I have been writing articles about Sirius XM (NASDAQ:SIRI) for more than three years, and it is interesting to see that the same misinformation and lack of understanding continues to persist over the number of outstanding shares. Most of the confusion stems from a lack of understanding about the calculation of Diluted Earnings Per Share (diluted EPS) and the calculation of the diluted share count. And, in the case of Sirius it can be a bit complicated.
In 2011, there was Liberty Media's (NASDAQ:LMCA) convertible preferred stock, the 7% Exchangeable Notes, Warrants and stock options in addition to the common shares outstanding. Liberty had 12.5 million shares of preferred stock that could be converted into nearly 2.6 billion shares of common stock. There were also nearly 440 million stock options and $550 million of 7% Notes that could be exchanged for more than 290 million shares of common stock (plus a comparatively small number of warrants). The shares underlying these instruments could go in and out of the share count based on earnings and the price of the stock.
The first thing one must understand is that the purpose of the diluted EPS is to let shareholders see what earnings would be if certain equity instruments were converted into common shares. For years, this was never an issue because Sirius had no earnings, and including the shares underlying these instruments would be "anti-dilutive." In other words, you would be dividing a loss by a larger number of shares, thereby reducing the loss per share and making the company appear to be losing less money on a per share basis. Once Sirius started to turn the occasional quarterly profits, the misinformation began to spread.
The preferred shares had a microscopic cost basis, so as soon as the company had any profits, the GAAP rules would require they be included in the diluted count if there were profits. However, on a quarterly basis, they would go in and out of the diluted count depending on whether there were any quarterly earnings to dilute.
Stock options were another matter. In addition to the earnings test, there are other factors to consider: vesting, the option exercise price and the share price at the end of the quarter. First, the options that are considered are those that are vested. Second, only those options that are in the money are included; in other words, the strike price of the options must be less than the share price at the end of the quarter. Then, the calculation takes a twist.
Since Sirius uses the Treasury Method of accounting, the company assumes all the vested and in the money options are exercised. Then, it assumes that the cash received from the exercise of the options is used to buy back shares. The difference between the number of vested, in the money, options and the hypothetical purchase are added to the diluted share count. For example, if there are 10,000 vested options with an exercise price of $2 and the share price at the end of the quarter is $4, the Treasury Method assumes that the 10,000 options are exercised and the company receives $20,000. It then "uses" the $20,000 to buy 5,000 shares of stock at $4. So, the 10,000 options would add a net of 5,000 shares to the diluted share count.
With the 7% Notes - as with all convertible debt - the treatment is somewhat different. Again, the company has to have earnings, or any conversion would be anti-dilutive. Second, the exchange or conversion price of the shares underlying the debt must be below the price of the stock on the last day of the quarter. Then, there is one more factor to consider. Would the diluted EPS be higher or lower assuming the debt is exchanged for shares? This last step requires that one consider the interest expense for the debt, and whether or not the EPS would be lower or higher with more shares and less interest expense. If the earnings would be lower, the shares underlying the Notes would be included in the diluted share count.
As I noted at the start, there is a surprising lack of understanding of the diluted share count by some of those that write about the company. Part of it has been, and continues to be, about the 7% Notes. Almost three years ago following the Q2 earnings, Brandon Mathews had his followers thinking that 300 million shares had just been added to the outstanding shares. I covered this in an article titled "Sirius Share Dilution: Uncovering The Nefarious Plot" where I wrote:
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.
Last year, also following the Q2 report, the issue of diluted share count came up once again. This time it was tied to statements about the buyback not working in an article at The Motley Fool and a critique of that article by Seeking Alpha contributor Stephen Faulkner. In my view, both writers had it wrong and I wrote an article once more explaining how diluted share counts work. I wrote another article, again explaining diluted share count, only this time there were additional complexities due to the timing of share buybacks and the impact from using weighted averages. Shares purchased early in the period have greater impact than those purchased later in the period.
This week an article on Seeking Alpha by Alexander J. Poulos presents misinformation about the buyback being ineffective based on the change in the diluted share counts. Poulos writes:
As we can see from the table below, yes the company did shrink the share outstanding but notice the diluted share count really didn't budge.
