Sirius Share Dilution: Uncovering The Nefarious Plot

| About: Sirius XM (SIRI)

Comments on my recent articles on Seeking Alpha reveal some interesting points of view about Sirius XM (NASDAQ:SIRI), especially as they relate to a potential takeover by Liberty Media Corporation (LCAPA) or alleged conspiracies. I hope to address those that deal with Liberty in a future article. It's the alleged conspiracies that I find more interesting. Unlike Dr. Hodgins on the TV series Bones who sees a conspiracy under every rock, I tend to dismiss these views as they relate to Sirius. (However, I think it's great that the geeky Hodgins marries the hot Angela, giving hope to all those science majors toiling away in our institutions of higher learning, but I digress.)

One recurring theme is that there are all these illegal short sellers out there working in concert to steal shares from the righteous longs. I find it very difficult to accept that this is occurring. 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.

Was Sirius management being deceptive about the increase in shares? Why did they dilute the equity? What's going on? Should any of this be a concern for Sirius investors? The answers are no, no, nothing and no. However, I am sure there must be one or two readers that might want an additional explanation. Everyone else can go right to the last two paragraphs in this article. WARNING! THE EXPLANATION WILL BE LONG AND BORING TO MOST!

Homer985 pointed me in the right direction with an explanation and a reference to the applicable FASB regulation: SFAS 128. FASB, the Financial Accounting Standards Board, is the official body that sets rules and regulations that govern financial reporting. In this case it is all about dilution of ownership and dilution of earnings per share (EPS). SFAS 128 paragraph 33 states:

In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market price—as they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.

I will attempt to explain where the mysterious 323 million shares are coming from, but I will not be tackling the dilutive effect on the EPS in any detail other than to note that there are several moving parts that govern dilution. In general, there are rules about how the shares are to be calculated, which ones get counted and when they are to be counted. The purpose of the statement is to provide information to shareholders about what their EPS would be under various circumstances. These circumstances consider what happens with employee stock options, warrants and convertible securities - both bonds and preferred stock.

First of all, there have to be positive earnings to have dilution. If there are losses, counting additional shares would reduce the loss per share - a negative EPS would get smaller. This is referred to as being anti-dilutive. From the Sirius year-end 10K:

Due to the net loss for the years ended December 31, 2009 and 2008, common stock equivalents of approximately 3,381,905,000 and 787,000,000, respectively, were excluded from the calculation of diluted net loss per common share as the effect would have been anti-dilutive.

For those familiar with the company's performance in the past several quarters, it is known that there were positive earnings, so we know that this anti-dilutive element was not in play. Following is another part of the same paragraph from the 10K:

Diluted net income (loss) per common share adjusts the weighted average common shares outstanding for the potential dilution that could occur if common stock equivalents (convertible debt and preferred stock, warrants, stock options, restricted stock and restricted stock units) were exercised or converted into common stock, calculated using the treasury stock method. For the year ended December 31, 2010, common stock equivalents of approximately 689,922,000 were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive.

It's quite a mouthful, isn't it? What is clear is that there were 689,922,000 shares that were excluded from fully diluted share count at the end of 2010. We also know from the first quarter 10Q that "For the three months ended March 31, 2011... common stock equivalents of approximately 587,254,000 were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive." And from the second quarter 10Q we know that "Common stock equivalents of approximately 96,155,764... for the three months ended June 30, 2011 ... were excluded from the calculation of diluted net income per common share as the effect would have been anti-dilutive." As you can see, what is occurring is that in all these cases "common stock equivalents" are being excluded.

The FASB gives detailed procedures that are to be followed where there are stock options and convertible bonds. The company must take the options that are in the money - in other words, those that have an exercise price above the market price of the shares - at the end of the quarter. The company is then supposed to assume that it takes the money from the exercise of the option and goes out into the market and buys shares with the proceeds from the exercise of the option. This procedure is what Sirius referred to in the 10k as "using the treasury stock method." Perhaps an example will help.

Sirius shares were trading at $2.19 at the close of the quarter. This means that options which are exercisable at prices below $2.19 are assumed to be exercised. For this example, let's assume there are 10 million options exercisable at $2.00 per share. The treasury method referenced above says you assume the 10 million shares are purchased at the $2 exercise price and the treasurer now has $20 million in cash. The treasurer would now go out and buy $20 million worth of shares at the market price of $2.19, and is able to buy $20 million/2.19 = 9,132,420 shares. Because the company was only able to buy back 9,132,420 shares while at the same time it had to issue 10,000,000 new shares, there are now an extra 867,580 shares outstanding ( 10,000,000 - 9,132,420 = 867,580 shares). These 867,580 shares would be included in the diluted share count. [Note: This exercise would only be carried out if there are positive EPS, otherwise the result is anti-dilutive.]

(For more detail, check out this presentation by Paul Zarowin, a Professor of Accounting at the Stern School of Business, New York University.)

In the case of Sirius, there is also the issue of convertible debt. These include the 3.25% Convertible Notes due 2011 (which are convertible at the rate of $5.30, so I think we can safely assume that they won't be converted and are currently anti-dilutive) and the $550 million of 7% Exchangeable Senior Subordinated Notes due 2014. These are exchangeable into common stock at the rate of 533.3333 per note or at a per share price of $1.875. Since the $1.875 is below the $2.19 market price at the end of June, it is assumed the notes are converted for the purpose of calculating dilution. The 550,000 notes are assumed to convert into 293 million shares.

As you can see, the lion's share (more than 90%) of the 323 million additional shares have been identified as coming from the 7% Exchangeable Senior Subordinated Notes. The remaining difference is most likely due to a combination of the effect of using the treasury method of accounting for stock options, the closing share price of $2.19 at the end of the second quarter, newly issued stock options and using daily weighted averages. There was no sudden infusion of 300-plus million shares. The fully diluted share count could change each quarter, and if the share price is still below $1.875 on September 30th, the 293 million will "disappear." Unfortunately for all those conspiracy theorists out there, this is not some nefarious plot. It is simply the result of one group of folks wearing green eyeshades (the FASB) telling another group of folks wearing green eyeshades (David Frear's corporate accountants) how to calculate the number of fully diluted shares. And although that may be disappointing to some conspiracy fans out there, they can still take heart that at least Dr. Hodgins, the conspiracy geek from Bones, still got to marry the hot Angela.

Disclosure: I am long SIRI. I have $3 January 2012 covered calls against most of my Sirius position. I may add to my long position of SIRI at any time and might close or open covered call positions at any time.