Part 1 of this article discussed the options available to corporations looking to return capital to shareholders and the rise in the popularity of share buybacks. At the time Part 1 was written, the shares of Sirius XM Radio (SIRI) were trading below $2.20, and Liberty Media (LMCA) and Sirius XM were engaged in a very public dispute over the control of Sirius XM. Most investors were anxiously awaiting a resolution to this issue so that a share buyback could begin. Although it had been planned that Part 2 would be completed much earlier, the share prices kept rising and the financial metrics were quickly outdated.
As many had expected, Liberty was successful in taking control of Sirius XM, and the much anticipated share buyback was announced. What should investors expect from that buyback? Not too much if Sirius XM's experience is similar to that of the S&P 500 companies in the Credit Suisse study cited in Part 1:
There are 306 companies or 61% showing a positive return, 154 companies or 31% with a negative return and 40 companies that had no buybacks over the past eight years. But if you were to benchmark against a cost of equity of let's say 7%, we find only 180 companies or 36% that beat the benchmark. As a result it looks like most of the buybacks for the S&P 500 over the past eight years have not yet added much value for the remaining shareholders.
Of course, the Sirius XM bulls know that it will be very different this time. They argue that the fully diluted share count for Sirius XM is close to 7 billion shares and needs to be reduced for the shares to have meaningful price appreciation. Perhaps, but the issue is that it will be very difficult to reduce shares by a significant amount based on the company's cash balance and future Free Cash Flow [FCF].
During a recent analyst meeting, Sirius XM CFO David Frear discussed the share buyback and stated that the $2 billion buyback could bring the share count down by 600 million shares. That assumes an average purchase price of $3.33/share. That price seems a bit low if one considers that a 600 million share repurchase should put considerable buying pressure on the shares. Then again, if the owners of the 7% Exchangeable Senior Subordinated Notes (or Notes) due 2014 choose to take advantage of the one-time bonus triggered by a change of control, a significant number of new shares could come on the market and/or the short position could drop significantly. Those actions could help keep the price of Sirius XM shares down to that $3.33 level while the share repurchase is underway.
The $2 Billion Buyback
When the share repurchase program begins, how would this impact the share price? If all other factors are held constant, the number of diluted shares outstanding would decline by 600 million and the Earnings Per Share [EPS] and FCF per share would rise. And, if the market sees fit to continue to value the company with the same multiples, the share price would also rise. However, we know that all other things will not be held constant. Debt and interest expenses will increase while the cash balances at the company will not increase.
At the end of the Q3, Sirius XM had $556.3 million in cash and the company subsequently paid out a $325 million dividend in Q4. When announcing the buyback, the company stated:
The company will fund the repurchases through cash on hand, future cash flow from operations and borrowings under its revolving credit facility.
With relatively little extra cash on hand after the dividend payment, if the buyback is to be completed in 2013, all of the revolving credit facility of $1.25 billion and utilizing all the 2013 FCF guidance "approaching $900 million" would be needed to fund the $2 billion buyback and the forthcoming satellite launch. Even at a favorable interest rate of only 4.25%, the increased debt will cost the company $53 million per year in interest.
Valuing the Shares
Without the buyback, FCF should be $950 million, and FCF per share should be $0.138/share. With the buyback, taking $900 million in FCF and a reduced share count of 6.3 billion shares, the FCF per share would rise to $0.143/share. A differential of one half cent, even if one uses a multiple of 25x, would only make a difference in the share price of thirteen cents. And, at 25x, that would put the share price at $3.58. 30x brings the share price to $4.29.
What about 2014? Well, FCF should rise as the company continues to grow. How much will FCF grow? 20%? That would give the company $1.1 billion in FCF. Assume that it is all used in a share re-purchase program. How many shares could Sirius XM buy? At $4/share, the company could only buy back an additional 275 million shares.
There should be more money available for a buyback in 2014. The Notes will have matured at that point, and $550 million of 7% debt would roll off the books as the debt is exchanged for shares. This would eliminate $38.5 million of interest. If we assume Sirius XM can borrow at 5.25% at that time, it can take on $750 million of new debt for $39.3 million in interest expense - roughly the same amount of interest paid for the $550 million. (The total debt at that point would be $3.9 billion.) The new debt would allow Sirius XM to purchase 175 million additional shares at $4 per share, or a total of less than 500 million shares in 2014.
This brings a total buyback to less than 1.1 billion shares over the next two years. The diluted shares would be reduced to 5.8 billion shares, and the 2014 FCF per share would be at $0.19. At 20x, 25x or 30x FCF per share, shares would be priced at $3.80, $4.75, or $5.70.
Liberty's CEO Greg Maffei has discussed three objectives with respect to the Sirius XM shares his company holds. The first is to get back the cash that Liberty has spent over the past year to go to majority. This total has climbed to $1.6 billion. The second objective is not to spin high cost basis shares. Liberty has acquired 705.8 million high cost basis shares. The third is to ultimately spin the stake in Sirius XM to Liberty shareholders.
If Liberty is to sell back its high cost basis shares, and remain at majority ownership of Sirius XM, Sirius XM needs to buy back the 705.8 million shares from Liberty, an equal number from non-Liberty shareholders, and the 300 million newly issued shares from the 7% Notes. Sirius XM buying back 1.1 billion shares through the end of 2014 would still leave Sirius XM share repurchases 600 million shares short of enabling Liberty to reach its objectives.
Liberty wants to start cashing in on its Sirius XM investment. It even agreed to participate in a Sirius XM share buyback while waiting for the FCC to rule on its application to go to de jure control of Sirius XM. Now that it is in full control, it may choose to accelerate the buyback, and the only way to accomplish that is for Sirius XM to take on more debt.
Both Liberty's Chairman John Malone and Maffei have stated that Sirius XM is underleveraged and that they believe the company can carry significantly more debt. Last August, before Sirius XM reduced its debt by calling its 13% and 9% bonds, Maffei said the following:
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.
Investors may get an indication of Liberty's future intentions when both Sirius XM and Liberty release earnings and hold conference calls next month. It seems clear that Liberty's new owners have no qualms about significantly increasing the debt at Sirius XM. And, how high the companies are willing to take that leverage is something that all investors should closely follow.
Sirius XM share prices have enjoyed high multiples on FCF. It remains to be seen if the market will continue to reward investors with high multiples while the company increases its debt load and decreases its share count.
Disclosure: I am long SIRI.