Many investors look at the recent announcements by Sirius XM Radio (NASDAQ:SIRI) to redeem some of its higher interest debt early as great news. The redemptions in September are $186.1 million of its 9.75% debt on September 1st and $681.5 million of its 13% debt on September 20th. This debt - frequently called toxic debt because of the high interest rates - has been an eyesore on the balance sheet and a flash-point for many critics of the company and its stock.
In other debt related news during the third quarter, the company floated a $400 million dollar bond issue maturing on August 15, 2022 at 5.25%. The low, long-term interest rate is a testament to the company's improved operating performance, cash balance and the overall low interest rate environment. The interest rate is a far cry from the $530 million 15% loan from Liberty Media (NASDAQ:LMCA) that had Sirius XM also relinquish 40% of the company to Liberty for $12,500.
Each of these three debt issues have ramifications to cash flow, leverage ratios and earnings over the next several years. There will be a particularly large hit to the upcoming third quarter earnings and cash balances. The following is an attempt to quantify the impact of each of these transactions on Q3 results.
The figures will not be precise, but will give investors an idea of what they can expect to see in the quarter. One figure that will be much more guess than calculation in this assessment is the total investment banking underwriting fees, commissions and expenses. These fees occur not only for the new debt issue, but are also typically incurred with redemptions. Nearly $1.3 billion of debt is involved in the third quarter transactions and a rate of 1% has been assumed and the fees are assumed to be an expense of $13 million.
For those who like details, there are plenty that follow. For those who are just interested in the net impact on Q3, skip to the Summary.
The 5.25% Debt
This issue was priced at 100%, meaning that the company received nearly all of the face value of the bonds, unlike the 9.75% and 13% (as well as several other) bonds of Sirius XM that were offered at a discount to the face value. According to the press release, there were certain fees and expenses associated with these bonds, although they were not specified:
The company will receive gross proceeds of $400 million from the sale of the notes before deducting the initial purchasers' commissions and estimated offering fees and expenses.
The press release also states:
Sirius XM intends to use the net proceeds from the offering for general corporate purposes, which may include, from time to time and as market conditions warrant, the repurchase, redemption, defeasance, tender or repayment of its outstanding indebtedness, including its 13% Senior Notes due 2013. Pending application of these amounts as provided above, Sirius XM currently expects to maintain any excess amount as cash on hand.
Since the announcement specifically addresses redemption of the 13% Senior Notes, the 5.25% interest expense will be considered in conjunction with the 13% notes for 2012 and 2013. Also, although the 5.25% debt may be called at any time, it is assumed that it will remain outstanding until maturity. This means that long after the 13% debt would - or could - have been paid off with cash on hand in either 2012 or 2013, the $21 million per year of interest will be an ongoing expense through 2021, and an expense of just over $13 million in 2022.
As to the third quarter of 2012, the 5.25% will accrue 1.5 months of interest expense, or $2.6 million. There will also be fees that I estimate at $4 million. In the fourth quarter there will be an additional interest expense from this debt of $5.25 million. I can already hear the shouts, "What about the savings from eliminating 13% debt!"
The 13% Debt
Okay, what about the savings on the 13% debt? This can be looked at in a variety of ways. First, the 13% debt could have been paid off with cash on hand. The Q2 balance sheet showed cash on hand of $868.3 million. So without the debt transactions, cash on hand at the end of Q2, added to the expected free cash flow in Q3, would have been close to the total debt retirement costs for both the 13% debt and the 9.75% debt. It would not be prudent to leave the company with a near-zero cash balance, but it could have been done with aggressive cash management, and it certainly could have been done in Q4 or at any time in 2013.
Calculating the Total Payment
More importantly, not very much would be "saved" by retiring the 13% debt early. This is due to the redemption costs associated with the bond issue. According to the indenture the redemption costs are:
...equal to the greater of the following amounts:
(1) 100% of the principal amount of the Notes then outstanding to be so redeemed; and
(2) the sum of the present values of the principal amount and the remaining scheduled payments of interest on the Notes to be redeemed (not including any portion of payments of interest accrued as of the applicable redemption date), discounted to the applicable redemption date in accordance with customary market practice on a semi-annual basis at a rate equal to the sum of the Treasury Rate plus 0.50%,
(B) plus, in each of the above cases (A)(1) and (2), accrued and unpaid interest on the principal amount being redeemed to the applicable redemption date.