Net income per common share:
3 months ended June 30th 2014
3 months ended June 30th 2013
6 months ended June 30th 2014
6 months ended June 30th 2013
Weighted average common shares outstanding: in millions
Figures derived from recent earnings release.
The option overhand issue remains here as the shares repurchased seemed to be enacted on the open market. If we take into account the amount of options that can be converted into shares, SIRI has an additional 345 million shares outstanding. To add further context to the number at a current price of $3.30, the shares are worth over $1 billion.
My original thesis concerning SIRI revolved around the company using their cash flow to aggressively reduce their share count. Capital return plays can be enormously profitable if they are executed properly. One of the key tenets of this strategy is for management to reduce the shares and to exercise some restraint in issuing options which can further dilute the share count. SIRI seems to lack this discipline and I am quite disappointed with them.
The data is obviously correct, but the conclusions are totally wrong. Note that Poulos states "The option overhand issue remains here as the shares repurchased seemed to be enacted on the open market." I assume this is a typo and the sentence should read options overhang. However, the options outstanding have declined. During the first half of the year, the 10Q shows the company granted only 5,441,000 options and that 5,910,000 options were canceled, retired or forfeited. In other words, options declined, and after taking into account the options that were exercised, the total options on the books declined from 264,239,000 to 252,202,000. Furthermore, only 104,117,000 are currently exercisable (at an average price of $2.15). There is not much evidence to suggest that management is not exercising "some restraint in issuing options."
So, why are there disconnects in dilution? This answer can also be found in the 10Q:
Common stock equivalents of approximately 116,655,000 and 355,918,000 for the three months ended June 30, 2014 and 2013, respectively, and 386,276,000 and 352,795,000 for the six months ended June 30, 2014 and 2013, respectively, were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive.
The 10Q also gives detailed information about what is included in the diluted share count, showing that only during Q2 of 2014 were the 272,856,000 shares underlying the 7% Notes included. During the other periods, the interest expense impact would have been anti-dilutive. Those Notes were on the books for all four periods in the above table, it's just that the shares underlying the Notes were not included in three of the four periods.
As to the options that Poulos was so concerned about? They accounted for 72,190,000 diluted shares in the most recent quarter and 92,762,000 in the year ago period. But it's not just the options and the 7% Notes that cause confusion. Weighted averages that take into account when buybacks occurred or when options were exercised or when Liberty converted its preferred shares or when certain of the 7% Notes were exchanged or revalued all distort the true share count.
One other set of data points for investors that are concerned about whether or not the shares outstanding are coming down should consider are the number of shares shown on the balance sheet. These are the actual common shares outstanding at the end of the period and eliminates some of the confusion caused by the use of weighted averages. The balance sheet in the current 10Q shows the following:
Common stock, par value $0.001; ...5,706,347,567 and 6,096,220,526 outstanding at June 30, 2014 and December 31, 2013, respectively
One year ago, the balance sheet at the end of Q2 showed:
Common stock, par value $0.001; ...6,247,221,498 and 5,262,440,085 shares outstanding, at June 30, 2013 and December 31, 2012, respectively
Clearly, there was a 540,873,931 reduction in outstanding common shares from 6,247,221,498 to 5,706,347,567 between June 30, 2013 and June 30, 2014. (The 5,262,440,085 figure for common shares outstanding as of December 31, 2012 may be confusing to some as it excludes Liberty Media preferred shares that were subsequently converted to common in January of 2013.) And, that reduction does not take into account the hundreds of millions of shares that were eliminated in the first half of 2013 or since the close of Q2 2014.
Many investors fail to take the time to fully understand their investments, and understanding the intricacies of diluted EPS can be daunting at times. Faulkner wrote:
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.
I agree, and concluded last year's article on this topic as follows:
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.
The share buyback has eliminated a lot of shares outstanding. Here's one last point of reference: there were 6,873,786,000 diluted shares outstanding at the end of 2012, well above the current level. I don't think Poulos intentionally misled investors; it would serve no purpose. I congratulate him on a profitable trade and I hope it works out well for him. If he made that trade because he thought management was showing no restraint issuing options, it's too bad he made it for the wrong reason.
Disclosure: The author is long SIRI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to my long positions, I have January 2015 $4 covered calls written against portions of my long positions in Sirius XM. I also trade blocks of Sirius XM on a regular basis.