Knowledge@Wharton Strategic Management Research Article

On Monday, the country's two satellite radio services -- Sirius and XM -- announced that they had finally agreed to merge. The move raises a number of questions, not the least of which is whether they can get this deal approved by the Federal Communications Commission and the Justice Department. But regulatory issues aside, what prompted these two archrivals to embrace each other, what do they expect to get out of it, and what does a combined company mean for consumers who currently pay a subscription fee of $12.95 a month? Knowledge@Wharton asked for comments from Wharton marketing professor Peter Fader, whom we talked with first, and business and public policy professor Gerald Faulhaber.

Knowledge@Wharton: So what do you make of this proposed merger?

Fader: Well, on one hand, it's big news because it will have lots of implications. On the other hand, it's not at all surprising. Everyone knew that something like this was coming; it was just a matter of when.

Knowledge@Wharton: How serious are the anti-trust concerns that such a merger would create a monopoly, and the FCC's concerns that this merger would not be in the public interest?

Fader: I think it's ridiculous. In this case, maybe it would create a monopoly on satellite radio, but given the breadth of competitors that they have -- Terrestrial radio and Internet radio and just so many other ways of obtaining content -- they're actually a very small player. In fact, that's one of the reasons why they are merging, because they can't dominate the market as if there really were a monopolist.

Knowledge@Wharton: Sirius spent $500 million over 5 years to sign up Howard Stern. Granted, Stern may have "legitimized" satellite radio by signing on, but was that a wise move?

Fader: I think that it was a terrible move. And first let me make the caveat that I'm a big fan of Howard Stern. I don't want to get "The Wack Pack" all mad at me, but from a business standpoint, I think it was a big mistake. And it was no different from some of the mistakes that XM has made as well. Both firms have been so focused on just acquiring new customers, with much less focus on how well they've been able to retain them -- which ultimately is far more important. So, I think that they were investing an awful lot up front and not getting a lot to show for it.

Knowledge@Wharton: So it was really the amount of money that they spent on Howard Stern and Oprah Winfrey and that kind of thing. It's not the fact that they're trying to get these huge names, it was just the cost.

Fader: That's right. In fact, one of the things that we'll miss by seeing the merger is the competition among them. They wouldn't have brought in some of those names. They wouldn't have had some of the kinds of innovative programming that they currently have, if they hadn't existed as rivals. The rivalry is kind of fun for us as business fans, as well as customers of these services. But ultimately, to make the business viable, they really need to stop focusing on outdoing each other and focus more on just retaining customers and giving them what they want.

Knowledge@Wharton: As we know, they were charging $12.95 a month to their listeners to provide satellite radio services. Wasn't part of the problem that the rest of radio is essentially free, and when you charge for a service that other people can get for free, that it's really hard for you to build a market? Was that the fundamental reason why they couldn't build a customer base and why this merger is happening?

Fader: Of course, you're talking in the past tense, as if the game is over. Yes of course it is hard to get people to change their behavior. It's something that has to happen slowly. But I do think that this kind of business model - set aside the technology and just focus on the idea of people paying for really good content -- that will win out.

I believe that whether if it's one of these firms or this combined firm or some other rival in this technology space or another one, that people are quite willing to pay. It's just the same kinds of issues that were arising 30 or 40 years ago with Cable TV and look how that market has played out. So, I think it's a great thing. I pay my money to XM every month. I rarely listen to it but it's nice to know that it's there. I think that's true of a lot of other subscribers as well.

Knowledge@Wharton: And, what do you think will happen to the price? Do you expect that to go up or come down after the merger?

Fader: It's hard to say, and in some sense it's less important. I think that they have got to figure out where that sweet spot is where people will be willing to pay, kind of in a mindless fashion, month after month after month. I think there is room to bring it down as long as they don't do some of the crazy things that they've been doing on the acquisition side.

So, I think it's too early to get into those kinds of tactical details. I think that at least it's important to wonder what kind of programming they will retain, what's going to have to go in the process. It will be interesting to see how all of that plays out. And, I'm sure that the combined entity will not only look quite different but will interact with its customers quite differently than the rivalry that we see right now.