Quite a mouthful, isn't it? The fact is that with treasuries trading at very low rates, Item 2, above, they will generate the greater redemption amount. The indenture further defines the Treasury Rate as those treasury securities having "a maturity comparable to the remaining term of the Notes". Since the remaining term of the notes on the redemption date will be 10 months and 10 days, the discount factor will be between the yields on the 3 month and six month maturities for the interest payment due February 1st, and between the six month and one year rates for the interest and principal due August 1, 2013. The rates on these treasuries were 0.10%, 0.14% and 0.17% on August 30th. Adding 50 basis points leaves the discount factors below 0.67%.
The total cash to redeem the 13% notes will be in excess of 99.33% of the remaining payments. The remaining payments are the two semi-annual interest payments totaling 13% * $681.5 = $88.6 million plus the $681.5 million principal balance.
For the sake of simplicity, and because the differences will not be material, a total cash payment of 99.32% of the total expected future payments will be used. This figure understates the total payments for several reasons, including:
- no discount rates are to be applied to the accrued interest ($10.3 million for the period 8/1/2013 through the redemption date of 9/20/2013),
- the discount factors that should be applied are overstated since there are less than 181 days to the next interest payment and less than 12 months to the principal and final interest payment, although
- this is slightly offset by the fact that semi-annual compounding was ignored.
The total cash payment would be:
($681.5 million face value on 8/1/13 + $44.3 million interest on 2/1/13 + $44.3 million interest on 8/1/13) * .9932 = $764.9 million. Note that these are cash costs. The actual expenses that would be charged in Q3 will be different.
The difference between $764.9 million and the $681.5 million, or $83.4 million needs to be allocated to interest expense and "loss on extinguishment of debt" on the income statement.
Allocating the expenses
There are two types of expenses associated with the 13% bond in the Q3 - interest expense and loss on extinguishment of debt. In addition, there are two components to the interest expense. The first is from the semi-annual payment based on the 13% coupon rate and the face amount of the bond. The second is the amortization of the original bond discount, and will be discussed below. Each month, one twelfth of the annual interest (or $7.4 million) would accrue to interest expense, along with the amortization of the original bond discount. The Q3 coupon interest total would have been $22.2 million. Since the notes are being redeemed on September 20th, the interest expense for the quarter will instead be $19.7 million, a savings of $2.5 million. This savings will be dwarfed by the call premium.
Complicating the calculation of the call premium is that the "accrued interest" on the bond through September 20th is part of the total redemption payment calculated above. Since the bond holders received their previous interest payment on August 1st, one month and 20 days of interest will have accrued at redemption, or,
(1 2/3 months * 13%/12 months * $681.5 million principal) = $12.3 million.
So, the total payment ($764.9 million), less the payment for the face amount of the bonds ($681.5 million), less the portion of the payment representing the accrued interest ($12.3 million) is $71.0 million, and that would be charged to "Loss on extinguishment of debt."
In addition to this $71 million charge, there is also an additional charge associated with the original bond discount. This has been amortized each quarter, and at the end of Q2 the remaining unamortized amount was $24.6 million. A portion of this would have been amortized during Q3 and charged to interest expense, but because the entire bond issue is being called, the entire amount will be written down to zero, with the non-interest portion charged to "Loss on extinguishment of debt".
Note that something similar occurred in the first half of the year when Sirius XM purchased portions of the 13% bond issue. The second quarter 10Q showed:
During the three and six months ended June 30, 2012, we purchased $62,729 and $96,983, respectively, in aggregate principal amounts of the 13% Notes for an aggregate purchase price, inclusive of interest, of $73,616 and $113,226 , respectively. We recognized an aggregate loss on the extinguishment of the 13% Notes of $11,596 and $17,789, during the three and six months ended June 30, 2012 , respectively, consisting primarily of unamortized discount, deferred financing fees and repayment premium, to Loss on extinguishment of debt and credit facilities, net.
