Earlier this week SiriusXM Radio (SIRI) CEO Mel Karmazin passed the midpoint of his previously announced 10b5-1 planned sale when he exercised another 7.6 million options and simultaneously sold the shares. In February Karmazin disclosed that he would be exercising 60 million of his options and selling the shares to fund his philanthropic endeavors. The two sales on the 15th and 18th bring the total sales to nearly 32 million shares.
For each of the past three months, Karmazin has sold the shares on two separate days during the middle of the month, and each sale has been at progressively lower prices. In April, the price was approximately $2.20 for 11.5 million shares, in May the price was approximately $1.98 for nearly 12.7 million shares and this week the 7.6 million shares were sold for approximately $1.84. Was it a coincidence that the shares rallied 4% to $1.91 the day after the sale was completed?
There have been several articles on Seeking Alpha about SiriusXM insiders exercising their Incentive Stock Options ("ISO") and selling their shares, depicting the moves as negative. Should investors be concerned about these types of transactions? According to Peter Lynch, who managed the Fidelity Magellan Fund to 29.2% annual returns for more than a decade, insider sales may not mean very much. One usually does not know the reason for the sale, and it may have nothing to do with the expected performance of the company or its stock. (On the other hand, he noted insider buying can have just one meaning - confidence in the future of the company.)
Insider selling could simply indicate a personal need for the money to fund an expensive purchase. Or, as stated in the case of Karmazin, to fund charitable efforts. ISOs have become a significant part of executive compensation, triggered in part by changes in the tax code that limited the deductibility of executive salaries in excess of $1 million. Unfortunately for the executives, ISOs can't be used to buy sports franchises, yachts, new homes, private jets or other fancy executive toys. They must first be exercised and the shares sold, creating insider selling activity.
Negatives of Insider Selling
That doesn't mean that Investors should ignore insider activity. When insiders execute ISOs and sell shares, the number of common shares outstanding increases. This causes some dilution in earnings per share ("EPS"), both on a diluted and non-diluted basis. It is obvious why there is dilution of EPS on a non-diluted basis - there are more common shares outstanding.
An investor might think that the diluted EPS shouldn't change. After all, one would think the diluted share count and diluted EPS should already take the conversion of options into account. This is not quite the way GAAP reporting works. When the diluted share count is calculated, there are specific rules followed with respect to options.
The following is an overview of the hypothetical transactions used to calculate the incremental diluted shares from options. First, ISOs that have an exercise price below the stock price at the close of the quarter become part of the diluted calculation. Second, the options are assumed to be exercised, with the proceeds from the exercise going to the company. Third, the company uses the proceeds to purchase shares on the open market (at the closing price at the end of the quarter.)
In the case of Sirius, where no share buybacks are taking place, step three never occurs. Consider that Karmazin is exercising options at a cost of $0.43 per share. When the diluted shares are calculated, the 32 million ISOs exercised by Karmazin would result in $13.8 million in funds going to Sirius. That money would hypothetically be used to purchase approximately 6 million shares, giving a net dilution effect of 26 million shares (the 32 million ISOs exercised less the hypothetical repurchase).
In reality, actual common shares outstanding have increased by 32 million. In addition, the diluted share count has also increased by 32 million, not the 26 million that would have been used in the diluted share count GAAP calculation. In the case of Sirius, the effect will be lost in rounding errors due to the billions of shares outstanding.
It will probably be beneficial to have Karmazin's selling completed as it will remove some of the selling pressure on the stock, but it seems as though investors will have to endure this for at least another three months. Regardless, the latest insider selling activity by Karmazin should not be of particular concern to long term investors in Sirius.
Interestingly, those investors that are not in favor of a takeover by Liberty Media (LMCA) might even view the selling as a small positive since the number of shares required for Liberty to get to a majority position increases slightly with more common shares now outstanding.
Disclosure: I am long SIRI.
Additional disclosure: I have $3 January 2013 covered calls against most of my Sirius position, as well as some $2 and $2.50 January 2013 covered calls. I may initiate (or close) a buy stock/sell option position in Sirius, discussed in another article, at any time. I have no positions, or any plans to open positions in the next 72 hours, in Liberty Media.