The company will receive gross proceeds of $600 million from the sale of the notes before deducting the initial purchasers' commissions and estimated offering fees and expenses.
SiriusXM intends to use the net proceeds of the offering, together with cash on hand, to redeem its outstanding 8.75% Senior Notes due 2015.
This would appear to be very good news for Sirius XM investors. Use cash on hand and proceeds from a new offering to pay off older debt carrying an interest rate 3 percentage points higher than the new debt, while at the same time extending the maturity by six and a half years. The 8.75% debt originally carried annual interest payments of $70 million. (As of July 24th, $753.487 remained outstanding, and future annual interest payments would be $65.930 million.) The new debt will have annual interest payments of $34.5 million, less than half cost of the debt it's replacing. It sounds even better than very good news for investors.
Unfortunately, the 8.75% debt has some large redemption costs, both in terms of income statement impact and in the near term use of cash. According to the indenture these notes can be redeemed
...at a redemption price (" Make Whole Redemption Price ") equal to the greater of the following amounts:
(1) 100% of the principal amount of the Notes then outstanding to be so redeemed; and
(2) the present value on the redemption date of 100% of the principal amount of the Notes to be so redeemed on April 1, 2015, plus the present value of the remaining scheduled payments of interest through April 1, 2015 that would have been due after the redemption date on the Notes to be redeemed, discounted to the applicable redemption date in accordance with customary market practice on a semi-annual basis at a rate equal to the sum of the Treasury Rate plus 0.50%;
plus, in each of the above cases (B)(1) and (2), accrued and unpaid interest, if any, on the principal amount being redeemed to the applicable redemption date.
Quite a mouthful, isn't it? And what does it mean? With today's very low interest rates on short term Treasuries, it means that the redemption will be significantly higher than 100% of the principal amount. More specifically, as I understand the language, it means taking each of the semi-annual interest payments and the principal amount and then applying present value discount factors against each of these payments. Those present value discount factors would be based on treasury rates with maturity dates corresponding to the interest payment and Note maturity dates.
The formula for calculating the discount factor is:
1 / ( (1 + ( ( i + 0.0050 ) / 2) n ) )
where i = annual yield percentage expressed as a decimal, and n equals the number of six month, or semi-annual, periods between the redemption date and the interest payment and Note maturity dates. (The "0.0050" factor is the 0.5% adder, and the "2" is used to get the semi-annual equivalent rate.)
For the principal, which comes due on April 1, 2015, there would be 3 semi-annual periods, assuming the official notice of redemption takes place in time for an official redemption date of October 1, 2013.
The current yield on a treasury maturing around April 1, 2015 is approximately one quarter of 1%, or 0.25%, according to the Wall Street Journal. However, since that is currently 20 months away rather than the 18 months that would be the interval on October 1st, a figure closer to 0.21% might be more appropriate. Following the calculations in the indenture, and adding the 0.50% factor, the formula becomes:
1 / ( 1 + ( ( 0.0071 / 2 ) )3 ) = 1/( (1.00355 ) 3 ) = .9894
Since this is the furthest out payment, it would be the most heavily discounted. The nearer term payments would have lower yields based on six-month and one-year treasuries, as well as fewer compounding periods, and the discount factors would be even closer to 1.0000.
For the $753.487 million principal and the $32.965 million interest payments due on April 1, 2015, the payment would be .9894 x $786.452 million or $778.116 million. The two $32.965 million interest payments due April and October of 2014 would add an additional $62.553 million to the redemption payment. This brings the total redemption cash payments to $840.669 million.
Sirius XM is required to give the holders of the Notes between 30 and 60 days notice of the redemption date. If, as used in this example, the redemption takes place on October 1st, it becomes a fourth quarter event. It also means that Sirius XM will be accruing interest expense on both the new 5.75% and the existing 8.75% notes. If the redemption takes place in the third quarter, there will be less overlap in interest expense.
