Sirius Takeover Talk? Why Liberty Media Holds All The Cards

Nov.29.11 | About: Sirius XM (SIRI)

This recent NY Post article with the sub-heading "Malone May Up Stake" has again raised the issue about whether or not Liberty Media (LCAPA) will make a takeover attempt of Sirius XM (NASDAQ:SIRI) in the near future. I remain firmly in the camp that feels such a takeover will happen sooner rather than later. I base my view on the following:

  • A takeover of Sirius would not be significantly different than past Liberty transactions

  • Sirius has been building up cash and will be generating significant additional amounts of free cash flow in the near to medium term

  • Sirius has a substantial net operating loss (NOL) carryforward that will shelter income from cash tax payments for several years

  • Sirius stock seems cheap today

  • Liberty has increased its credit lines and changed its capital structure to make its stock more attractive as a takeover currency

  • All restrictions on a takeover by Liberty expire in March of 2012

I have noticed many recent comments on Seeking Alpha and elsewhere about what Liberty can't do or won't do. Obviously, no one can predict exactly what Liberty won't do. And, similar to the standard mutual fund disclaimer "Past performance is no guarantee of future results," one can't "guarantee" that Liberty's past actions will be replicated in the future when it comes to its stake in Sirius. But, like mutual fund past performance, it is one of the few guides investors have for predicting the future.

In the past, Liberty executed a complex transaction with DirecTV (DTV) that is in some ways similar to its interest in Sirius. In early 2008 Liberty acquired a 41% stake in DirecTV. It subsequently increased that stake to 48% a few months later. On May 4, 2009, Liberty issued a press release titled "DIRECTV Group and Liberty Media Corporation Announce Combination." The release discusses the proposed combination and subsequent split-off of DirecTV. Will Liberty follow the same path with Sirius?

Since an acquisition would not be out of character for Liberty, an investor needs to ask what the primary drivers would be. The drivers for Liberty shouldn't be much different than those of many other investors, and that means it's probably all about the cash flow. According to the earnings announcement and the following statement by David Frear, SiriusXM's Executive Vice President and Chief Financial Officer, Sirius "... ended the third quarter with more than $600 million of cash and cash equivalents." With free cash flow (FCF) in Q4 expected to exceed more than $200 million and 2012 forecast to be $700 million, the near term cash and cash flow are powerful drivers. Part of the reason for the large FCF is the Sirius's large NOL carryforward (nearly $8 billion) that will minimize cash taxes for several years.

Arguments that Liberty gets a benefit from the FCF and NOLs through its 40% ownership are valid, but only up to a point. Without a takeover, Liberty can not use the NOLs to shelter its own income or dictate the use of the FCF. Liberty can provide input on the use of FCF through its board representation, and can exert additional controls through rights acquired in the agreements governing the loan and preferred shares entered into in the first quarter of 2009, but Liberty does not have the absolute control that outright ownership of Sirius would provide.

Takeovers structured to take advantage of the NOLs can be used not only to shelter the income of Sirius, but also the income produced by other assets of Liberty. In addition, Liberty would be able to use the FCF generated by Sirius for other potential Liberty projects. These are a pair of important reasons for Liberty to engineer a takeover of Sirius.

Would Sirius be anxious to enter into this type of agreement? Probably not. The company's brush with bankruptcy that drove the agreements with Liberty probably bruised some egos. To now lose autonomy when it appears that the company has reached a solid position would seem to be adding insult to injury. Is there anything that Sirius can do to prevent it?

Not much, it would appear. The Certificate of Designations of Convertible Perpetual Preferred Stock, Series B-1 of Sirius XM Radio Inc. gives certain rights to Liberty and takes rights away from Sirius. The Certificate provides that as long as Liberty beneficially owns at least half of its initial equity stake, Sirius will need Liberty's consent for certain actions, including:

  • the grant or issuance of Sirius equity securities

  • any merger or sale of all or substantially all of the Sirius assets

  • any acquisition or disposition of assets other than in the ordinary course of business above certain thresholds

  • the incurrence of debt in amounts greater than a stated threshold

  • engaging in a business different than the business currently conducted by Sirius

  • amending the Sirius certificate of incorporation or by-laws in a manner that materially adversely affects the holders of the preferred stock

Some of the defense mechanisms that companies use to prevent a takeover include poison pills, taking on large acquisitions, selling off a major portion of assets and taking on large amounts of debt to pay out a special dividend. The above Liberty rights prevent most of these types of unilateral arrangements. For instance, part of Section 12 states:

(e) any incurrence of indebtedness, or the assumption or guarantee of the obligations of any person, other than (i) the incurrence, assumption or guarantee of indebtedness not in excess of $10,000,000 per calendar year...

This clause would preclude taking on large incremental debt ($10 million is less than a penny a share) to pay out a special dividend. Similarly, buying an unrelated business would be precluded due to provisions that limit acquisitions. Poison pills involving rights or warrants typically require amending the corporate by-laws or certificate of incorporation. Also, there is the following Anti-Takeover Provision that appears to prevent Sirius (the "Issuer") from adopting a poison pill that would apply to Liberty (the "Purchaser"):

In addition, the Investment Agreement prohibits the Issuer from (i) amending, modifying or rescinding the Section 203 Resolutions, (ii) adopting any rights plan or charter or bylaw provision that would materially adversely affect Purchaser’s ability to acquire or dispose of the Issuer’s equity securities to a Liberty Party (as defined in the Investment Agreement) or in block transactions (after the third anniversary of the Closing Date), or that otherwise would impose material economic burdens on Purchaser’s ability to do so.

One additional point on a proposed takeover by Liberty. The 13D filing regarding the original investment agreement had a series of "standstill" provisions. These included certain restrictions during the first three years following the execution of the agreement:

Until the second anniversary of the Closing Date, without the prior written approval of the Independent Common Directors ... none of Purchaser or any of its affiliates may, directly or indirectly, acquire, offer or propose to acquire or agree to acquire beneficial ownership of any Common Stock if such acquisition will result in Purchaser and its affiliates having beneficial ownership of 49.9% or more of the outstanding shares of Common Stock.

AND

From the second anniversary of the Closing Date through the third anniversary of the Closing Date, without the prior written approval of the Independent Common Directors, none of Purchaser or any of its affiliates may, directly or indirectly, acquire, offer or propose to acquire or agree to acquire beneficial ownership of any Common Stock if such acquisition will result in Purchaser and its affiliates having beneficial ownership of 49.9% or more of the outstanding shares of Common Stock, unless such acquisition or offer or agreement is made pursuant to a cash tender offer for all the outstanding shares of Common Stock that are not then beneficially owned by Purchaser or its affiliates at a price per share greater than the closing price of Common Stock on the trading day immediately prior to the earlier of the public announcement or commencement of such tender offer.

The inclusion of these provisions clearly take into consideration the possibility that Liberty would want to be able to acquire Sirius. They allowed Liberty to acquire up to 49.9% of Sirius at any time during the first two years, and, with the approval of the independent directors, permitted a full acquisition. After the second anniversary, Liberty did not even need approval to make a full acquisition under certain conditions. And, with the third anniversary rapidly approaching, Liberty will soon have even more freedom in the way it can structure a Sirius takeover.

As I stated earlier, no one can guarantee that Liberty's past actions will be replicated in the future when it comes to its stake in Sirius. But, like mutual fund past performance, it is one of the few guides investors have for predicting the future. And it certainly seems as though Liberty holds all the cards at this time.

Disclosure: I am long SIRI.

Additional disclosure: 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. I have no positions in any of the other stocks mentioned in this article.