Knowledge@Wharton: Two of the executives involved in the merger, Sirius CEO Mel Karmazin and XM Chairman Gary Parsons, say a merger would be "in the public interest". Is this a credible statement and what exactly is the primary motive behind this deal?

Fader: I don't think that it's in the public interest. I don't think that the public is clamoring to have these two firms brought together. But I do think that it makes good business sense. I think they're making those kinds of statements because of some concerns about some of these regulatory issues. I'm not an expert on that particular topic, but I don't see that as a big deal by itself.

I think that it's just time to realize that the titanic battle that they've been fighting with each other for content and for subscribers isn't paying off for either one of them. It makes much for sense for them to focus on the bigger, broader enemy which would be all of these other sources of content that people currently have. And I think there's a lot to be said for them to be working together. I don't think that there's any down side to it at all.

Knowledge@Wharton: Well, they have gone from this titanic battle, as you've called it, to a merger of equals. Isn't that kind of the kiss of death among mergers, when you have two companies that claim it's a merger of equals? Most of them don't seem to work out; is this one likely to be any different?

Fader: I think his one can be different and it's not because they're equals or despite the fact that they're equals. I think it's because of their positioning in the marketplace. The two of them are hard to distinguish from each other. Very often it's hard for people to know which is the one with Stern, which is the one with baseball? They're seen as largely similar to each other and so very often these mergers fail because it's just too hard to take these two different entities and jam them together.

It doesn't seem to be a problem here, at least from a consumer's standpoint. It's hard to say internally how easy it will be to blend the operations. Once again, the goal here is for them to put together a single business model that will be a credible threat against all these other sources of content. I see it as something that they can do better together than apart.

Knowledge@Wharton: Which company do you think is getting the most out of this merger? In other words, who is it a better deal for?

Fader:  Well, XM is the older, more established player. Sirius is the upstart. So, you can frame it either way. You can say that Sirius has proven to be such a threat against XM that XM had to cave in and play along with them. Or again, you can say that XM is the one that's been around longer and probably has a little bit higher name recognition. I think that they both stand to gain from it.

I think [they can be successful] by combining some of the sources of content that they have, by focusing a little bit more on some of these day-to-day business issues, instead of the splashy stuff, that tends to get associated with them. I don't think that it's important to declare which one or which management team will come out ahead. This is a case where it really can benefit everyone.

Knowledge@Wharton: As you said at the beginning, both of these companies have been losing lots of money. Is that going to change after the merger?

Fader: Well it ought to. Otherwise it really is time to wave the white flag. I think that a lot of the losing money is because of the rivalry -- each one trying to outspend the other. In some sense, it's not just a matter of which content did they get, but how much they paid for it. They're almost boasting about this kind of thing and implying that there will be a pay off from it in the short to medium term -- and there hasn't been. 

So, I think that by putting all of those issues aside and focusing much more just on content, creation and delivery and more mundane things rather than what the headlines have been focusing on, I think that's what it's going to take to make this business successful -- again this idea of keeping customers around for a long time, giving them just a great value proposition to stick with and not just a reason to try it for a while and then jump away.

I've always found it disappointing that they haven't focused so much on customer retention types of statistics. We keep seeing numbers about how many subscribers they have, but it begs the question of how many of them stick around. If they can not only give attention to those kinds of issues, but boast about their ability to retain customers, then it should be a success. 

Knowledge@Wharton: Let me ask one last question. You've mentioned a couple times now, that consumers have a lot of choice as to where they can get their music these days, whether it's iPod's or Internet radio or HD radio or mobile phones. Where do you listen to music?

Fader: I'll listen to pretty much everything. A part of it is I just enjoy technology. So, I'll use everything from XM to subscription music services. Probably most of it I would get just from Terrestrial radio, because it's so easy, regardless of price points. I think that it's important for customers not to just make a choice about which one will be their source, but to have a portfolio of different technologies that meet different kinds of needs.

One might say that these two firms coming together in some sense restricts choice, but there were very few people who had [both] XM and Sirius. And so, maybe [this way] there will be more people who just have that combined entity. That should make consumers quite happy.

