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There have been rumors for quite some time that this will be the year that Sirius XM (SIRI) returns capital to shareholders. Investors have been hoping that the company would offer either a share buyback or a dividend to the stockholders. On the conference call last Thursday, both CEO Mel Karmazin and Executive VP and CFO David Frear said the board will now consider this since the company will end the year with a boatload of cash:

Mel: Our ending cash balance in 2012 should be about $1.5 billion or about $1.2 billion if you assume we call the 9 3/4% notes this September. And our gross leverage will have fallen to under 3.2x. There is an opportunity for the Board of Directors to consider a return of capital to shareholders beginning later this year. The board has not taken up this topic, so obviously no decision has been made as yet.

Frear: Cash will expand to nearly $1.5 billion and net debt to EBITDA will fall to about 1.8x. During the course of the year, we will begin to evaluate returning capital to shareholders through dividends or stock buybacks. We expect to discuss our plans with you later in the year.

Although neither of them guarantee that investors will get the capital back this year, they certainly are leaning that way. They can not end 2012 with over a billion dollars in cash. This would set them up as a takeover target. So this article will assume that the board does approve a return on capital to shareholders and discuss the pros and cons of a stock buyback versus a dividend.

The most controversial of the two would be the buyback. There are numerous investors who feel that this would cause a sudden rise in the stock, followed by a fall when the buyback is over. However there are even more investors and analysts who think a buyback would strengthen the stock and therefore the company:

During market downturns, such as in a recession, an opportunity may arise for companies to purchase some of their own shares on-market and cancel them, hence reducing the overall number of shares on issue.

The effect of less shares means that the future earnings per share is likely to increase - which is a good look for the earnings per share bar graph in the next company report.

I will add to this that less shares also will make the P/E ratio lower than it would have been with more shares. The high P/E has been one of things scaring some investors away from Sirius XM. Consider this from an article written by fellow Seeking Alpha Contributor Vatalyst:

Generally, I like it when a company announces a share buyback program, since it is an indication that the company values its shares higher than the market does and it believes the investment offers the best possible return on investment for the cash they are holding. The value of shares in investors' hands should also increase as the earnings per share do.

If you are interested in researching stocks that have had success with buyback programs, Vatalyst's article is a good start. There are many types of buybacks and just as many ways to structure a buyback. The most popular would be a market repurchase of shares where the stock is bought in the open market at the current price. With this type of purchase Sirius could take advantage of buying the stock while having "insider information":

It is relatively easy for insiders to capture insider-trading like gains through the use of "open market repurchases." Such transactions are legal and generally encouraged by regulators through safe harbours against insider trading liability.

And this information does not have to be shared with the public. As long as the trades do not exceed a certain number of shares per day, Sirius XM can keep the timing of buybacks a secret. And they do not have to repurchase the entire amount of the buyback at once. It can be daily, monthly, yearly or any combination of these. There are many SEC guidelines and rules which include the stipulation that the company must use one broker so there is not the appearance of many different investors trying to purchase large amounts of the stock:

The section of the law concerning trading volume, which limits the amount of shares an issuer can purchase on a single trading day, has been streamlined after the same SEC amendments. It now requires that an issuer may simply not purchase shares exceeding 25 percent of the stock's four-week ADTV.

So this discounts the argument that investors will see the buyback and the subsequent rise in share price and then short the stock because it will fall when the buyback is over. If the buyback were announced and the share price were to fall, the company could take advantage of this and purchase more shares at an even lower price. Also, as noted above, the timing of a share buyback does not have to be announced. And Sirius XM can buy the stock based on information that only it is privy to. This also helps to protect Sirius XM from a takeover because the share price is higher:

Sometimes the best offense is a good defense... Beyond the prevailing wisdom of boosting earnings per share, buybacks are often anti-takeover measures as well.

Now the other way to return capital to shareholders is by paying a dividend. Many shareholders like a dividend because they receive the money and it can't be taken away. Usually a dividend is only a few cents per share paid quarterly. Many investors consider that a major drawback to a dividend is that it is taxable. Another concern is that once a dividend is started investors react very negatively when it stops. This then has a negative impact on the share price, and it is usually more than the few cents that the dividend paid.

I think that a buyback offers a much better option to Sirius XM investors. When the board announces a buyback, there is the probability of "instant gratification" because many investors will buy the stock knowing that the value will go up even higher than it would have anyway. So then not only will the price of the stock go up, but even if earnings remain the same, the EPS will go up and the P/E will go down, which will attract even more investors. And if the company were to stop the buyback program, it would not negatively impact the stock the way that ending a dividend program would. The EPS and P/E will remain "baked" into the price of the stock.

Source: Sirius XM: Buyback Versus Dividend