Now that Sirius XM Radio's (SIRI) board has finally announced that it has authorized $2 billion for a share repurchase plan, investors should consider some of the objectives of Sirius XM's largest shareholder, Liberty Media (LMCA). And, while we don't have access to the private conversations between Liberty's executives and its Chairman, John Malone, we can review their past public statements and actions. Some of these statements and actions directly involve Sirius XM. Others are more general in nature.
Liberty Hates To Pay Taxes
Nearly everyone, both individuals and corporations, dislikes paying taxes. Some of us will hold onto an investment longer in order to realize a break in the capital gains tax rate. Others will purchase a home rather than rent in order to realize the benefit of the mortgage interest and property tax deduction, or we open IRAs to avoid or defer taxes. Liberty is more creative.
Last week, Liberty filed an 8K disclosing that it was accelerating the vesting of hundreds of millions of dollars of stock options. The action was tied to the separation of Liberty and Starz businesses that would result in a reduction in taxable income and the loss of the compensation deduction tied to option awards.
By realizing the compensation deduction in 2012, [Liberty] ensures it will have the benefit of the deduction. The Company also effected these transactions based on the belief that the corporate tax rate will decrease in 2013 and beyond. The Company will benefit from these transactions by realizing the compensation deduction in respect of the affected incentive awards at a potentially higher corporate tax rate than if such deduction were realized in later years.
An article at Bloomberg.com titled Liberty Media Makes Bet Corporate Tax Rate Will Decline, included the following statement:
"Liberty Media and Liberty Interactive have effected transactions with respect to outstanding employee stock options in a manner that is consistent with the company's historical goal of minimizing the company's taxable income," the companies said in an e-mailed statement. Whit Clay, a spokesman, declined to comment beyond the statement.
Its historical goal of minimizing taxes is one of the reasons that Liberty is likely to execute a Reverse Morris Trust ("RMT") when it splits out its stake in Sirius XM and distributes it to shareholders. Not only does the RMT eliminate a tax liability, it is also a transaction that Liberty used several years ago to spin its stake in DirecTV. If that section of the tax code remains intact, the RMT would eliminate the Liberty corporate tax liability. A concise explanation of the RMT from Investopedia.com describes the RMT as "A tax-avoidance strategy" where a corporation [in this case Liberty] can "dispose of unwanted assets ... while avoiding taxes on any gains from those assets." It further notes:
If those shareholders control over 50% of the voting right and economic value in the unrelated company, the Reverse Morris Trust is complete. The parent company has effectively transferred the assets, tax-free, to the smaller external company.
The RMT would be a two step process where Liberty places its "unwanted asset," the Sirius XM shares, into a separate subsidiary - call it SplitCo - and then Sirius XM acquires SplitCo from Liberty shareholders in exchange for a majority stake in Sirius XM. The RMT would certainly appeal to a company that has used this transaction in the past and has the "historic goal" of minimizing taxable income.
The Liberty Investment
Liberty made more than a half billion dollars in loans to Sirius XM nearly four years ago. Taking advantage of Sirius XM's immediate need to refinance debt in a very tight credit market, Liberty was able to earn 15% interest on the loans. In addition to the high interest rate, Liberty was also able to buy a 40% equity stake in Sirius XM for $12,500. The investment also granted Liberty the authority to approve cash certain expenditures in excess of $10 million.
That $12,500 investment is currently worth more than $7 billion at current Sirius XM share prices of $2.75-$2.80. Unfortunately for Liberty, the 40% equity stake was not more than the 50% ownership that Liberty would need to complete the RMT and avoid the taxes on that $7 billion gain. As a result, late last year, Liberty made arrangements to begin purchasing additional shares in Sirius XM and subsequently applied to the Federal Communications Commission ("FCC") for permission to take a majority stake of the company. The FCC is currently evaluating that application.
In its efforts to acquire that additional 10% ownership of Sirius XM, Liberty has now spent in excess of $1.5 billion and increased its ownership percentage, including both its common and preferred shares, to 49.8%. That percentage is not static, and the number of shares Liberty needs to move above 50% changes when Sirius XM issues new shares for contributions to employee savings plans, the exercise of employee stock options, the exercise of other convertible instruments or employee stock grants.
Assuming that the FCC grants its request, it is not entirely clear how Liberty will move to, and remain at, an ownership position of more than 50% of Sirius XM. There are several paths it can take. Obviously, one path is for Liberty to continue buying shares of Sirius XM through forward contracts or market purchases. Another is to put additional Liberty assets into SplitCo. A third option would be to negotiate with the Sirius XM board to "purchase" SplitCo at a premium to its underlying assets. And, the percentage and number of shares needed to get to 50% would also change when Sirius XM begins buying back shares.
The Sirius XM Stock Repurchase Plan
Since the FCC has not yet granted permission to Liberty to take a majority position in Sirius XM, the recent Sirius XM stock buyback announcement included the following statement:
Liberty Media Corporation, the beneficial owner of approximately 49.8% of the company's stock, has indicated that it will participate in the company's share repurchases on a pro rata basis so that its relative ownership interest will not be affected by the program.
This participation allows Sirius XM to begin a buyback immediately without putting Liberty into a majority position prior to FCC approval, while at the same time it allows Liberty to begin recovering its $1.5 billion incremental investment.
The type of share buyback announcement made by Sirius XM is not a commitment to actually purchase shares. It is an indication of its current intention, and specifically states that it could change:
The timing and amount of any shares repurchased will be determined based on the Company's evaluation of market conditions and other factors and the program may be discontinued or suspended at any time.
