At the recent Bank of America Merrill Lynch Global Telecom and Media Conference held in London, Sirius XM (SIRI) CFO, David Frear, was questioned on a wide range of topics. It was no surprise that much of the focus was on the used vehicle market. It is an area that Sirius XM management has been discussing quite a bit in recent presentations and conference calls. Not only has the number of dealers participating in the program risen dramatically over the past two years, but the pool of potential subscribers - buyers of used vehicles with OEM-installed satellite radios - has also been growing rapidly and the growth of that pool is expected to continue.
What may have been of more interest to investors was the discussion of a holding company, or "HoldCo", its purpose and its implications. For those unfamiliar with this topic, it was initially mentioned on the first quarter conference call when Frear stated:
At the end of the first quarter, gross debt to EBITDA was at a very conservative 2.5 times, debt market conditions are very favorable, and you should expect to see us periodically and opportunistically raise new debt financing to extend maturities, ease covenant restrictions, and maintain our leverage ratio. The combination of our strong free cash flow and 3.5 times leverage target will provide ample liquidity to maintain a very robust return of capital program and continue to strategically invest in the business. Additionally in the next several weeks we will also form a new holding company to enhance our financial flexibility.
During the Q&A session, the following exchange took place:
Matthew Niknam of Goldman Sachs: Are there any updates you can provide in terms of how quickly you're seeking to get there, to the target? And in conjunction with that, does a formation of a holdco imply you might be open to accelerating the buyback pacing, potentially, this year?
Frear: The formation of the holdco is one of those things that simply gives us optionality. I don't think you should read anything into timing on it. There's a lot of administration associated with getting it set up, so just one of those options that you want to set up as soon as you can. On getting to the leverage target, I think as many know that we are somewhat restricted or will be somewhat restricted later in the year with - by two of our debt issues in making restricted payments that we will probably work our way to that 3.5 times sort of over the next several months perhaps into sometime early next year.
At the Bank of America presentation earlier this week, Frear stated:
We've got the process started for creating a HoldCo, so it's more administration to getting it in place. We'll have one eventually. I can't tell you exactly when it'll be. Hopefully it will be weeks as opposed to several months.
The process, which was several weeks away at the end of April, is still "hopefully weeks, as opposed to several months, away." While it may be taking longer than originally expected, the timing apparently won't become much of an issue until "the very late part of this year", but without a HoldCo, it could be more constraining on the operating company in 2014. It's important that investors understand more about that "optionality" that Frear mentioned and how a holding company would allow Sirius XM greater flexibility.
As Frear stated on the Q1 conference call, the company is "somewhat restricted" by two of its debt covenants when it comes to increasing the Sirius XM leverage ratio towards 3.5x. Since those comments, the company added $500 million of Senior Notes due 2020 and $500 million of Senior Notes due 2023, or a total of $1 billion. This brought the total company debt to about $3.4 billion, and the leverage ratio to the 2013 Adjusted EBITDA guidance of $1.1 billion would be 3.1x. And while the company has used a 3.5X leverage ratio based on gross debt to Adjusted EBITDA, the bond covenants are different.
The new debt is investment grade without restrictive covenants, but the older 7 5/8% debt due 2018 - callable at what Frear termed "a pretty attractive price" in November of 2014 - and the 8 3/4% debt due April 2015, both have restrictions. That restriction is what Frear termed:
a regular RP builder. It's consolidated operating cash flow minus a muiltiple of interest expense.
Here's what else Frear had to say about the formation of a holding company and its potential uses.
We don't have any current plans for HoldCo. What can it be used for? It could be used for equity returns that are outside the covenants from the debt structure. It also could be used for acquisitions that aren't accretive to the leverage ratios. So, for instance, if you acquire something for more than 3.5x EBITDA, then that would actually place some kind of a constraint on RP.
Besides the added flexibility with potential acquisitions, there is the issue of additional debt. One way to avoid those restrictions would be to redeem and refinance the current debt issues. Another would be to place new debt in HoldCo.
For several years, Sirius XM has discussed what it would do with its growing free cash flow and what it believed would be an optimal debt leverage ratio. These choices included paying down debt, returning capital to shareholders and accretive acquisitions. During 2012, much of the older, high interest debt was redeemed and late in the year the company announced a one-time dividend and a share repurchase program. Sirius XM is now in the midst of that $2 billion share buyback program.
Sirius XM will once again be facing choices about what to do with its free cash flow. While another dividend does not appear likely, and management has often stated that it has found no attractive acquisitions, it is widely accepted that once the current buyback program ends, a new one will begin. And, it is expected that the company would like to borrow to fund that new buyback program.
Setting up a holding company will allow the company maximum flexibility to borrow and increase its debt.
Additional disclosure: In addition to my long positions, I have January 2014 $3.50 covered calls written against most of my long positions in Sirius XM and June $3.50 covered calls on a short term trade. I also trade blocks of Sirius XM on a regular basis.