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Star Potential for Sirius Stock

We think Sirius Satellite Radio (SIRI) will be a key beneficiary of a continued ramp-up in the penetration of satellite radio. We believe the arrival of shock jock Howard Stern in January, 2006, was a watershed event for Sirius, extending its breadth of compelling programming, and building increased awareness for this nascent category.

Satellite radio is the fastest-growing entertainment service, in our view, with a potentially sizable addressable market -- not only cars, but also, increasingly, portable devices. The emerging portable-device and advertising businesses could provide viable platforms to augment longer-term growth.

We expect Sirius to gradually close the gap in market share against 3-STARS (hold)-ranked XM Satellite Radio (XMSR), its larger rival in the satellite-radio market, which currently has only two players. In our view, the combination of Sirius' outstanding growth prospects, its fixed-cost structure, and high contribution margins should drive increased operating leverage in the years ahead.

HIGH-RISK PROFILE. With declining subscriber acquisition costs (SAC), and sizable working-capital inflows from subscriber prepayments, a self-funding business model could lead to free cash-flow breakeven in 2007. Despite low speculative-grade credit, we view Sirius' balance sheet as strong, with only $1.1 billion in debt and $900 million in cash. We also see a strong management team led by Chief Executive Mel Karmazin.

Still, the shares have declined sharply year-to-date in 2006, partly, we think, on concerns of potential dilution resulting from Stern's equity grants, and other issues not unrelated to recent governance developments at XM. We view this retreat as an enhanced buying opportunity, but note that the valuation is highly subjective, given the company's developmental stage.

The stock carries Standard & Poor's highest recommendation of 5 STARS, or strong buy. However, with above-average historical volatility, we think the shares carry a high-risk profile, with potentially sizable downside risk on possible earnings disappointment or other adverse news.

GROWING SUBSCRIBER BASE. Sirius offers more than 125 digital-quality programming channels, over half of which provide commercial-free music. Other program offerings include NFL and NBA sports, as well as an array of news, talk, sports, and entertainment content targeting various preferences and demographic segments. In addition to Stern, Sirius' well-known talk personalities include lifestyle maven Martha Stewart.

Sirius radios are distributed through national retail outlets at various price points, as well as through major automotive partners. Subscribers can utilize car-based, home, or portable devices to receive content for a fee of $12.95 per month, with discounts offered to family-plan and multiyear customers. The company recently launched its service in Canada through a joint venture with a local partner.

After adding about 2.2 million subscribers in 2005 to triple its customer base to more than 3.3 million, we expect Sirius to add another 6.5 million over the next two years, reaching 9.8 million customers by the end of 2007. With a potentially large addressable market, including more than 200 million registered vehicles and nearly 110 million homes in the U.S., we think Sirius could approach 20 million subscribers by 2010. This should reflect continued strong growth in both the retail and automotive OEM channels, in our view.

LEGAL BAGGAGE. We believe Howard Stern's much-anticipated debut in January, 2006, created significant brand awareness for Sirius, which should help fuel subscriber growth. Of Stern's approximately 12 million fans in terrestrial radio, the company has estimated it needs to sign up about 1 million subscribers to break even on Stern's contract, worth about $600 million over five years. We view this target as realistic and attainable, and think the robust gross additions of more than 1.2 million customers in the fourth quarter of 2005 were largely attributable to Stern's switch to Sirius.

However, the controversial Stern also arrived with some baggage, in our view. Just last week, CBS named Sirius as a co-defendant in a breach-of-contract suit against Stern, its former employee, alleging misappropriation of millions of dollars worth of CBS radio's airtime to promote Stern's move to Sirius. We would not speculate on this potentially distracting suit, but think Sirius gained highly valuable brand awareness during Stern's final months at CBS. Arguably, this development could also translate into further positive publicity for the brand.

Sirius has exclusive long-term factory-installation agreements with several automotive partners, including DaimlerChrysler (DCX), Ford Motor (F), and BMW. Its key OEM partners account for more than 40% of the U.S. annual production of cars and light trucks. We expect Sirius to significantly pick up the pace of its subscriber additions through the automotive channel, doubling its OEM subscriber base to nearly 1.7 million by the end of 2006, and reaching more than 2.6 million OEM subscribers in 2007.

PLUG-AND-PLAY PRODUCTS. With availability in about 90% of Chrysler's vehicles lines, Sirius' penetration of DaimlerChrysler's total production is currently over 30%, and we expect it to ramp up in 2006 and beyond. More recently, after launching its own factory-install program in September, 2005, Ford targets about 1 million Sirius-equipped cars for its 2006-07 model years, with 19 of Ford's vehicle lines expected to offer Sirius by the end of 2006. We see continued progress with other automotive partners, including BMW and Mazda. All told, Sirius radios could be available in nearly 130 vehicle models by the end of 2006, most of which will be under factory-installation programs.

