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Sky-High Stakes for Satellite Radio

It's no mystery -- to me at least -- why XM Satellite Radio (XMSR) is such a fast-growth stock. Let me explain: A couple of months ago, I had the chance to tool around Arizona, test-driving the XM Radio-equipped Cadillac SRX sport-utility vehicle.

With radio reception breaking up in the remote canyons near Sedona, I turned the dial over to XM, which offered more than 100 superclear channels featuring every type of music imaginable, plus news, sports, and comedy. Soon enough, I was rocking in the Red Rocks to Muddy Waters on Bluesville, the blues channel. Then I flipped to the reggae channel (titled "The Joint" -- a double entendre, perhaps), with classics that go well beyond the usual Bob Marley fare. The XM stations I listened to even had DJs who knew their genre of music and played tunes for the cognoscenti.

In short, if you're a music lover or information junkie, this is one great product to have in your car. FM radio may have a few blues channels here and there, but an all-reggae station for hard-core fans? Forget it. It would never sell enough advertising to stay in business. Still, plenty of listeners seem to be willing to shell out $10 a month for XM -- usually in new cars but also available in aftermarket car stereos, home receivers, and boom boxes -- to listen to specialized music and news channels on a satellite radio that's a lot like a cable or satellite TV.

2004 BREAKEVEN? Small wonder that XM's subscriber base will almost double this year to 1.2 million listeners and that XM's stock price has tripled to $13 a share. This could be just the beginning. XM has a solid base for more growth since General Motors (GM) and Honda (HMC) are shareholders. Both have exclusive deals with XM to equip many of their cars with XM hardware. This fall GM will expand its XM-equipped lineup to 40 cars, from 25 now.

Says Janco Partners analyst April Horace: "XM's growth prospects are very, very good." Some analysts who follow the industry have a target price of $20 for next year, predicting that the total satellite radio market could hit 50 million listeners.

The biggest question now: Can XM make money? It announced second-quarter earnings on Aug.7, reporting a $164 million loss on $18.3 million in revenue, but XM figures on breaking even by late 2004. Investors certainly seem sold on the idea that XM can generate enough new subscribers to pay off mounting debt.

POSSIBLE PRICE WAR. Yet, that could be a challenge as other music and entertainment technologies get rolling. "No doubt the product is very popular," says Rodman & Renshaw analyst Daniel Ernst. "But the market has overdiscounted the ability of other products to compete with satellite radio."

First out of the box: Upstart rival Sirius Satellite Radio (SIRI

}, which closed at $1.60 on Sept. 2 but has also tripled in value for advernturous investors over the past year. Sirius has exclusive deals with DaimlerChrysler (DCX), BMW, and Ford (F) to offer its receivers as an option in many models. Sirius is about a year behind XM in development and charges $13 a month for a similar suite of more than 100 channels with less advertising than XM.

As Sirius rolls out its services to more new cars and retail stores, XM could be pressured to lower prices, say analysts. Plus, MP3 players are becoming more popular. And since they allow listeners to keep many CDs on file, such listening could be a substitute for satellite radio.

LESS COSTLY GROWTH. While its future is promising, XM is still borrowing money to fund growth. It pays GM a subsidy to put the satellite radio receivers in its cars. All told, between those subsidies and marketing costs, XM pays $160 to acquire new subscribers, says XM Chairman Gary Parsons, a former MCI executive. So in effect, GM, which is a 20% shareholder in XM, is loaning money to XM, whose debt is now $732 million and could grow to $1 billion, says Ernst.

That's why it's imperative that XM continue its red-hot subscriber growth. If that happens, Parsons predicts that next year XM will be paying less than $120 per new subscriber, meaning it'll take less than one year of subscription revenue to break even on every listener. In a couple of years, XM won't have to subsidize the hardware to auto makers. So its fastest-growing business -- car units should become two-thirds of sales from one-third right now -- will be less costly.

XM isn't hurting for time to generate new revenue, notes Bear Stearns analyst Robert S. Peck. Most of its debt comes due around 2006. Says Parsons: "The real key to this is to keep the service affordable but add customers like crazy."

ROLLING IN DOUGH? XM's prospects are also enhanced by its link with Honda, which owns 8.7% of it. The Japanes carmaker has an exclusive deal to equip its high-end models with XM receivers. That should put XM radio in an additional 200,000 cars in the coming year.

Other auto makers will offer their buyers XM or Sirius, however, which means XM could soon be in a race for the next hotbed of new subscribers. If it can keep bringing them in and keeping them happy with tunes and news, the profits will likely roll in. If not, XM could be just another promising technology that can't seem to break into the black ink. By David Welch in Detroit

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