I'm cheap. I won't pay for radio. At least not the almost $200 per year that Sirius XM Radio (NASDAQ:SIRI) wants from me for the opportunity to listen to the same programs I listen to on terrestrial radio. And, since I'm cheap, I also hate overpaying for stock.
How does one know when they are overpaying for stock? The snide response is: If the price declines after your purchase. While it may be the best measure, it is not particularly useful unless one has a time machine or an accurate crystal ball. Instead, one uses either technical analysis or fundamental analysis, or a combination of both, to determine where the stock price is going in the future. I rely almost entirely on fundamental analysis.
In an article written in January of 2012 titled Is Sirius XM Really Worth $3 A Share?, a valuation model using the projected free cash flow ("FCF") was presented. Using the company's 2012 guidance of $700 million of FCF, it showed why a $3 valuation at that time appeared high.
In order to get to a $3 valuation, one needs to assume a very low return or a very high FCF number. $2 billion in FCF and an expected return of 10% will get you there. So would $1.4 billion and an expected return of about 6.5%. Most investors are looking for much more than a 6.5% return, and Sirius isn't yet close to generating $1.4 billion in FCF, let alone $2 billion.
If it wasn't going to be worth $3/share, it made sense to sell $3 January 2013 calls and risk losing the shares. It also made sense to me to write in the money calls at a strike price of $2 per share that would almost "guarantee" a 17%-19% return. These were actions that I wrote about in detail almost exactly one year ago. The article titled A Sirius XM Bull's Trading Strategy demonstrated that one could be moderately bullish on the stock, while at the same time be willing to put a cap on their gains with the use of covered calls.
At the time, I had written some $2 in the money covered calls and some $2.50 out of the money covered calls, but the bulk of my position was still uncovered. From that article:
My largest position in Sirius consists of 30,000 shares that are uncovered at the current time. I have sold calls against these shares many times and will continue to do so. I expect to sell $3 January 2013 covered calls against this position at some point in March. The logic behind this trade is that I do not think the share price will reach $3 plus any premium I pocket on the sale before the options expire. Even if Liberty makes a move to take a majority position in Sirius, I do not expect them to overpay for the acquisition or the shares to move above the $3 strike price. And, even if I am wrong, I will be satisfied with the yield on that investment.
In mid-March of 2012 I disclosed that I had sold January 2013 $3 Sirius XM calls against most of my position for $0.14 per share. When the shares were trading at $3.16 at the options expiration in January, the shares were assigned and I "lost out" on $0.02 per share. Still not convinced that the shares deserved a current valuation above $3, I had been sitting on the sidelines until early this week. (I should point out that these investments are in IRA accounts and are not subject to current taxes.)
The Covered Call Strategy
I remain committed to a covered call strategy with Sirius XM, willing to limit my potential gains for reduced risk. On December 12, 2012, prior to the shares being called, the shares were trading at $2.73. Another article laid out how an investor could open a new long position and use covered calls to get a 25% gain with extremely low risk.
$3 January 2014 call options are currently trading at $0.34 Bid and $0.38 Asked. So, buying the stock for $2.73 and selling the call at $0.34 results in a net cash outlay of $2.39. Opening this transaction also entitles the investor to collect the $0.05 special dividend. If the analysts are correct and the stock price is over $3 on January 18, 2014, your calls will be assigned and you will sell the shares for $3. Since your adjusted cost basis is $2.39, your gain is:
$3 / $2.39 = 25.5%.
Add on the $0.05 dividend and the return is 27.6%. The annualized yield is a few percentage points less because there are commissions and the time period is 402 days rather than 365. Still, it's a substantial gain. The downside is that if the shares are substantially above $3, the investor sacrifices that potential gain. How much higher? Since the gain is capped at $3, the maximum gain is $0.61 - the difference between the net cost of $2.39 and the sale price of $3. To get a $0.61 gain on a straight purchase, the shares need to rise to $3.34 ($2.73 + $0.61 = $3.34). But, that's only the cash gain. Because the initial cash outlay is higher on a straight stock purchase, the percentage return is less. To get the same 25.5% return (both trades get the $0.05 dividend), the price must rise from $2.73 to $3.42. The actual breakeven could be more or less depending on the actual price realized for the call and your actual commissions, but it is within a couple of pennies either way.
That position can be closed for about $2.67 today, giving the investor a gain of about 12% (excluding the dividend). Not bad for two and a half months, although it's less than the 15% gain of taking a straight long position. On the other hand, the covered call investor can also sit on the sidelines and just wait for the call to be assigned next January, fairly confident that the shares will still be above $3. (Opening a new position today - buying the stock today with the price at $3.15 and selling the $3 2014 January call for about $0.47 - represents a very conservative investment with a gain of about 12%.)
Why bring this up now? Because I was looking for the opportunity to get back into Sirius XM with the opportunity for a low risk 25% gain.
In the after-hours session on Monday the shares dropped back to $3 and fell below $3 early Tuesday. I took that opportunity to re-purchase the 30,000 share position, although I feel that the average cost of $3.01 was a bit high. On Thursday, when the shares jumped to $3.17 late in the session, a $0.26 limit order to sell 300 $3.50 Jan 2014 calls against that position was executed.
If Goldman Sachs with a $3.50 price target and Bank of America-Merrill Lynch with a $4.00 price target turn out to be correct, the shares should be gone by January 18, 2014. The net cost, including the commission expense of the transactions, comes to just under $2.76 per share. If this position gets assigned, the gain is just under 27% and annualizes to a yield of more than 30%.
Note that a straight long position opened at $3.01 (the average share cost) needs the stock price to $3.82 to show a 27% gain, and to exceed $3.91 by January 2014 to generate the same yield. Both of these prices are significantly above what I expect my assessment of fair value will be next January.
Most analysts are projecting a good year for Sirius XM in 2013, with 15 of the 16 analysts at Yahoo Finance rating the stock as hold (4) or better (11). They have target prices that range from a low of $2.45 to a high of $4.20 with an average around $3.50. That $3.50 average price target is slightly above the upper bound of my fair value estimate based on my 2014 anticipated FCF/share.
Some may find this type of investing far too conservative and the idea of losing potential upside as un-American. Others will find it prudent or frugal. I noted at the beginning that I'm cheap. I'm also quite comfortable with a position that provides me 8% downside protection while limiting the gain to 30%.
Additional disclosure: I have $3.50 January 2014 covered calls against most of my SIRI position. I may initiate (or close) a buy stock/sell option position in SIRI at any time or day trade blocks of shares at any time to take advantage of the price volatility.