We're all guilty of it. While it is the responsibility of authors to extensively research the material and opinions they publish, sometimes we miss a critical issue or fail to research appropriately and in the process mislead readers. Intentional? Not usually.
Stephen Faulkner, July 26, 2013
So began the recent article by Seeking Alpha contributor Stephen Faulkner. Is it ironic (I'm never quite sure of the correct usage of the term) that Faulkner's article was not fully researched and also could mislead readers? The article was titled Sirius XM: Do Not Be Misled By Claims The Buyback Is Not Working. Although the article probably assuaged the fears expressed by some Sirius XM (SIRI) investors, there were numerous inaccuracies about the causes for the changes in diluted sharecount.
This is not the first time readers of Seeking Alpha have raised the issue of changes in the diluted sharecount. I wrote an article about the topic two years ago when similar fears were raised. At that time, another website had published a piece about how Sirius XM was withholding material information about an increase in the number of shares outstanding. Sirius Share Dilution: Uncovering The Nefarious Plot was written in response to conspiracy fears about dilution:
Another, more interesting conspiracy theory popped up earlier this month after the Sirius XM earnings were released. There were comments posted that espoused the view that Sirius management was deliberately concealing information regarding the issuance of more shares. This was apparently triggered by a quick look at the 10Q that showed the average fully diluted share count had jumped from 6,481,384,000 to 6,804,297,000, an increase of approximately 323 million shares from the prior report.
I took the time to dig deeper into the calculation of diluted sharecount and found that fully diluted sharecount is a complex formula that is dependent on earnings, share price, convertible bonds, options (employee and director options, not the options traded on the exchanges) and warrants. The diluted sharecount is different than the weighted average basic shares outstanding only if there are positive earnings. The rules state that if there are losses, the inclusion of any of these additional shares would reduce the loss per share and would be considered anti-dilutive.
So, what are my issues with both the article Faulkner criticized and Faulkner's response? First, the Motley Fool article by Rick Munarriz stated:
Sirius XM revealed this morning that it has spent $1.3 billion this year to buy back 391 million shares. The only negative point there is that the number of fully diluted shares outstanding over the past year has only shrunk from 6.51 billion to 6.48 billion in that time.
There are four numbers for the weighted average diluted shares outstanding in the most recent 10Q. They are:
YTD Q2 2013
YTD Q2 2012
Let's assume that the 6.48 billion is a typo. There is still a problem. The $1.3 billion and 391 million shares are repurchases through July 24th. We know this because during the July 25th conference call CFO David Frear said:
Through yesterday we have repurchased $1.28 billion of our stock, representing 391 million shares.
The numbers through the end of the second quarter can be found in the 10Q which showed 352.6 million shares had been purchased for $1.14 billion. And if Munarriz can't keep his dates and numbers straight, I suppose Faulkner shouldn't get too much blame when he introduces another set of dates. Faulkner wrote:
To properly understand the buyback let's take a look at the quarterlies and annual from November of 2012 up until the most recently released July 26th report. ...
...If you notice, since the buyback program was put in place earlier this year the outstanding diluted share count has decreased from 6.873 billion to 6.447 billion. The buyback program most certainly is reducing the share count.
Note that Faulkner points out a decrease in the diluted sharecount from 6.873 billion to 6.447 billion, a decline of 426 million. However, something else should be obvious. If "only" 352.6 million shares were repurchased since the start of the buyback program, how was the diluted sharecount reduced by 426 million? Faulkner continues:
What Munarriz is being misled by here is the fact that between the Q3 and annual report for 2012 the outstanding diluted share count increased from 6.577 billion to 6.873 billion. This is an increase in shares outstanding by 296 million shares.
However, Munarriz never referenced the Q3 or year end reports. Faulkner then goes on to discuss the 7% Exchangeable Notes as the "culprit."
So where did they [the 296 million shares] come from? Did Sirius XM issue 296 million shares in the last quarter of 2012?
No. And a little basic math points to the culprit here. Investors will remember that a significant number of shares have been tied up in Sirius XM's $1.875 convertible debt, or alternatively what has been called the $550 million senior secured notes. $1.875 multiplied by 296 million gives you $555 million. Throw in a few shares for options added to those notes and we have the culprit right here staring us in the face. These shares have simply been recognized in the diluted count as of the 2012 annual report.
First of all, the Notes were originally convertible into 293.3 million shares, not 296 million. Second, weren't those "296" million shares also included in the November report? It seems the answer is both yes and no. From the Q3 2012 10Q:
Common stock equivalents of approximately 451,577,000 and 417,427,000 for the three months ended September 30, 2012 and 2011, respectively, and 144,014,000 and 407,649,000 for the nine months ended September 30, 2012 and 2011, respectively, were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive.
