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I have to be honest. My immediate reaction to the news of Liberty Media's (NASDAQ:LMCA) exchange offer that essentially valued Sirius XM (NASDAQ:SIRI) minority shareholders' stake at $3.68 per share was that it was a low ball offer that did not reflect what I felt the true value of shares should be currently. At first glance, though, the deal sounded intriguing, but my opinion has changed. While shares have traded lower than that pricing in recent history, and the offer was slight premium to what shares were trading for at the time, I feel shares are undervalued at present and that the recent pullback in Sirius XM post Q3 results was completely overdone.

This pullback has not been mirrored in Liberty Media's share price as it should have, and thus has put Liberty Media in a brief favorable position to offer what I feel is about 10% less than it normally would have had to.

To illustrate what I am looking at, consider this graph of Sirius XM's chart in green superimposed on Liberty Media's chart in red since earlier in the year when Liberty spun out Starz (NASDAQ:STRZA). You will notice that for the majority of the year, Sirius XM's chart nearly mirrored Liberty Media's. Arguably each company, with Liberty's market cap being primarily comprised of its stake in Sirius XM, has rarely traded significantly more or less than the other on a relative basis.

(click to enlarge)

That all changed with the release of Sirius XM's Q3 call at the yellow X above. Shares dropped following the call on some very slight misses along with slightly reduced guidance for the fourth quarter. The cut? $4.18 down to $3.38. A reduction of over 19% top to bottom. Given how the two companies have traded, Liberty should have seen a similar decrease. It did not. Liberty dropped, top to bottom, 9%.

So what?

So what, you say? Well, the offering from Liberty to Sirius XM's shareholders is an equity swap. Since Liberty class A and B shares will receive the new Liberty class C shares, which will be the "new" Sirius XM, this unwarranted divergence in the performance of each stock has given favorable opportunity to Liberty Media, by over 10%, to make this offer.

In short, Liberty Media is currently enjoying a 10% premium relative to how it has traded to Sirius XM in the past. In an equity restructuring like this, that is significant.

Investors will notice something in looking at the chart above. Once shares resumed trading following the announcement, Sirius XM spiked and Liberty Media dropped to the point where the charts both gravitated towards each other.

What should the offer be?

Given the relative divergence in share pricing, and since this is an equity swap and not a cash buyout, I am of the opinion that not only should Sirius XM be valued fairly relative to how it is traded compared to Liberty Media in the past, but also that Sirius XM shareholders should receive a premium to that relative valuation.

There are two ways of looking at this to determine a "fair" value for Sirius XM today relative to Liberty, but let's keep it simple. I never wish to go down the road of manipulation discussions, but let's assume Sirius XM is the stock which is not where it should be and that Liberty is fairly valued.

A simple look at the chart above places Sirius XM at a valuation of $3.85 considering Liberty Media's $145 pricing on January 3rd. This, I believe, would be a fair equity swap valuation and a ratio which offers this today would be fair, today.

If only it were so simple, though...

Things are never that simple, though, and there are a few other considerations here to take into account.

Working from a $3.85 valuation, Sirius XM shareholders should consider what they are giving up in the transaction. While there are some benefits to being wholly owned and completely under the Liberty umbrella, there are significant drawbacks to that as well which are extremely important to consider.

  1. Sirius XM investors, while currently minority owners, still have a vote. Liberty Media owns a majority in the company but Sirius XM as a company is still required to work in the best interests of ALL holders of Sirius XM shares. That goes away in an exchange of shares for Liberty "C" class non-voting shares. It's not so much the votes that have value, but rather the fact that, currently, Sirius XM shareholders have certain rights and the company is supposed to be responsible for acting in their best interest.
  2. Sirius XM investors currently enjoy optimistic price targets and buy ratings from many analysts who cover the company. The average 1 year price target is over $4.50 per share, with some targets exceeding $5 per share. This is 22% to 36% over and above the equivalent $3.68 per share offer outlined in the equity swap.

Point number 1

With regards to number 1, I'm of the opinion that if this transaction goes through, Sirius XM, which will now be "Liberty Media Class C" will be used as a cash sponge and wrung out to the benefit of Liberty Media as a whole. It is well known that Liberty has been in pursuit of deals in the cable industry, notably issues with Charter (NASDAQ:CHTR) and Timer Warner (NYSE:TWC) and there is speculation that Liberty may be in need of cash for further deal making.

This cash is currently difficult and time consuming to pull from Sirius XM, as in order for Liberty to get to that cash, Sirius XM must raise Liberty's stake by buying shares in an extensive share buyback plan. This buyback retires shares, Liberty's stake subsequently increases, and Liberty may then sell back small percentages at a time. It's a time consuming process for Liberty but a beneficial one if you are a Sirius XM holder seeing benefits of a reduced float and steadily rising share price. If you're on a clock, and need cash quickly as Liberty may, this is not the optimal pace for cash extraction.

Were Sirius XM under the Liberty umbrella as a mass of class C non-voting shares, Liberty would be free to use the cash flow and leverage capabilities of Sirius XM's market cap and current borrowing capacity for the benefit of Liberty Media without specific responsibilities to do what is best for what are now the minority shareholders of Sirius XM. Yes, Liberty would be responsible for Liberty shareholders, but the C class shares that represent Sirius XM could end up akin to Cinderella shares, scrubbing and mopping the floor for Liberty Media while John Malone attends the royal ball.