The important point to understand is that there will be a one-time charge in one of these quarters recorded under the line item "Loss on extinguishment of debt and credit facilities, net" of approximately $87 million dollars ($840.669 million redemption cost less the $753.487 million remaining face amount of the bond), as well as a charge for the write-down of the remaining $5.4 million discount (as of June 30th) on those 8.75% bonds. And, we also know that there will be millions of dollars of additional fees and expenses for the redemption of the current debt as well as the issuance of the new debt. The fees associated with the redemption are likely to be written off in the quarter they are incurred. The fees associated with the new bond will show up as a discount and be charged to expense over the life of the bond.
It is also important to recognize that there will be savings in interest expense as the $5.833 million per month expense of the 8.75% note is replaced by the $2.875 million per month interest expense on the 5.75% note.
If there are minimal cash savings from retiring these bonds early, are there other motivations? Considering that the new $600 million dollar debt extends the maturity by six and a half years, there is a modest benefit. The 2021 maturity date also fits neatly between the $500 million of 4.25% notes due 2020 and the $400 million of 5.25% notes due 2022, and occurs in a year when no other notes are maturing. However, there may be another reason.
The 8.75% notes have a number of covenants. These covenants cover nearly 20 pages of the indenture and discuss all types of restrictions, limitations and exceptions. One of these is an operating leverage limitation of 6.0x.
The New Rate
The rate of 5.75%, while attractive relative to the coupon rate and the maturity of the 8.75% debt that it is replacing, is higher than all three of Sirius XM's recent offerings. It is 50 basis points higher than the $400 million of 10-year debt issued last August, despite having a shorter maturity - 8 years vs. 10 years. And, it is higher than the two $500 million issues borrowed in May of this year, which had coupons of 4.25% for a 7-year maturity and 4.625% for a 10-year maturity.
Federal Reserve Impact
Long-term rates rose markedly last month after Federal Reserve Chairman Ben Bernanke spoke about potentially tapering bond purchases towards the end of the year. The market wasn't about to wait until - or even if - the Fed actually began tapering, and immediately sold off stocks and bonds, driving bond yields higher. And, remember, Bernanke's comment wasn't about tightening monetary supply, but only about reducing the level of quantitative easing.
If the Fed actually does stop bond purchases, interest rates can be expected to move higher. These Fed actions would take place because the economy would be improving to the point where targeted unemployment is reached. And, with the economy improving, overall demand for debt should increase and there will be even more upward pressure on rates. At some point, the Fed will drive interest rates even higher as it brings its balance sheet down to a more normal level.
Sirius XM had spent $1.28 billion through July 24th on its $2 billion share buyback program. If it continues purchases at the current rate of more than $50 million per week, it will use up the remaining $0.7 billion around the start of the fourth quarter. By that time, based on statements by Sirius XM CEO Jim Meyer and CFO David Frear on the recent conference call, there is an expectation that the board will authorize funds for additional share repurchases.
While free cash flow from Sirius XM is substantial, it is not nearly large enough to provide funds for meaningful share repurchases without adding a significant amount of new debt. And, as the recent bond offering indicates, the cost of that debt is rising.
At some point in the second half of 2013, Sirius XM will incur a charge for the early termination of debt of more than $100 million. Perhaps equally important, the bond redemption and new issue will use approximately $300 million of current cash.
However, the most important point from this investor's perspective is the sharp jump in the cost of the latest debt from just two months ago. While the company will continue to spend its free cash flow on share buybacks, it is highly likely to also take on additional new debt, and the interest cost on that debt is likely to continue to rise.
It should be clear that Sirius XM cannot continue purchasing stock at the rate of the past six months, even with significant new debt. It should also be clear that the cost of such new debt will continue to rise. While Sirius XM has the capacity to service the interest expense on a substantial amount of new debt, that expense will impact both earnings and free cash flow.
What is far less clear is how much impact the combination of rising debt levels, higher interest expense and a slowdown in buying by Sirius XM will have on the price of the stock.
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.