I recently wrote an article on the impact that Liberty Media (LMCA) going to a majority ownership position of Sirius XM Radio (SIRI) would have on Sirius XM's 7% Exchangeable Senior Subordinated Notes (or Notes) due 2014. That article speculated about the exchange ratio and the additional shares that the holders of the Notes would be entitled to, and how it could influence their behavior. Some key dates had not yet been established by Sirius XM, and those dates would determine some of the actual numbers in the article. However, as expected, a Fundamental Change Notice (Notice) was issued within the required 30 day window. That Notice was issued on February 1.
For those not familiar with the Notes, there are 550,000 $1,000 Notes paying 7% interest and scheduled to mature on December 1, 2014. Each Note was originally convertible into 533.3333 shares of Sirius XM stock. At the time, it was the equivalent price of $1.875 per share. These Notes had some provisions that could adjust that conversion ratio under certain circumstances. Two such adjustments took place recently.
The first was due to the dividend payment that took place in December. The Notes had the following clause and formula to adjust the exchange rate:
(4) if any cash dividend or distribution is made by Sirius to all or substantially all holders of Sirius common stock, the exchange rate will be adjusted based on the following formula:
ER' = ER0 x SP0 / (SP0 - C)
ER0 = the exchange rate in effect immediately prior to the ex-date for such distribution
ER' = the exchange rate in effect immediately after the ex-date for such distribution
SP0 = the last reported sale price of Sirius common stock on the trading day immediately preceding the exdate for such distribution;
C = the amount in cash per share Sirius distributes to holders of Sirius common stock
The earlier article calculated that this adjustment increased the initial exchange rate from 533.3333 to 543.1732 shares per $1,000 Note. The Notice confirmed that this was, in fact, the case.
The second adjustment would be caused by a "fundamental change." This clause was triggered last month by Liberty increasing its ownership to more than 50% of the common stock and inserting its own Board of Directors. The earlier article speculated that the second adjustment would be for an additional 37.7366 shares. The Notice places the actual number of additional shares at 38.1380. (The difference is due to the actual date of the Notice and share price.)
Options for the holders of the Notes
The purpose of the Notice is to inform the holders of the Notes of the additional shares available due to a fundamental change, the early redemption option, the timeframe for the holders to make a decision and the procedures for notifying Sirius XM of their decision. The holders of the Notes have three choices:
(1) require the Company to repurchase (the " Purchase Right ") his or her Notes at a purchase price in cash equal to $1,000 per $1,000 principal amount of the Notes (plus accrued and unpaid interest to, but excluding March 1, 2013) (the " Purchase Price "); OR
(2) exchange his or her Notes for the Company's common stock, par value $0.001 per share (the " Common Stock "), at an exchange rate of 581.3112 shares per $1,000 principal amount of Notes; OR
(3) retain his or her Notes pursuant to their terms through maturity on December 1, 2014, or otherwise transfer or exchange them in the ordinary course, ...
The Notice further goes on to state:
As of January 31, 2013, the closing price of the Notes in the over-the-counter market as quoted on Bloomberg was $1,841.23 per $1,000 principal amount.
Clearly, with the Notes trading at $1,841.23, no one will be in a hurry to redeem them for $1,000 plus interest of $18.08, and investors in Sirius XM can ignore the implications of this option. It should also be noted that the shares of Sirius XM closed at 3.14 on January 31st and the 581.3112 shares underlying the notes would have had a market value of $1,825.32. With the share price increase on February 1st to $3.23, the value of those underlying shares increased to $1,877.64, nearly 2% above the January 31st price cited by Sirius XM in the Notice.
This leaves the other two options: owners continue to hold the Notes and collect 7% interest with the right to exchange the Notes for 543.1732 shares up until the maturity date, or exchange the Notes for shares by the Expiration Date in order to receive 581.3112 shares. The Expiration Date is defined in the Notice as 10:00 AM New York time on March 1, 2013.
What Will the Note Holders Do?
This is the key question. It has been speculated that most of the Note holders have shorted Sirius XM against the Notes. When the Notes were initially offered, Sirius XM actually loaned 90% of the shares underlying the Notes to the underwriters so they could open a hedged short position. Those shares have since been returned to Sirius XM, but most views are that a short position still exists, although the extent is not known.
Currently the holders of the Notes can expect to receive up to four remaining interest payments of $35, or a total of $140. If the holders elect to exchange the Notes by the Expiration Date, they will receive an additional 38.1380 shares worth $123.18 at the $3.23/share closing price on Friday. Taking into consideration the time value of money, there's not too much difference between the two choices.
However, if the share price continues to rise during February, the Note holders will become more motivated to redeem the Notes for shares. It should also be pointed out that the Note holders have some incentive to decide sooner rather than later, as the exchange of the Notes for shares results in the loss of interest accruing since the last semi-annual interest payment on December 1st, 2012.
Impact on Investors in the Stock of Sirius XM
Investors should closely watch the share price as March approaches. If the shares continue to increase, or even increase modestly from these levels, the Notes become more likely to be exchanged. And, if they are exchanged, it would be unlikely that the Note holders will want to keep the shares. For the hedged positions, some of the shares would be used to cover their short position and the rest of their shares would be sold.
To the extent that many millions of additional shares enter the market, the stock price could come under some pressure. To the extent that there is a reduction in the short position that is reported every two weeks, some of the enthusiasm for, and expectation of, a short squeeze would evaporate. Both factors could reduce the positive sentiment for the share prices.
To a lesser extent, there will be a minimal impact on earnings per share [EPS]. Not only will there be more common shares outstanding, but the diluted EPS will also decline. The impact on diluted EPS is unlikely to be noticeable (it's only a 31 million share difference on nearly 7 billion diluted shares, so unless the rounding causes a change there would be no reported impact).
On the positive side, if some or all of the $550 million of 7% debt is eliminated, the company will save up to $38.5 million in interest expense in 2013 and $35.3 million in 2014.
Investors are unlikely to have a definitive answer to the issues surrounding the Notes before early March. This assumes Sirius XM finds the event material enough to file an 8K or issue a press release. Otherwise, answers won't be known until the first quarter results are released in early May. Investors should also pay close attention to the short interest figures reported in late February and early March to try and gain some insight into how the Note holders are reacting.
There are now 298.7 million shares underlying the Notes. If the early exchange related to the fundamental change takes place, that number increases to 319.7 million shares. It is a significant number of shares, and the owners of the Notes could make decisions that will impact the price of the stock.
Disclosure: I am long SIRI.
Additional disclosure: I may buy additional shares of Sirius or Liberty at any time and may do so in conjunction with covered calls.