Understanding Sirius XM's Potential Share Buyback and Liberty Media Stake

| About: Sirius XM (SIRI)

Over the last two or three quarters, the potential of a share buyback by Sirius XM (NASDAQ:SIRI) has become more realistic. The thought of such an event was quite remote only two years ago, but as things stand today, a share buyback has real potential in 2012.

One key element that needs to be considered if a share buyback were to happen is the Liberty Media (LCAPA) stake in Sirius XM. Liberty's stake is often referred to as 40% of the company, but perhaps it is time that we address the Liberty stake for what it is, especially as we consider the prospects of potential share buybacks in the next year or so.

The Liberty deal granted the company preferred shares that would equate to 40% of the company. Upon announcement of the deal, it was stated in SEC filings that after the 15 day Hart Scott Rodino waiting period, the effect of preferred shares would be determined.

On February 17, 2009, we entered into an Investment Agreement (the “Investment Agreement”) with Liberty Radio, LLC (the “Purchaser”), an indirect wholly-owned subsidiary of Liberty Media Corporation. Pursuant to the Investment Agreement, we agreed to issue to the Purchaser 12,500,000 shares of convertible preferred stock with a liquidation preference of $0.001 per share in partial consideration for the loan investments described herein.

Upon expiration of the applicable waiting period under the Hart-Scott-Rodino Act, the preferred stock will be convertible into 40% of our outstanding shares of common stock (after giving effect to such conversion). Issuance of the preferred stock is subject to the satisfaction of certain conditions, including the conditions to funding under the XM Credit Agreement described below.

Essentially, when the deal with Liberty was closed, the company was issued enough preferred shares to equate to 40% of the company (if converted to common). While the Liberty stake currently remains at about 40% (right now it is actually in the 39% range), that number is not cast in stone. What is cast in stone is how many common shares Liberty gets if it does convert its preferred shares. That number is 2,586,976,761 shares. I have taken the time to confirm this with both Sirius XM and Liberty. Each share of preferred can be converted to 206.9581409 common share.

Perhaps the best way to think of the Liberty stake is in terms of the conversion ratio and shares of common rather than as 40%, as that 40% number is subject to change based on events at the company. Liberty's stake now represents a bit more than 39% of the company because employee stock options have happened in the time since Liberty and Sirius XM closed their deal. The reason this is important is that the company is now talking about buying back stock. If Sirius XM were to buy back common stock only, and no preferred, the percentage of the company Liberty owns would actually increase. The effect is the reverse of the slight dilution that has actually served to decrease Liberty's stake to 39%.

Sirius XM CEO Mel Karmazin addressed the potential of a share buyback at the annual meeting of shareholders. When he addressed it, he stated clearly that the company would have to be careful in any buybacks so as not to trigger giving Liberty a controlling interest in Sirius XM. In fairness, any buyback of common that might happen would have to be far more substantial than anyone is anticipating to trigger Liberty having over 50% of the company. In his example, he stated that any buyback would have to be done proportionately, with 60% of the funds being used to buy common, and 40% used to buy back preferred from Liberty if the company did not want to shift Liberty's ownership stake.

Essentially, if Sirius XM were to announce that it was buying back $500 million worth of stock, and the price was $2.50, $300 million would be used to buy back 120 million shares of common, and $200 million would be used to purchase 388,350 shares of preferred (convertible into about 80 million shares) . Thus, any potential buyback is diluted by the Liberty preferred if the company does not want to increase Liberty's stake.

During some investor conferences Liberty's Greg Maffei has stated that Liberty has no interest in selling any preferred shares at this point. If this stance were to include not selling back to Sirius XM, the potential share buyback is limited to about 1.36 billion shares of common without taking Liberty over the 50% threshhold (current share count of 3,946,383,454 - Liberty conversion of 2,856,976,761). Quite frankly, Sirius XM does not have the cash available to even come close to a buyback of this magnitude.

Karmazin made it quite clear that Sirius XM has no control over what Liberty does. The company can not be forced to sell, and Liberty can do as it pleases with its preferred shares. In the example above, if $500 million were used to buy back common only, the Liberty stake would go from its current 39% of SIRI to a bit over 40%.

The wild card in this whole situation is that Liberty can benefit from share buybacks in two ways. If the company refuses to sell preferred, it can increase its percentage stake in Sirius XM without having to buy any shares to do so. If Liberty allows some preferred to be bought back, it can monetize its shares at what is a substantial premium over its initial investment. Understanding that Liberty's John Malone likes to do tax friendly deals, he is most likely to stand pat, and await an opportunity to monetize his investment in another manner, such as a Reverse Morris Trust (if he can get to a majority position in Sirius XM).

The reason that understanding all of this is so important is because there are many investors out there who believe, incorrectly, that the Liberty stake is 40%, no matter what. This can wreak havoc as potential share buybacks happen as well as issues like the Howard Stern lawsuit. If we were to believe that 40% is 40% no matter what, then Liberty would be fully insulated from any dilution should Stern prevail. And comments by Karmazin that he needs to be careful and consider the Liberty position of ownership when doing buybacks was in point of fact Karmazin not understanding his company.

In its recent annual filing, Liberty stated the following,

As of December 31, 2010, we owned $337 million principal amount of SIRIUS XM's public debt, as well as preferred stock of SIRIUS XM which is convertible into common stock representing approximately 40% of SIRIUS XM's fully diluted equity.

Notice the term approximate. This is because Liberty's 40% initial stake has changed at this point due to some minor dilution.

I fully realize that there is a contingent of investors that believe 40% is 40%. What I would suggest is that these people review the fact that Liberty has registered its preferred shares with the conversion rate attached with the SEC. I would also suggest that these people contact the companies in question (Liberty or Sirius XM) or their broker, should they disagree.

The bottom line is this:

  1. Sirius XM has plenty of room to buy back a lot of common before being in danger of giving Liberty control.

  2. It should make shareholders feel good that Liberty has the same type of skin in this game as common shareholders. Liberty loses if we lose, and it wins if we win.

  3. Things such as share buybacks can be impacted by Liberty in that not all benefit may come to common (If Sirius XM buys back preferred then the common will not see the immediate impact, but rather a delayed impact).

  4. Liberty's stake is a set number of shares and its position in Sirius XM, on a percentage basis, can fluctuate.

  5. Liberty is free to do with its shares what it wants, and does not have to sell any of its position if it does not want to.

Disclosure: I am long SIRI. I have no position in LCAPA