some Cadillacs. Auto makers generally have lined up in either the XM or Sirius camp. XM has General Motors, which has been the most aggressive installer of satellite radios. There now are about two million drivers of GM cars with active XM radios. Honda (HMC) also is aligned with XM. Its luxury division, Acura, now has XM radios as standard equipment in its cars. And behemoth Toyota (TM) plans to roll out factory-installed cars with XM radios later this year. Toyota's new Lexus flagship, the LS460, is likely to come standard with an XM radio and NavTraffic. Nissan (NSANY) plans to roll out factory-installed XM radios in 2007. Fast-growing Hyundai plans to make XM a standard feature in its cars by 2007. The car makers in the XM camp could approach a 65% U.S. market share in the coming years. The bad news for XM is that, at least this year, it will be highly dependent on General Motors, whose woes likely won't help it sell cars. Subscriber additions from GM were weak in the fourth quarter. Sirius' key partners are Daimler Chrysler (DCX), Ford (F) and BMW. Daimler is further along than Ford, which doesn't plan widespread availability of factory-installed Sirius radios until later this year. The vast bulk of Sirius radios are purchased by consumers at retailers like Best Buy and Circuit City, rather than as standard equipment in cars. XM had a nine-month head start launching its service because its in-house technology was available earlier than Sirius' outsourced technology, and XM has maintained a technological lead since then. The XM edge could be evident in the coming launch of portable devices from Pioneer and Samsung that will combine a live XM radio and MP3 recording capabilities that will allow users to store 50 hours of programming, including music recorded off XM channels (see Our Gadget of the Week.) One limitation is that music recorded from XM's 160 channels can't be moved from the device and will no longer be accessible if the XM subscription lapses. The music industry isn't crazy about such devices, including one from Sirius called the S50 that allows subscribers to record off the air. XM and Sirius now pays less than $1 a month per subscriber in royalties to the music industry, far less than the estimated $4 to $6 a month that RealNetworks' Rhapsody and other subscription services pay. Later this year, key agreements expire between XM and Sirius and the music companies. The music industry is apt to seek higher payments, arguing in part that XM and Sirius' recording devices are turning XM and Sirius into interactive services. "We do not believe the [music] labels will succeed in converting the framework of the satellite radio service from radio to interactive service," wrote Morgan Stanley's Benjamin Swinburne in a client note. He warned that it would be "catastrophic" for satellite radio if the music industry could succeed in imposing costly Rhapsody-type royalties on XM and Sirius. XM and Sirius also have developed a host of retail products, including radios that can be self-installed in cars, boom boxes for home use and MP3-type players priced from $50 to $500 to broaden the market. It's important to recognize that there are few companies in today's stock market like XM and Sirius, with robust market values and only modest revenues. Yet both are legitimate growth stories with clear paths to profitability. Assuming that XM and Sirius stay rational and Americans don't tire of satellite radio, the two companies are apt to make good money within a few years. But given XM's edge in subscribers, automotive partners, technology and customer-acquisition costs, its stock looks like the better buy.