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Liberty Media (NASDAQ:LMCA) made an offer to Sirius XM Holdings (NASDAQ:SIRI) to exchange 0.076 shares of a new, non-voting, class of Liberty shares for each share of Sirius XM that it does not already own. The exchange ratio would value Sirius XM at $3.68 per share as of the January 3rd.

I suspect that the holders of Sirius XM shares are being offered this non-voting class of C shares rather than A shares is so that Liberty Chairman John Malone can easily maintain his control of Liberty. Malone's B shares, although carrying the same ownership percentage as A or C shares, have 10 votes for each share. This allows Malone to easily retain control of Liberty.

In its letter to the Sirius XM Board of directors, Liberty lists the benefits of the transaction to Sirius XM shareholders:

• Continued and significant participation in Sirius' future prospects plus significant participation in Liberty's broader portfolio of businesses, assets and investment opportunities.

• Potential uplift in the valuation of a combined Liberty and Sirius as the result of:

· Eliminating any perceived ambiguity regarding the nature of Liberty's and Sirius' long-term relationship;

· Further alignment and focus of management at all levels on maximizing the overall value of Liberty/Sirius' combined portfolio of businesses, assets and investment opportunities;

· The combined company being better able to optimize its consolidated capital structure;

· Greater scale and better coordination in the deployment of capital to pursue both organic and strategic investment opportunities, including greater flexibility to use equity capital shares of the combined company when and if appropriate; and

· The combined company having greater flexibility to maximize returns to shareholders.

• Enhanced stock market liquidity for Sirius' existing public shareholders, who will become significant shareholders of an enlarged Liberty that will have a pro forma equity market capitalization of approximately $27 billion based on the closing prices of Liberty's shares of Series A common stock and Series B common stock and Sirius Common Stock on Friday, January 3, 2014.

For Sirius XM investors, most of these arguments appear quite weak.

  1. Investors in Sirius XM already have "participation in Sirius' future prospects" and if they had wanted to participate "in Liberty's broader portfolio", they have had ample opportunity to sell Sirius XM shares and buy Class A shares of Liberty common stock which carry voting rights.
  2. Liberty could easily eliminate "any perceived ambiguity" by simply laying out a detailed road-map of its plans for Sirius XM and adhering to it.
  3. "Further alignment and focus of management" seems unlikely because Liberty already controls the Sirius XM board and is currently able to set management objectives.
  4. Sirius XM has no apparent problems with its current "capital structure" with easy access to debt markets. And, if Liberty felt it was in its best interests, it could have Sirius XM issue additional shares as currency in an acquisition.
  5. Sirius XM shareholders already have ample stock market liquidity with 3 billion, non-Liberty-owned, publicly traded shares and a company with a total market capitalization of almost $22 billion.

The weakness of these arguments should be of concern to Sirius XM investors. An investor in Sirius XM has had a relatively simple investment, and analysts have projected the stock to appreciate nearly 30% in 2014 with an average price target of $4.50-$4.60. In contrast, Liberty's stock price appreciation is expected to be only 16%-20% with an average target of $170-$176, and clearly much of that appreciation is due to its holdings of more than 50% of Sirius XM.

In fact, Liberty's 3,255,062,556 shares of Sirius XM at Friday's closing price of $3.57 represented $11.62 billion of Liberty's $16.60 billion market cap, or 70%. The remaining 30% of Liberty would be worth $4.98 billion. Now, consider what would happen if those 3,255,062,556 shares appreciated to $4.50 and, or $14.65 billion, while the market cap of Liberty grew by the 20% expectation of the analysts to $19.92 billion. It means that the rest of Liberty, based on market cap, would only grow by $0.29 billion, or 5.8%.

I would expect that the rest of Liberty would be growing far greater than 5.8%, but this exercise illustrates one of the issues with market valuations of complex entities like Liberty. The stocks of such companies frequently trade at a discount to the underlying assets. It is why we see announcements by companies that they are spinning off units to "unlock shareholder value." It is something that companies as diverse as PepsiCo (NYSE:PEP) (Yum Brands), Merck (NYSE:MRK) (MedCo), Hewlett Packard (NYSE:HPQ) (Agilent) and Liberty Media (STARZ) have done over the years.

Another question that holders of Sirius XM shares need to consider is why has Liberty suddenly changed direction? Less than three months ago Liberty agreed to participate in the Sirius XM share buyback by selling back $500 million of its stock in Sirius XM. At the time I noted:

It is also not surprising that Liberty has begun selling its shares back to Sirius XM. At the recent Goldman Sachs 22nd Annual Communacopia Conference, Liberty CEO Greg Maffei had discussed the relatively low cash position at Liberty and how Sirius XM could be a source of cash, saying the following:

At some point, we will either, through dividends up from Sirius or sales of Sirius or some other longer term refinancing mechanism, reduce that margin debt.