While Sirius' retail offerings have recently featured an array of "plug-and-play" products targeted to various price points, including the top-selling Sportster and Starmate, we expect the portable-device segment to play an increasingly crucial role in the years ahead. We note that this nascent market represented less than 7% of total satellite-radio net additions in 2005. Yet, this potentially large and growing market opportunity includes nearly 15 million MP3 players and 80 million cell phones.

The company launched its highly anticipated S50 wearable satellite radio ahead of the 2005 holiday season. Sirius' first wearable device with MP3 capabilities, the S50 debuted to critical acclaim, generating strong fourth-quarter sales that, absent a major product shortage, should accelerate in 2006. Also, last fall, the company launched its first service on cellular phone -- in a partnership with Sprint (S) -- offering 21 commercial-free music channels. In addition, we expect a new and improved line of portables with live satellite radio, MP3, and enhanced interactive capabilities to hit the shelves this summer.

NORTHERN EXPOSURE. With a total inventory of more than 125 channels (68 of those currently offering commercial-free music), we see a potentially sizable base on which Sirius can build a viable long-term advertising platform. We think Stern's arrival should help to jump-start a dual revenue stream through ad sales, which accounted for just 2.5% of the company's total 2005 revenues, but are expected to ramp up quickly to about 10% in 2007.

Meanwhile, Karmazin has been aggressively building an advertising sales force, and recently said the company had booked more than $6 million of ad sales in 2006 through mid-February -- more than its total in all of 2005. Over time, as Sirius ramps up its subscriber base, we expect more advertisers to jump on this bandwagon, despite concerns about the lack of an audience measurement mechanism for satellite radio.

The company also has focused its energies northward. After receiving regulatory approvals in June, 2005, to offer its service in Canada, Sirius Canada launched its service on Dec. 1, 2005, in a joint venture with local partners. (Rival XM recently launched in Canada as well.) Sirius Canada currently offers a total of 100 programming channels, including the company's most popular offerings, as well as 10 Canadian channels.

OPTION EXPENSES. Sirius owns a minority stake in the Canadian venture, and is also entitled to some percentage of the subscription revenues. With nearly 17 million households and more than 17 million registered vehicles, we believe Canada offers Sirius a potentially sizable growth market, which could help drive increased penetration over the longer term.

Sirius has historically expensed marked-to-market equity incentive grants to certain third parties and employees, but adopted a pro forma treatment for compensatory stock grants to other employees. Accordingly, our Standard & Poor's Core Earnings estimates for the prior years included additional option expenses of 3 cents per share in 2004 and 4 cents per share in 2005.

As new accounting standards now require all employee stock grants to be expensed, we included a projected $55 million of option expense (4 cents per share) in our full-year 2006 operating-loss estimate of 82 cents per share (which also includes an estimated $225 million for Stern's equity grants, entirely expensed in the first quarter). Likewise, our 2007 operating-loss estimate of 39 cents per share includes about $65 million (5 cents per share) of option expenses. No further adjustments were deemed necessary to our model.

CORPORATE GOVERNANCE. Sirius' negative earnings and limited operating history render most traditional valuation techniques of limited usefulness, making discounted cash-flow analysis a more appropriate tool, in our view. Our DCF model assumes that Sirius will reach positive free cash flow in 2007, likely accelerating thereafter. (Management recently reiterated its target to turn free cash-flow positive in the fourth quarter of 2006, indicating about $1 billion in 2010.) We also expect continued sizable working-capital inflows from prepaid subscriptions. Our outlook is predicated on average prepaid revenue per subscriber increasingly exceeding SAC per gross addition over the next few years.

Based on these and other factors, we have derived an intrinsic value of $8 for the stock, implying substantial upside from the current trading level. We caution, however, that our DCF model has its limitations, as the stock price has been, and may be, affected by any number of exogenous factors.

We view the company's corporate-governance policies as satisfactory. The board is composed of eight members, all but two of whom were determined to be independent. All directors stand for election annually. The board has three standing committees -- Audit, Compensation, and Finance -- the first two composed solely of independent directors. There is a separation of the chairman and CEO positions. The company's executive-compensation practices seem generally consistent with industry norms. No stock options were recently repriced.

POTENTIAL RISKS. On the negative side, in our opinion, the board does not have a governance or nominating committee, and there's no presiding independent director. Also, Sirius has adopted certain stock-based incentive plans without shareholder approval, a significant portion of which remains available for future issuance. Sirius has been perceived as somewhat generous with equity grants to third parties and employees. Still, we do not find this to be excessive compared to its peer, and expect future third-party grants to be reined in.

Risks to our recommendation and target price, in our view, include continued losses and further delays in reaching positive free cash flow; weaker-than-expected subscriber contributions from Stern; significant dilution from equity grants and outstanding warrants; increased competition for customers, talent, and programming against rival XM; negative developments on corporate governance; and increased Federal Communications Commission regulation of satellite-radio operators.

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