Knowledge@Wharton: Now we would like to welcome Gerald Faulhaber to the discussion. Gerry, given that you were once the chief economist for The Federal Communications Commission, what do you think the chances are that the FCC will approve this merger?

Faulhaber: Well, I would not be amiss in saying that the FCC is certainly a political organization. When these radio licenses were granted to these two companies, back during the Michael Powell days, I would have said that the chance of their being able to do this merger was nil. Now, with Kevin Martin in charge, who's certainly a political animal and I don't think he would deny that, I think that it's not nil. It's something. I don't think it's big, but it's not zero.

Knowledge@Wharton: It's interesting. When they were first granted their operating licenses, I believe that they were prohibited from ever owning each other's license.

Faulhaber: They were indeed, yes.

Knowledge@Wharton: Do you think that the FCC might decide to waive this rule?

Faulhaber: They can always do so. The fact that that rule exists makes it harder for them to do that, but they could find extenuating circumstances. It will be a difficult merger to exercise for them. If the FCC does backtrack on this, they would have some egg on their face.

Knowledge@Wharton: The FCC, four years ago, rejected the merger of Satellite TV broadcasters EchoStar and Direct TV. How is this different?

Faulhaber: I don't think that it is different at all. In both cases, EchoStar and Direct TV were both fairly marginal financially and they made the argument, which potentially could have been compelling and wasn't, that "Gee, as a single satellite company we can more effectively challenge the cable companies." That was, in my view, a bogus argument.

It was turned down at the FCC and turned down by the Justice Department as well, and I think events have shown that that was a good decision. Like Sirius and XM, they were both in some financial difficulties and they used this as an argument to say, "We're not financially strong enough to challenge the cable companies." I don't think that they were right then, I don't think that they're right now. I think that they are very similar. It's a duopoly looking to merge into a monopoly. That's where we are on this.

Knowledge@Wharton: Kevin Martin, about whom you were just speaking, has apparently said that the commission is going to evaluate this proposal, but even if it does, the hurdle will be high. How could this proposal leap over those hurdles? Do you think that there is a chance that it might?

Faulhaber: It's always possible. Obviously the commission has to evaluate. They can't just say "No we're not going to do it" and walk away from it. They have to give it very careful consideration and they have to weigh it. They also have to take into consideration their current position, which is, "No we're not going to let this happen."

And they will certainly be aware that if they let this go through and if they recommend this to the commission, that it will hurt the commission's credibility big time. Now there could be arguments that would be brought to bear and I suspect that there would be some pretty intense lobbying [as well].  

In Washington, you never know what's going to happen. People can reverse themselves. I would say that even though Michael Powell is a Republican and Kevin Martin is a Republican, they are very, very different people and they may take a different tack on things. Kevin might not agree with the fairly tough position that Michael Powell took when these licenses were granted.

Knowledge@Wharton: How do politics affect the situation even beyond that, in the sense that the two companies view the Bush administration as being probably friendlier to the idea of a merger than a Democratic administration would be? Is that one reason why they are trying to move it through now? 

Faulhaber: Oh, absolutely, I don't think there is any question about that. And, it depends not only on the administration, but you have to burrow down a little further. You have to look at the commission itself and who is on the commission, because that's where it's going to get decided. Then there's the question of the anti-rust Division of the Justice Department and what they're going to do about this. Even under the Bush administration, the DOJ turned down the EchoStar and Direct TV merger.

I suspect that they might come out in the same place now. There is a discussion however, that when these rules were put in by the FCC four years ago, "Well we have a different market now; there are other forms of music available; we didn't have iPod's four years ago; we didn't have HD radio four years ago." Some people have argued that those are substitutes for Sirius and XM radio. I don't buy that, but that's probably the argument that they will try to make.

Knowledge@Wharton: Why don't you buy that?

Faulhaber: TheiPod is a very different service than Satellite radio. With Satellite radio, they do programming; they're real programmers. They offer a choice of formats. With iPod, you're picking your own music and that's fine but it's a different experience. They also do not have the personalities on iPod that they do on XM and Sirius radio.