So, it appears that the shares underlying the Notes were excluded from the figures for the third quarter of 2012, but were not excluded in the third quarter YTD numbers for 2012. Further, if one looks at the current 10Q, the following statement discusses the instruments excluded from the sharecount for both Q2 reports that Munarriz references:
Common stock equivalents of approximately 355,918,000 and 427,160,000 for the three months ended June 30, 2013 and 2012, respectively, and 352,795,000 and 428,045,000 for the six months ended June 30, 2013 and 2012, respectively, were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive.
These numbers show a change of approximately 70 million shares, so, clearly there was not a "296" million share change that could be attributed to the Notes, unless Faulkner is claiming that new common stock equivalents are taking their place. There are a few points that we do know about the 7% Notes.
- When the dividend was issued, the conversion factor for the Notes went from 533.3333 shares per Note to 543.1732, potentially adding 5.4 million shares to the diluted share count.
- The change of control provision in Notes led to $47,630,000 of the Notes being redeemed. The redemption resulted in 27,687,850 shares being issued. (The 543.3333 shares/Note plus the change of control bonus provision of an additional 38.138 shares/Note.) Those 27,687,850 shares became part of the "basic" shares issued and outstanding.
- Currently, the remaining $502.37 million of Notes can potentially add 272.9 million shares to the diluted share count.
- The Notes can move in and out of the diluted share count based on the price of the stock and the earnings of the company.
- Unless there is another change of control or dividend between now and December of 2014, and presuming the share price is above $1.84 at that time, and assuming that Sirius XM does not repurchase the Notes in the open market or through a tender offer, the remaining Notes will eventually add 272.9 million shares to the basic sharecount.
All of this suggests that other "culprits" might also be at work. Employee stock options are another factor in calculation of the diluted share count and also a bit complicated. These options are considered dilutive when they are in-the-money, meaning when the market price of the stock is above the exercise price of the option. However, there are additional steps involved. The calculation for the diluted share count assumes that the in-the money options are exercised and that the proceeds the company receives from the exercising of the option are then used to buy shares in the market at the end of the quarter.
Obviously, Sirius was not using the proceeds to buy shares in the market in 2012 (we know this from the 10K) when former CEO Mel Karmazin, Frear and others were cashing in more than 100 million options. This results in differences between the treasury method fully diluted sharecount reported from one period to the next.
So, are the bonds and the options the "culprits"? Yes, at least in part. But even more importantly, there is a third culprit. What both authors have failed to consider is that both the basic shares and the fully diluted shares used to calculate the EPS are weighted averages. This means that the Note and option transactions impact the calculations depending on the dates of the transactions and the share prices.
And, most importantly, from this author's perspective, it means that we don't currently see the full impact of the share repurchases in either the basic or diluted share counts used to calculate EPS. Think of it this way. We know that the share repurchase program did not begin before February 5, 2013. On that date, in response to a question on the program, David Frear stated, during the conference call:
Two things. 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 nonpublic information into the marketplace, which I think we effectively do with this call and getting the K filed.
There were at least five weeks at the beginning of the year with zero shares repurchased. This impacts the weighted averages for the 2013 quarterly and year to date sharecounts - both basic and diluted. Since we don't know the daily purchases of the shares, we have no way of knowing precisely how the diluted sharecount was calculated. We do, however, know that the full beneficial effect of the share repurchase is not yet recognized in the income statement.
Faulkner states, "...it is the responsibility of authors to extensively research the material and opinions they publish,..." At times, it can be a daunting task. This is certainly true when it comes to the calculation of diluted sharecount, especially when those outside the company do not have access to all the facts and data.
Munarriz misled investors when he failed to recognize some of the intricacies in the diluted share calculation, failed to match dates with data points and should have known that Sirius XM did not issue more than 300 million common stock equivalents between during the 12 month period ending June 30, 2013. Faulkner failed to extensively research his rebuttal, failed to fully investigate the implications of the 7% Note, and misled investors when he told us it only required a "little basic math". Remarkably, both overlooked the impact of using weighted averages, especially as it pertains to the ongoing share buyback and those shares being removed from both the basic and diluted sharecounts.
I'm certain that this article fails to fully address all of the aspects of calculating the fully diluted sharecount. It does not fully address the impact of dilution. It does not address the effectiveness of the share buyback.
Investors in Sirius XM should be aware of the following:
- Diluted sharecount can change based on earnings.
- Diluted sharecount can change based on the price of the stock.
- The extensive use of options as a form of compensation dilutes shareholder equity, and unless the company actually uses the proceeds from the exercise of those options to purchase shares, the dilutive effect can be understated in the P&L.
- The dilutive effect of the 7% Note can be a moving target.
- There are limitations when using weighted average basic or fully diluted shares as points of reference.
In one sense, Munarriz, Faulkner and I are professional writers - we get paid for writing. I can't speak for the others, but I am not a trained reporter. Unlike trained reporters, I certainly bring my own set of biases into the articles I write and I will emphasize those points that support my position.
I like to think that I extensively research the materials and opinions I publish. In the event that I fail, I know there are plenty of readers that will be quick to point out each and every one of my shortcomings.
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.