The mere possibility of this is a huge risk for Sirius XM shareholders to take. The fact that I and others feel this is likely to happen means that a premium should be paid for this loss of vote, and thus loss of security. Yes, a change like this gives the ability for Sirius XM as Liberty class C shares to move more easily, take on debt, etc. but if we are being honest with ourselves, it is easy to understand that these moves will be for the benefit of current holders of Liberty "A" and not current minority holders of Sirius XM.

In short, if Liberty Media and John Malone wish to have the free and clear ability to use all of Sirius XM for the benefit of Liberty Media, then Liberty Media should pay a premium for what Sirius XM holders risk losing in the future, and do lose (their right to vote) in the exchange.

Point number 2

Analyst price target averages of $4.50 bode well for Sirius XM in the coming year. My own estimation of $5 by January of 2015 matches some targets, and even comes in lower than others. With Sirius XM closing after hours on Friday, January 3rd at $3.70, this represents a year of significant gains ahead.

Much of this has to do with Sirius XM's continuing performance as a company. Strong auto sales have led to increasing subscribers, and demand for the product has kept churn in check. Because I do not see that trend coming to a halt, the future looks favorable for the company and the share price.

But on top of this, Sirius XM has another $2 billion share repurchase program on the table. Removing and retiring just under 10% of existing shares is scheduled. This should serve the share price well over the coming year, the same as it did in 2013 until it was temporarily halted after Q3 in order to repurchase a large block of shares from Liberty Media.

So again, if conversion were to take place, there is no guarantee that Sirius XM's borrowing power and cash flow would be used to the benefit of Sirius XM shareholders. My opinion is that it would not, and would instead be used for what would be touted as the greater good for Liberty Media. That changes the game, and Liberty Media class C may stagnate or even drop, while Liberty class A and B rise considerably as value is shuffled from one to another. Not a problem for those who own A and B shares currently, even if they are spun C in dividend form. That results in a rough wash on the transfer. But what of the Sirius XM holder who now only owns Liberty class C shares? Are prospects for Liberty class C shares going to be as good as the current expectations for 22% to 35% or more gains year over year for Sirius XM? If $2 billion is borrowed against "class C" and used in acquisitions for "class A" are current Sirius XM holders, future class C holders, going to see benefit or detriment?

Nobody knows, but educated guesses can be taken. A premium should also be paid for future expectations.

What valuation do I feel is fair?

Obviously, opinions will vary considerably. There are those who will feel anything short of a $10 per share valuation is unacceptable, as they were looking to hold for another 3 to 5 years and were looking forward to a much higher target. There are also those who will feel the $3.68 valuation offer is acceptable and will be happy to take it given recent price volatility.

For me, considering I feel around $3.85 is an appropriate relative current valuation for Sirius XM's shares when considering trading history vs. Liberty Media, and considering points 1 and 2 above, I believe investors should hold out for at least an 11% premium over $3.85, and vote "NO" on the exchange for anything less. That 11% premium puts my personal valuation in this deal at $4.28 per share equivalent currently. I'll go so far as to say $4.25, which is close enough to my current target, would be enough for now. Since I am not the one bargaining I feel that offering my honest minimum for a yes vote does not put me at a disadvantage. Were I negotiating, I'd certainly seek more.

I also believe that after the exchange, if one happens in present form as offered, investors would do well to divest themselves of their Liberty Class C shares after conversion, or simply sell their Sirius XM shares before the transaction takes place. If you wish to remain tied in to Sirius XM, your best bet may be to own Liberty Media class A shares before the exchange and be 'spun out' your Sirius XM in class C shares, especially if the conversion equivalent price is low.

In conclusion

I don't blame Liberty Media for coming in with an offer while the two stocks have had such a divergence in pricing. It's a prudent move for Liberty at this time, and were I a Liberty Media shareholder I would applaud the attempt.

I am not a Liberty Media shareholder at this time, though. I am a shareholder of Sirius XM. This is not a good time for Sirius XM to entertain an offer of an equity swap from Liberty, because it is a good time for Liberty to entertain an equity swap offer for Sirius XM. If you are a Sirius XM shareholder, I urge you to consider the risks and the future prospects of Sirius XM as it stands right now. Consider both what is possible and what is also probable if a deal like this goes through, and what is an appropriate and fair valuation on a swap for your shares.

Liberty Media has a demand that Sirius XM minority holders can choose to fill. Sirius XM minority holders should expect a reasonable premium in order to give up the voting rights and potentially the future prospects of a company that is poised for a good to excellent 2014. When a deal is presented for a vote, know your worth.

I know, and you should know, Sirius XM is worth more than a $3.68 per share valuation.

Source: Sirius XM: Vote 'NO' On Liberty's $3.68 Offer

Additional disclosure: I am long SIRI January 2014 $2 and $3.50 calls. I am long SIRI January 2015 $2 and $2.50 calls. I may exit my January 2014 calls early through conversion and sale before coming expiration.