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It has been no secret that Liberty Media (NASDAQ:LMCA) management believes that its Largest holding - Sirius XM Radio (NASDAQ:SIRI) - is under leveraged. Last August Liberty CEO Greg Maffei said: "Our view is that Sirius is under leveraged..." It was part of a larger conversation of the capital structure at Sirius XM and the desire of Liberty to recoup its investment:

No, I don't think that that's the real driver. 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.

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 including this Starz transaction, we'd probably be wanting to get that cash back. So, that would be the biggest consideration in our minds, a major one.

For those expecting that the ultimate goal of Liberty is to avoid taxes and spin its stake in Sirius XM to Liberty shareholders using a Reverse Morris Trust, the announcement this past week by Sirius XM is another step in that direction. On May 2nd, Sirius XM issued a press release stating:

Sirius XM Radio ... today priced offerings of $500 million of Senior Notes due 2020 and $500 million of Senior Notes due 2023. ...

The notes were offered to qualified institutional buyers... The Senior Notes due 2020 will bear interest at an annual rate of 4.25% and the Senior Notes due 2023 will bear interest at an annual rate of 4.625%. The price to investors will be 100% of the principal amount of the notes. The company will receive gross proceeds of $1 billion from the sale of the notes before deducting the initial purchasers' commissions and estimated offering fees and expenses.

The seven and ten year debt issues carry very favorable interest rates, and are even lower than its previous $400 million offering that took place only nine months ago. At that time the debt carried a coupon rate of 5.25%. In between these two offerings, Sirius XM retired nearly $1 billion of debt carrying interest rates of 9.75% and 13%. It also opened a $1.25 billion dollar 5-year revolving credit facility.

The new debt is to be used:

...for general corporate purposes, which may include, from time to time and as market conditions warrant, share repurchases and the repurchase, redemption, defeasance, tender or repayment of its outstanding indebtedness. Specifically, the company intends to repay all outstanding drawings of $150 million under its revolving credit facility with a portion of the proceeds from the offerings. Pending application of these amounts as provided above, the company currently expects to maintain any excess amount as cash on hand.

As of the end of the first quarter it appeared as though the revolver had not been drawn. The $150 million may have been drawn and used towards the purchase of 52 million shares made between the end of the first quarter and April 26th (or additional subsequent purchases made between April 26th and May 2nd).

What's next for Sirius XM? Expect Liberty to have the company continue to leverage up the balance sheet. At the end of the first quarter Sirius XM had long term debt of $2.4 billion. The recent addition of another $1 billion would bring the company's debt to $3.4 billion, and if the revolver is to be fully drawn, another $1.25 billion would be added for a total of $4.65 billion. According to the latest 10Q, there are certain covenants and restrictions regarding the maximum amount of debt and leverage available to Sirius XM:

Covenants and Restrictions

Our debt generally requires compliance with certain covenants that restrict our ability to, among other things, (NYSE:I) incur additional indebtedness unless our consolidated leverage would be no greater than 5.0 times consolidated operating cash flow after the incurrence of the indebtedness, ... ...In addition, under the Credit Facility, we also must comply with a maintenance covenant that we not exceed a total leverage ratio, calculated as total consolidated debt to consolidated operating cash flow, of 5.0 to 1.0.

Note that the company has restrictions that prevent it from increasing its leverage above 5:1, and that if it is to fully draw the revolver, it would be closing in on that ratio. Now consider that Liberty has stated that it does not want to spin its high basis shares, and if it chooses to spin its stake in Sirius XM to Liberty shareholders using a Reverse Morris Trust, those shareholders will need to own a majority of Sirius XM post-spin.

Liberty holds more than 700 million high basis Sirius XM shares. At the recent share price of nearly $3.40, that would require $2.4 billion of share repurchases by Sirius XM. And, if Liberty is to remain at a majority ownership position, Sirius XM would need to purchase an additional 500 million shares from non-Liberty shareholders - another $1.7 billion. Then, there are the nearly 300 million additional shares that will be issued when the Sirius XM 7% Exchangeable Notes mature in late 2014 and millions of additional shares issued from stock options that are likely to be exercised in the future. The 300 million shares to be issued when the Notes mature will also eliminate $0.5 billion of debt, allowing additional borrowing.

The $1 billion of new debt, the $1.25 billion revolver and future free cash flow will allow the company to increase its share repurchase program well above the $2 billion previously announced. However, with $150 million of the new debt used to restore the revolver, the total currently available for share repurchases is $2.15 billion in addition to the company's free cash flow.

Summary

The new debt issue will allow Liberty to advance a small step towards its presumed objective of spinning its stake in Sirius XM using a Reverse Morris Trust. But even if prices don't move above $3.40 for the next two years, the $2.4 billion for Liberty's shares, the $1.7 billion for non-Liberty shares and another $1 billion to buy shares to be issued for the Notes, would require more than $5 billion in share repurchases.

The two new bonds, drawing the revolver, and issuing $0.5 billion additional debt to replace the Notes gives the company access to $2.6 billion of cash. Sirius XM should also generate about $2 billion of excess cash over the next two years, but the total of $4.6 billion would still leave a share repurchase program far short of the level that Liberty needs for a Reverse Morris Trust before the end of 2014. And if, as expected, the share prices continue to rise, the spin could be pushed off to a late 2015 or early 2016 event.

Source: Liberty's Plans For Sirius XM Take Another Step Forward

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.