Over the past few years I have written a number of articles about Sirius XM Holdings (SIRI) where I discussed my use of covered calls on the stock. Some of these positions, including one in a 2011 article titled A Sirius Option For Generating Return were opened with the full expectation that the shares would be assigned. That particular article noted:
If the shares get called as I expect, the return is slightly more than 50% over the next 16 months.
Shortly after the article was published, I noted in a comment that the trade was made:
...this morning I executed the combination trade in this article, buying SIRI and simultaneously selling the $2 January 2013 call for a net cost of $1.30. The stock was purchased for $1.69 and the call was sold for $0.39. My current intention is to just forget about it and wait for the shares to be called away.
The expected return on the net cost would be more than 53% over a 16 month period, or a compounded annual yield on that net cost to assignment of approximately 33%. And, yes, those particular shares were assigned at $2 while the stock was trading at $3.16 in January of 2013. Many would argue that this was a poor trade based solely on the result because the shares increased 87% vs. the 53% of the covered call transaction. However, it was a trade with a much lower risk profile, and an incremental investment in Sirius XM that I would not otherwise have made.
Other covered call trades were made with the expectation that the calls would expire worthless and I would simply pocket the premium. The strike prices of the calls selected for these transactions were chosen at levels above where I perceived the future fair value of the stock. Was the strategy correct? Many of the investors that choose to comment on Seeking Alpha have often disagreed.
The first article I wrote for Seeking Alpha was published on May 27, 2011. It included the disclosure that I had written covered calls against my long position in Sirius XM. That disclosure, rather than the content of the article, resulted in the first comment that has become typical of several of those that are very bullish on Sirius XM.
I suspect your covered calls will be called away in the not to distant future. Perhaps then, you might re-think your analysis. For the foreseeable future, the direction is up. ...
I expect SIRI to be over $3 by this time next year. We will soon see which one of us is correct.
The price of Sirius XM did not reach "$3 by this time next year [May of 2012]." It would not reach that level until December 18, 2012, and it would not remain above that $3 price level until late April of 2013.
Sirius XM has been a very volatile stock over the past four years despite a highly predictable subscription model and a continuous increase in revenue. The volatility of the underlying share price is one of the factors that affects the price of the options and the premium that the option seller demands and the option buyer is willing to pay. The large premium for Sirius XM options is what makes selling covered calls attractive. It also indicates that there is a larger risk that the investor will lose the shares. Is the risk of loss worth the extra premium?
That all depends on the goals of the individual investor. If the objective is to simply put the stock away and forget about it for five years, it's a poor choice. If the investor is willing to sell the stock when it exceeds what they feel is its fair value, it can enhance one's return. And that raises the question about where one sees fair value.
When those $3 calls expired worthless in January of 2012, I wasn't convinced that the shares would be "worth" more than $3 in January of 2013. As a result, I simply sold more $3 calls with an expiration in January 2013. The market decided otherwise, and when January 2013 expiration approached, the share price was $3.16 and the shares were assigned. As noted above, the shares could not hold the $3 price point and soon fell below that level, providing the opportunity to repurchase the shares at $3.
I was able to buy the number of shares assigned at approximately $3 per share, and sold January 2014 calls with a strike price of $3.50 for $0.26. The $3.50 price was selected because it had an attractive premium, provided an annualized yield on net cost of 30%, and most importantly, if the shares were called it would be at a price I considered slightly above the high end of my estimation of fair value.
At times, over the past six months, the market has violently disagreed with my estimates, sending the shares as high as $4.18. Currently, with the expiration of those calls just two weeks away and the share price slightly below $3.50, the trade looks fine. Then again, considering the volatility of the stock, there is plenty of time to be proven wrong.
Some of the key events between now and the expiration of those options are:
- Reports on US new vehicle sales should be released in the next few days. These have historically had a short term impact on the stock price.
