Why Sirius XM's $1.875 Convertible Bonds Will Be Exchanged

May.14.12 | About: Sirius XM (SIRI)

There has been a considerable amount of talk around the Sirius XM (NASDAQ:SIRI) campfire lately following Liberty Media's (NASDAQ:LMCA) disclosure that they had a forward contract for roughly 302 million shares of Sirius XM with an undisclosed third party.

One of the rumors being passed around is that this deal may be with the holders of the convertible bonds, and what that might mean for investors. My personal sentiment is that it would be rather beneficial for Liberty to make a deal for the convertible bonds, but I do not think they have them yet. Whether or not they do have them, investors should welcome the fact that they are likely to be exchanged early.

For those who are interested in the details surrounding the $1.875 convertible bonds, everything you could possibly ask for can be found here.

A bit of history on these bonds is as follows. In 2008 Sirius XM entered into an agreement and secured $550 million in financing in a deal which almost immediately destroyed the share price of Sirius XM, and assisted with sending it on a free fall to $0.05 per share in 2009. The reason for this is that the terms of the agreement provided for loaned shares from Sirius XM against the bonds, which the owners of the bonds could use to short the stock. They did just that, and almost immediately millions of shares of Sirius XM were shorted into the market in order for the bond holders to secure cash positions as a hedge. See the circles in the chart below for the rough time frame, and it should be fairly obvious.

When you look at the nasdaq short data, a very large part of the short position are shorts hedged against the long position in these bonds. How many? That's a question that is impossible to answer, but one can arrive at a reasonable assumption by looking at Sirius XM's lowest pricing last year, and the short data from that time. 10/14/2011, 252 million shares were short, and since then the number has been higher. For reference, refer back to this chart throughout the article.

If you read the details of the bond, there is an important clause which covers change of control in Sirius XM:

If you elect to exchange your Notes in connection with a corporate transaction that constitutes a fundamental change described in clause (1), (2), (3) or (6) of such term the exchange rate will be increased by an additional number of shares of Sirius common stock.

If a fundamental change occurs at any time, you will have the right, at your option, to require us to purchase for cash any or all of your Notes, or any portion of the principal amount thereof, that is equal to $1,000 or integral multiples of $1,000 in excess thereof. The price we are required to pay is equal to 100% of the principal amount of the Notes to be purchased plus accrued and unpaid interest to, but excluding, the fundamental change purchase date

Liberty obtaining over 50% of Sirius XM would constitute a fundamental change of control.

This gives the bond holders certain options. They may elect to take payment in the form of cash for the bonds based on the initial purchase price plus all as of yet unpaid interest (bi annual payment schedule), or they may exchange them for Sirius XM shares "early." This affords them an increased number of shares beyond the 533.33 each $1000 bond is tied to. By my calculation from the table included in the details of the bond, if one were to exchange the bond today they would receive an additional 98 shares for each bond for a total of 631. As time moves onward, this number will decrease by roughly 1 share per week.

Since the price of Sirius XM is over $1.875, a bond holder would almost certainly choose the option where they receive 631 shares per contract. What this will do is provide them with 533 shares to close out their short, and 98 shares as "interest." The result to Sirius XM is the removal of debt at zero cost. Does this dilute the stock? Yes, to an extent, but consider the benefits to Sirius XM in the closure of a massive short position and the reduction of debt by $550 million, lowering the debt to equity ratio considerably. If you expect Liberty to obtain control, then you can expect the bonds to be exchanged for shares early. Sirius retains their cash, and interest paid on the bonds at 7% is no longer paid out through 12/1/2014, saving Sirius XM nearly $100 million in the same time period.

The above is under the assumption that the bond holders at the time of change of control are not Liberty Media. My thought on this is that it would be extremely beneficial for Liberty to purchase the bonds from the bond holders in advance of taking a controlling stake in Sirius XM. Why would the bond holders sell to Liberty (if they have not already)? Because Liberty can offer them a better deal beyond the bond agreement and they can offer them cash guarantee. Why would Liberty want to pay a premium on the bonds? Because of what would ensue if the bond holders covered through the open market.

Consider Liberty purchases the bonds from the bond holders. The holders close out their short positions through purchases in the open market. This creates demand, and should drive up the share price. To what degree would remain to be seen. Liberty, as holder of the bonds will be interested in the 631 shares. As the share price is driven up, the value of the bonds increase. Since Liberty is not hedged short, they can take advantage of the share price appreciation unlike the majority of the current bond holders.

The result to Sirius XM in the scenario that Liberty gains control and holds the bonds, is that Sirius XM prints 631 shares per bond, and Liberty takes possession of those shares increasing their stake. $550 million is removed from debt, and there is a savings of roughly $100 million on interest payments.

The only way the bond holders, if they assume Liberty will be purchasing over 50% of Sirius XM, would not convert the bonds early would be if they believed the share price of Sirius XM would be below $1.875 between now and the expiration date of 12/1/2014 on the bonds. With the strong technical cup and handle formation that the stock is in right now this points to a large break to the upside. With improving fundamentals and guidance along with Liberty Media's willing to pay $2.15 each for millions of shares, it is unlikely that the stock will see a sharp decline in price without street interest, or interest by Liberty Media in fortifying their stake.

Another important number to watch is $1.50. If Liberty were to take control over 50%, and the share price were at $1.50 at this time, a holder of the bonds would receive 133 extra shares instead of 98. $1.50 presents the maximum "benefit" though it is unlikely that a short attack on the stock to drive it down to this price would be cost effective for the possible gains involved, and thus unlikely that this will happen.

Regardless of what happens, shareholders should be aware that after a change of control, that these bonds are very likely to be exchanged. They have been a thorn in the side of Sirius XM for a very long time, and once they are gone each and every investor should be thankful. The small amount of dilution this will cause by getting rid of them early, will be paid off with far greater reward for Sirius XM moving forward. The removal of a massive shorting "hedge" will also be highly beneficial and shareholders should watch the short interest after this happens, and smile at the huge reduction in short positions.

Disclosure: I am long SIRI, LMCA.

Additional disclosure: I am long June $2 SIRI calls.