Clearly, Liberty has chosen to use one of the above options by selling shares of Sirius XM. However, Liberty never keeps things simple. In a related press release by Liberty, it also revealed that it was raising $500 million through a private offering of convertible senior notes and had entered into a complex transaction with Comcast (NASDAQ:CMCSA).

As part of the notice to Sirius XM, Liberty CEO (and Sirius XM Chairman) Maffei requested that the $500 million share sale to Sirius XM be suspended:

With respect to the Share Repurchase Agreement, dated October 9, 2013, between Liberty and the [Sirius XM], as amended by the letter agreement, dated November 13, 2013, we also propose to defer [Sirius XM]'s obligation to make any additional repurchases under such agreement pending the completion of our negotiations relating to the Proposed Transaction.

Liberty rarely keeps things simple. Since it is unlikely that Liberty has less of a need for cash today than it did in October, one must suspect that it will be able to more efficiently access cash from its investment in Sirius XM than it could by selling back shares. How could it do this?

Where Will Liberty Take Sirius?

Investors often need to make decisions based on limited information. We are required to put together scenarios based on statements and past actions by management. So, what follows is my speculation about what may occur.

It should be remembered that much of the financial engineering that takes place at Liberty is to avoid taxes. It should also be remembered that Liberty has roughly 2.6 billion shares with a total cost basis of $12,500 and another 0.7 billion shares that it purchased to go to majority ownership of Sirius XM. The 0.7 billion shares cost approximately $2.34 per share (plus fees and expenses).

Selling back those shares to Sirius XM creates a taxable gain for Liberty. The $500 million sale referenced above was scheduled to be at an average price of $3.6603, creating a gain of more than $1.30 (more than 50%) per share. But why pay taxes?

Once Sirius XM becomes a wholly owned subsidiary, Liberty will have access to all of Sirius XM's cash flow, mostly tax free. It will be able access that cash without going through the motions of a taxable share sale or jeopardizing its majority ownership of Sirius XM. It can also leverage up the debt at Sirius XM and pull additional billions of dollars of cash out of the company in that manner. And, if Malone wants to rebuild a cable empire, he can use that cash to increase his stake in Charter Communications (NASDAQ:CHTR) and his pursuit of Time Warner Cable (NYSE:TWC).

After squeezing out as much cash and using as much of the NOLs as possible to avoid taxes, Sirius XM can be spun off from Liberty.

The $3.68 Offer

The $3.68 offer is not cash, but was based on the closing price of Liberty stock, and an exchange ratio of 0.0253 shares of Liberty stock.

The proposed exchange ratio of 0.0760 would value Sirius common shares at approximately $3.68 per share based on closing prices of Liberty's shares on Friday, January 3, 2014.

On Friday, Liberty shares were trading at $145.33 and that price was:

0.0253 * $145.33 = $3.6768.

That $3.68 "price" will move up and down as the market evaluates the proposed transaction over the coming weeks and months.

It is not clear how much flexibility there will be on the part of Liberty, or if a counter-offer will be entertained by Liberty. The offer letter states:

It is our expectation that Sirius' Board of Directors will appoint a special committee of independent directors to consider our proposal and make a recommendation to the Company's Board of Directors. We will not move forward with the Proposed Transaction unless it is approved by such a special committee. In addition, the Proposed Transaction will be subject to a non-waivable condition requiring the approval of a majority of the shares of Sirius Common Stock not owned by Liberty or its affiliates and, under applicable Nasdaq Stock Market requirements, the approval by the Liberty shareholders of the issuance of the Series C Common Stock in the Proposed Transaction.

... we encourage the special committee to retain its own legal and financial advisors to assist in its review of our proposal.

It will be up to those "independent directors" and the financial advisors they retain to determine if the proposal is a reasonable deal for the Sirius XM investors.

Summary

If the proposal is approved by the special committee, and subsequently approved by a majority of the shares of Sirius XM common stock not owned by Liberty, Sirius XM investors will need to make a number of decisions. Do they want to own shares of a non-voting class of Liberty common stock? Do they want to own Liberty Media with its additional investments in Charter, Live Entertainment, Barnes & Noble (NYSE:BKS), the Atlanta Braves and a host of what Liberty terms "available for sale" securities? From my perspective, it makes absolutely no sense.

Despite the alleged advantages laid out in the offer, I see no benefit to holding non-voting Liberty C shares over the current Sirius XM common shares. And, even if the offer were for the voting Liberty A shares, I would prefer Sirius XM. Why? Quite simply, I expect a separately traded Sirius XM to appreciate at a greater rate than the remainder of Liberty over the coming year.

Source: Liberty Makes Unacceptable Offer For Sirius