Understanding Sirius XM Convertibles

| About: Sirius XM (SIRI)

Nearly every article I write is criticized heavily by two specific people, which I have known online for several years. They appear to be offended by my success, and spend their days explaining to retail investors on message boards why they think I'm "an idiot" and why retail investors should not subscribe to my site or read my articles here on Seeking Alpha.

Each serves a useful purpose however, in that they create enough confusion, to motivate me to clarify that which may be confusing to other investors, as I will now attempt to do on the issue of Sirius XM's convertible debt and how its potential ending will benefit shareholders.

Sirius XM (NASDAQ:SIRI) has two separate convertible debt issues that are either approaching retirement or the conversion strike price. If two are confused over the issue, then I am making the assumption that others may be confused also. Allow me to expand on the information.

At issue is whether or not someone would choose to convert a 7% note. Such is the case with Sirius XM's 2014 which is convertible at $1.875. The confusion first stems from not understanding the difference between a bond buyer and a convertible bond buyer. A bond buyer is specifically invested for income and purchases bonds for the purpose of generating income. A convertible bond buyer, on the other hand, is bullish on a company's stock and the interest is viewed as a bonus.

In the case of this particular Sirius XM 7% note, it does not trade on the open market but is held and/or traded privately and institutionally through the PORTAL market. The 7% notes were issued in July of 2008, and these Sirius XM bulls have waited nearly three years for the stock price to rise above the conversion price. The buyers of these notes have been basically stuck in an illiquid investment for nearly three years.

My personal thoughts are that the bonds were bought solely for the convertible arbitrage value, as Sirius XM was in dire straits at the time. The divergence at the time of issuance between the bond value and stock price made it an outstanding investment. The convergence now makes any arb plays fruitless.

Having established that convert buyers are not in it for the interest income, consider that the notes have now peaked in value. When interest rates fall, the value of a convertible bond rises. Conversely, as interest rates climb, the value of convertible bonds falls. Interest rates will rise in the not too distant future and it is widely expected that they will rise sharply and as they do, the value of the converts falls. This is yet another incentive for the holders of the notes to convert.

Convertible bonds are usually callable. I have been unable to locate the indenture for the 7% convertible to determine whether or not it is callable, nor on what date, if any. The covenants specifically allows for repurchase of the notes in the event of a change of control, yet no mention is made as to the callable nature of the notes. Last week, Sirius XM issued several filings relating to XM debt, including these 7% convertibles, specifically providing details of the new indentures following the change of control that had occurred.

If it is callable, and given Sirius XM's credit rating improvements, there is every chance that the note will be called at an inopportune time. In other words, the buyers which bought the converts because they were bullish on the equity, not for income, could see the notes called prior to Sirius XM reaching the strike price. One other important note on this issue is that they are convertible at any time, and some could have chosen to do just that already for tax loss purposes.

The conversion of the 7% notes will result in the elimination of $550 million in Sirius XM long term debt and its associated interest expense. This can only be viewed as a positive for the equity. While some look at potential dilution from conversion, it's important to remember that over 200 million shares were loaned against these notes for hedging purposes, which will be returned and retired. Some may mistake selling pressure created by the conversion and sale of the notes with dilution. Share price dilution occurs on the issuance of convertible debt, which occurred years ago.

Similarly, there is the issue of the 3 1/4% converts due in October of this year. The conversion price of $5.30 is unlikely to be reached. While some may consider the repayment of this debt to be a zero sum game, in that the debt is offset by the cash required to repay $230 million, there are psychological benefits. Debt has been an issue with Sirius XM in that much has been moved, yet little repaid or retired. The elimination of over $800 million in debt will eliminate the "burdening debt" headlines that have plagued the company, while increasing its ability to service its remaining debt; this while cash flow increases, leading to further credit upgrades and even lower cost, refinancing opportunities.

You either get it, or you don't.

Disclosure: I am long SIRI.