And, if you look at where they're spending their money, they are spending it on the Howard Sterns and Oprah Winfreys. The iPod doesn't have that; it's a different experience and I think it's a good idea. I think it's going to take a while for that market to mature, but I see signs of it developing. The notion that these guys are losing money now doesn't really concern me very much.

Knowledge@Wharton: We've talked about the anti-trust issues. Could you talk a little bit about what kind of technological challenges are involved with this merger going through?

Faulhaber: We have two different pieces of spectrum which have been allocated. My guess is that they will continue, if the merger went through, to be used probably separately and for separate programming niches. In which case, one might argue, why are we doing the merger?

I don't see them trying to get rid of one of those channels because that's a valuable spectrum to have. I don't see any other technological issues that would be there. They will certainly use the same spectrum and the same receivers and they'll have to either use both or they'll have to choose one.

Knowledge@Wharton: I believe that the two run on separate and incompatible systems though, is that right?

Faulhaber: Yes, if you're going to use a particular radio channel, let's say we're deciding that the XM is better than Sirius and so we're going to abandon the Sirius one. Well, then you'd move all of the equipment and you'd move the spectrum; you'd move everything or else you'd have to keep two separate operations going. So, I don't see that what goes on at the head end of this is much of a deal. I don't think that's too important.

Knowledge@Wharton: Why are broadcasters so opposed to this merger?

Faulhaber: They may see that a combined Sirius XM presents even more of a challenge to them. Right now, Sirius and XM are financially shaky and so maybe broadcasters don't have to worry about them, that much. I think that broadcasters have been concerned more for the future rather than the present about how seriously [satellite radio] is going to cut into the broadcast market. The broadcast market, either AM or FM, is primarily an automobile market. And this is precisely what Sirius and XM have targeted.

They have been very successful, for example, at getting automobiles, particularly high-end automobiles, to put in both Sirius and XM receivers. That's the market they are targeting and that's the same market, the driving to work market, that is so important to the broadcasters. They're both going after the same market. So if they see that as a tougher competitor, yes, I could see why they would be opposed to it.

Knowledge@Wharton: Right now the audience for broadcast media is so much larger than satellite radio. I believe that even the two companies combined have just about 12 to 14 million subscribers whereas, broadcast media is about 90 million or thereabouts. Do you think that that's a valid argument, that this could be a threat to broadcast radio?

Faulhaber: Absolutely. I mean look at the early days at Amazon and ask, "Gee how big was Amazon compared to Barnes & Noble?" [Nothing] Or, if we look at, let's say Voice over IP telephony - now there's an even starker example, and ask, "What kind of a threat can Voice over IP telephony, [which is almost a toy], be to the telephone companies? Well, they didn't' seem to think it was a big one -- and it is.

Now, we always make the mistake of thinking that if some new thing comes along and it's superior, that if it doesn't take over the old business in six weeks then it's not serious. That doesn't happen this way. It takes a while for this stuff to migrate.

We've seen this happen. For example, we are beginning to see some serious change out of people dropping their wire lined telephones for wireless. But, how long has wireless been around? It's a long time. That change will continue. It's happening moderately rapidly now and it's going to take another five to ten years, I would think. I would say the same thing here. Getting your radio through satellite radio is a very unique experience. People that buy it love it. I think that we will see this.

It will come in particularly at the high-end, but it will also start trickling down to the small Ford Tauruses and what have you. And I think it will be much more standard than we see it, but it's going to take a long time. The fact that it hasn't displaced broadcast radio in the last two years, I just don't even consider that a serious comparison. Look at growth rates -- that's what you need to look at.

Knowledge@Wharton: If you had to say whether you were pro or con this merger, what side would you come down on?

Faulhaber: I think that I would be against it for the same reason I was against the DirecTV and EchoStar merger. It's a merger to monopoly that can't be good for consumers. It's on the basis of, "well we're not really making money." Well, yes, but you haven't been in the market that long.

This market is going to take a while to develop. It's growing; we're getting receivers in cars. I think that it's happening. The fact that it's not happening immediately is okay. That's what investors are for. They are buying a little bit of this risk so that they can get the rewards in the future. That doesn't bother me so much. So, mergers to monopolies -- I'm not a big fan.

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