- A presentation will be made by Jim Meyer, Sirius XM CEO at the Citi Internet, Media and Telecommunications Conference on Tuesday, January 7th. Information provided by Meyer could move the share price.
- Shortly after Meyer speaks, Sirius XM Chairman, and Liberty Media (LMCA) CEO Greg Maffei will speak. Liberty Media is the majority owner of Sirius XM, and any revelations about its future plans with respect to Sirius XM could affect the share price.
- Last year, shortly before Sirius XM CFO David Frear spoke at this annual conference, the company reported the number of net adds for 2012 and issued detailed guidance for 2013 in a press release. If a similar press release is issued, there could be significant movement in the share price.
At the same time that the Citi conference is occurring, the 12th annual Consumer Telematics Show will also be taking place in Las Vegas. This show is somewhat more relevant for Sirius XM this year due to its $530 million acquisition of the Connected Vehicle Services Unit from Agero completed two months ago. Although it is doubtful that any significant news that would affect the Sirius XM share price would come out of that event, anything is possible.
Sirius share price targets vary greatly. A look at the estimates on Yahoo Finance shows 17 brokers with price targets ranging from a low of $3.65 to a high of $5.80. Their mean target is $4.57 and the median is $4.50. I find the average of the targets to be above levels that I consider fair value.
In a recent article I discussed using free cash flow as the basis for share price valuation. A continued reduction in shares outstanding in 2014 from the ongoing share buyback program, and a continuing growth of free cash flow should result in free cash flow per share of $0.17-$0.19 for 2014. While I would be unwilling to pay more than 20-22 times free cash flow per share, others are not so reluctant, anticipating greater future growth from the company. 22 times would result in a maximum price target of $4.18.
The "average" analyst with a price target of $4.50 appears willing to assign a much higher multiple or is anticipating a greater reduction in shares outstanding or a higher free cash flow. A $4.50 share price, using my estimate of shares outstanding and free cash flow would indicate a multiple of 24-26 times, a number that I believe is excessive.
Going for 30%
While one can wait for the flow of news next week, there is an opportunity to open a covered call transaction now with a potential return approaching 30% and some protection against bad news. With the shares recently trading in the $3.45-$3.50 range and the $4 January 2015 calls trading at $0.36-$0.39, one can buy the stock and sell the call for a net outlay of approximately $3.10.
Assuming that the share price increases approximately 15% from the current levels, the shares would trade above $4 and the shares would be assigned. The profit? $4 divided by the net cost of $3.10 or 29%.
What if the average analyst is correct and the share price gets to $4.50? How much better off would the plain buy and hold investor be? That investor would spend $3.50 to acquire the stock and could sell it at $4.50. The return? 29%!
Sirius XM has had a fairly predictable subscription model. This simplifies the forecasting process and has allowed the company to consistently meet - or slightly exceed - most of the guidance figures issued each year. It also makes it difficult for the company to significantly exceed the revenue forecast.
These factors should result in a steadily improving share price and low volatility. That has not been the case. Instead shareholder expectations drive the share prices to excessive levels and eventually the share prices retreat.
This volatility creates attractive premiums for the options and investors can take advantage of it. The covered call strategy outlined above has many positives:
- It achieves the same percentage return as a straight long position if the shares meet the average analyst target.
- If the share prices don't move at all in 2014, the strategy results in a low double digit return.
- Even if the share prices decline by 10%, the investor has made a small profit.
The risk is that the price goes significantly above the $4.50 average target. Whether this is due to stronger than expected guidance, better results or investor exuberance, the result would be the investor missing out on that extra appreciation. For me, it is a risk worth taking.
Additional disclosure: I actively trade SIRI. In addition to my long positions in SIRI, I have January 2014 $3.50 and January 2015 $4 covered calls written against many of these positions. As the January 18th options expiration date approaches, I may roll those $3.50 calls into $4 January 2015 calls. I may close out positions or open new positions, execute the trade outlined in this article or trade blocks of SIRI at any time.