Sirius XM currently plans on buying back $2 billion worth of shares, Liberty "has indicated that it will participate in the company's share repurchases on a pro rata basis," and we know that Liberty approved the buyback because it is a cash expenditure of more than $10 million. But what happens if Liberty gets approval to go over 50%? Liberty could simply stop participating, allowing a continued buyback program to move its ownership percentage over 50%. And, if Liberty ceases to participate, Sirius XM could suspend the program.
Liberty Wants Its $1.5 Billion Back
A suspension of the program does not help Liberty recoup its incremental investment of more than $1.5 billion, so it is not in the best interest of Liberty to cease its pro rata participation, at least not without the approval of Sirius XM. How do we know that Liberty wants to sell the shares it has purchased over the past year and recover the $1.5 billion? On multiple occasions, Liberty CEO Greg Maffei has made statements to that effect. At the Liberty Media Investor Meeting held in October, Maffei and Liberty Chairman John Malone discussed the transaction. Even earlier, Maffei made several statements during Liberty's Q2 earnings conference call. First, he stated:
I think a consideration in our mind would be, and obviously we have announced no intent to do a Reverse Morris Trust. We've only suggested its one path. But I would note, if we pursued that path, something that would weigh on our mind is, we got the first 40% of the company for free virtually. The next 11 points have cost us well over $1 billion something if we got to 51. We would probably like to get the bait back on the 11 points.
Some have focused on the bold portion of the statement to conclude that Liberty's goal is to recoup the amount it spent to acquire the "11 points." And, they are correct.
However, I would suggest that Liberty is currently interested in getting much more than that. It's not just the $1.5 billion or even the tax free spin of SplitCo that Liberty wants. It spent more than $1.5 billion to acquire 655,823,552 common shares for an average price of less than $2.29 per share. Maffei's statement continued:
We've noted that there is flexibility in the capital structure at Sirius, there's plenty of availability for them over the next short-term to lever further and return capital to shareholders including ourselves, and whatever we did, we would be unlikely to want to spin out high basis stock, we'd probably given how much we've already shrunk Liberty Media over the last several years. ... we'd probably be wanting to get that cash back. So, that would be the biggest consideration in our minds, a major one.
Notice the concern over "how much we've already shrunk Liberty Media over the last several years" and how Liberty would be unlikely to "spin out high basis stock." I interpret this as Liberty wanting to sell all 655.8 million shares. At current prices of $2.75-$2.80, that total is more than $1.8 billion. And, with the price of Sirius XM predicted to rise from its current levels (the average price target of the 15 brokers on the Yahoo web site is $3.18-$3.25), the $1.8 billion could easily surpass $2 billion.
Liberty and the RMT
Keeping in mind that the end game is to avoid taxes on the gain built up in the 40% of Sirius XM shares that Liberty got "for free virtually," Liberty shareholders need to own more than 50% of merged entity comprised of SplitCo and Sirius XM. So, if Liberty won't be spinning out its high cost basis shares, Sirius XM will need to buy not only all of Liberty's 655.8 million shares, but also a similar number of non-Liberty shares.
Then, Sirius XM will also need to purchase newly issued shares from the future conversion of employee stock options or the 7% Exchangeable Note. Finally, Liberty is not yet over 50%, and that would require another 15 million shares. That's probably an additional 0.4 billion shares.
All of these shares, the 655.8 million high cost basis shares owned by Liberty, another 655.8 million shares currently held by non-Liberty investors and the 0.4 billion need to be removed from the float if Liberty shareholders are to be at a majority ownership position at the time of the RMT. That's a total of more than 1.7 billion shares.
Those investors that think Liberty's principal objective is to recoup the more than $1.5 billion spent over the past year may want to reconsider that position. If, on the other hand, one accepts the premise that Liberty's principal objective will be executing the RMT to avoid taxes on the gain of more than $7 billion from the 40% stake it obtained for $12,500, then the recovery of the $1.5 billion investment, while still important, becomes secondary, and investors should think about some of the implications.
It would suggest that a Sirius XM share repurchase program needs to absorb more than 1.7 billion shares for Liberty to achieve its two main objectives of maintaining its ownership above 50% and avoiding distribution of its high cost basis shares. That repurchase program would cost Sirius XM more than $5 billion if the company were able to purchase those shares at an average price of $3 per share. If the average price is $3.50, then the total cost increases to $6 billion.
The recent announcement of a $2 billion buyback may only be the first small step in a very expensive share repurchase program. A program that could either take a very long time, or one that requires Sirius XM to take on billions in new debt. And, if Liberty is unwilling to wait a long time, that means a lot of debt. Discussing debt on that Q2 call, not only did Maffei say "there's plenty of availability for them over the next short-term to lever further and return capital to shareholders including ourselves," but he also added:
Our view is that Sirius is under-leveraged and there's plenty of opportunity for share repurchase and other financial actions of the Company, which we deem as ultimately positive and being a shareholder, an increased shareholder in Sirius is a good thing.
The increased debt at Sirius XM is certainly good for Liberty. Is it just as good for the rest of Sirius XM investors?
Additional disclosure: I have $3 January 2013 covered calls against most of my SIRI position, as well as some $2 and $2.50 January 2013 and $2.50 December covered calls. I may initiate (or close) a buy stock/sell option position in SIRI at any time. Also, in addition to long-term holdings, I have recently begun day trading 10,000 share blocks of SIRI and may continue to do so. I have no position in LMCA.