Ever since Sirius XM Radio (SIRI) announced its $2 billion share buyback, many investors have expected the share price to dramatically increase. And, many have been disappointed. Were such expectations justified and what should shareholders reasonably expect?
The day before the announcement, the shares were trading at $2.76 and hardly moved, even though the company also announced a special dividend of $0.05. One week later, the shares were still trading below $2.80. The price slowly drifted down to an intra-day low of $2.68 on December 14th, when the shares suddenly turned around and closed at $2.91, up 7% on the day. That move had nothing to do with the share buyback and was clearly tied to a Copyright Royalty Board decision. That decision was to increase the music royalties to be paid by Sirius XM, but the increases were lower than the market and many analysts had expected.
The shares eventually closed 2012 at $2.89. Until the $2.99 closing price on Thursday, April 18th, Sirius XM had closed above the $3 level each day in 2013. The stock would close above $3.20 on eight occasions, was able to reach a $3.25 intra-day high a few times, and its highest closing price was $3.24.
As of February 4th the buyback had not begun. We know this because of statements made by Sirius XM CFO David Frear on the year end conference call:
When we announced the program in December, we were pretty close to earnings. And so the advice we had was to stay out of the market until we had gotten kind of the material non-public information into the marketplace, which I think we effectively do with this call and getting the K filed.
Now investors are still wondering whether the share buyback has started, and if it has, why hasn't there been more of an impact on the price? Perhaps expectations are far too high.
A share buyback is supposed to be a way to return capital to shareholders in a tax-efficient manner. By purchasing outstanding shares, the earnings and free cash flow (or FCF) are spread over fewer shares and the earnings per share should increase. It is considered more tax-efficient than paying dividends because the recipient will have to pay taxes on the dividend distribution. If the share price rises as a result of a buyback, the shareholder has unrealized capital appreciation, and no taxes are due until the shareholder sells. At that time, it is also possible that the preferential treatment of long-term capital gains provides a benefit.
Before continuing, I should point out that I am generally not in favor of share buybacks. Not only does a buyback indicate that the company has no better uses for the cash internally, but the expected reduction in shares outstanding often fails to materialize as new shares are issued to company employees or are used as currency for acquisitions. I would rather receive a dividend and look for my own alternative investments.
There is one other key point to consider. At year end 2012, Sirius XM had $0.5 billion in cash on the balance sheet. So, if the buyback is to be done quickly, much of the $2 billion for the buyback will be coming from the company's $1.25 billion revolver. Drawing down that revolver will increase interest expenses and reduce earnings and free cash flow.
Now, consider what happens. Assume the company buys back $2 billion of Sirius XM at an average price of $3. The reduction in the diluted share count would be $2 billion / $3 = 666.7 million shares. If the average price was $3.25, the reduction would be 615.4 million shares.
We also know that Sirius XM had 5,262,440,085 common shares outstanding as of December 31, 2012. In addition, Liberty Media (LMCA) converted its remaining preferred shares into 1,293,509,076 common shares in January 2013, bringing the total to nearly 6.6 billion shares. Once the shares underlying the 7% Exchangeable Notes and the exercise of options are considered, the diluted share count is approximately 6.9 billion shares.
Using the company's 2013 expected free cash flow of $900 million and 6.9 billion diluted shares, we can see that the FCF per share is expected to be $0.13 per share. If 666.7 million shares are repurchased, the number of diluted shares declines to 6,233 million. However, there will be an interest expense associated with drawing down a $1.25 billion dollar revolver. At a 4% interest cost, that would reduce annual FCF by $50 million. So, after a buyback, we get [ ($900 million - $50 million) / 6,233 million shares ] = $0.136 FCF/share. That's an improvement of only 4.6% and really not that much of an increase.
When Frear discussed the impact of a buyback at the Citi Global Internet, Media and Telecommunications Conference he talked about a 40% growth in FCF/share from 2012 to 2013. What he did was to show that using the 2012 FCF of $700 million and 6.8 billion diluted shares (FCF per share of $.103) and comparing that to 2013 FCF of $900 million and a reduced share count of 6.2 billion (FCF per share of $0.145) would result in FCF per share growth of 40%.
What is ignored in the example used by Frear is that total FCF is growing by 28.6% from 2012 to 2013, and it fails to recognize the increase in interest expense. Whether the interest expense for the revolver is included in the $900 million guidance, or whether the FCF guidance would have been $950 million without the buyback is certainly open to debate. What is not debatable is that the impact of the buyback is not what is largely responsible for the 40% growth in FCF per share.
A share buyback probably improves the FCF per share and could provide some small incremental increase to the share price. However, many analysts and investors were already expecting the 2013 Sirius XM FCF guidance to increase above the $700 million realized in 2012, and may even have had numbers that were somewhat higher than the $900 million guidance. That future growth was likely to have already been factored into their share price estimates.
Those expecting a fairly large increase in the share price based solely on a debt financed buyback are likely to be disappointed.
Additional disclosure: In addition to my long positions, I have January 2014 $3.50 covered calls written against many of my long positions in Sirius XM. I also trade blocks of Sirius XM on a regular basis. I have no position in Liberty Media at the current time.