It seems accountants like to make things difficult. Instead of using straight line amortization, the preferred amortization treatment is something called the effective interest rate method:
Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond's book value at the beginning of the accounting period. This means that as a bond's book value increases, the amount of interest expense will increase.
The end result is that during each successive period, the amount of the amortization, and as a result the amount of the interest expense, will typically increase. In 2010, the amortization was $17 million, and in 2011 the amortization was $20.1 million. At the end of 2011 the unamortized discount was $39.5 million with only 19 months left before the bond would mature, and a reasonable estimate is that about $28 million would have been amortized in 2012, with approximately $7 million of that in Q3. Using the $7 million in Q3 as an interest expense, the remaining unamortized discount amount of $17.6 million ($24.6 million - $7 million) becomes an additional charge to "Loss on extinguishment of debt."
The total is now $17.6 million plus $71 million or $88.6 for the extinguishment of debt. If there are fees of 1% of the face value of the redemption, there would be another $6.8 million charge, bringing the total to $95.4 million in the third quarter.
Net impact of the 13% debt
The impact in Q3 should be more than $90 million in incremental expenses for the 13% bond. ($95.4 million offset by $2.5 million of interest savings by retiring the debt 10 days before the end of the quarter.) And, if one considers the $400 million of 5.25% debt as part of this transaction, then the additional $2.6 million of interest and the $4 million in fees should also be considered.
The total incremental expenses should be in the neighborhood of $90 - $100 million. And, regardless of whether the number is closer to $90 million or $100 million, it's a fairly expensive neighborhood.
On the cash side, the total cash payments in the third quarter would include the banking fees $10.8 million ($6.8 million on the 13% + $4 million on the 5.25%) and the redemption expenditure of $764.9 million, offset by the $400 million of cash from the new debt. The total would be a net cash usage of $376 million.
The 9.75% Debt
It has been expected that the 9.75% debt would be called for quite some time. Not only had this been discussed at analyst conferences this year, but Sirius XM CEO Mel Karmazin discussed the note on the February 9th conference call:
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.
A large portion of the The 9.75% debt - nearly $70.9 million of the $257 million issue - was purchased by the company in the first half of 2012. So, although there is still an impact on the Q3 earnings and cash balances, its impact will be somewhat less in the quarter than had been expected earlier in the year.
This debt has a simple call premium of 4.875% and was called exactly 3 years prior to maturity. As of the end of Q2, there was an unamortized discount of $5.3 million.
The call premium was $186.1 million * 4.875% = $9.1 million and will be charged to loss on extinguishment of debt in Q3. In addition, almost all of the remaining unamortized discount will be charged to extinguishment of debt. A small portion, estimated at $0.2 million, is assumed charged to interest expense in Q3. The investment banking fees have been estimated at $1.9 million.
The cash used in calling the 9.75% debt in Q3 is $186.1 million + $9.1 million + $1.9 million in fees = $197.1 million.
The incremental expenses on this debt that will be incurred in Q3 are $9.1 million call premium + $5.1 million write-down of unamortized discount + $1.9 million in fees = $16.1 million charged to loss on extinguishment of debt. This will be partially offset by saving one month of interest expense, or 9.75% * $186.1 million * 1/12 = $1.5 million, plus one month of amortization of $0.1 million.
Sirius XM will use a lot of cash and incur several expenses in the third quarter that investors may not have anticipated. It makes sense to ignore the expense impact of calling the 9.75% debt because it has been so well telegraphed since the early part of the year. However, the early redemption of the 13% notes will use $765 million of cash in addition to the $113 million spent to purchase some of these notes in the first half of 2012. From the same 10Q paragraph quoted above:
During the three and six months ended June 30, 2012 , we purchased (a portion of) ...the 13% Notes for an aggregate purchase price, inclusive of interest, of $73,616 and $113,226 , ...
That's a surprisingly large usage of cash this year - $878 million. Add to this the expenditures to rid the balance sheet of the 9.75%, and it may explain the borrowing of an additional $400 million of new 10 year 5.25% debt.
On the expense side, again ignoring the impact of calling the 9.75% debt on the assumption that most had already factored it in, there will be significant net incremental expenses from the 13% note redemption and the new 5.25% debt. The actions surrounding these two debt issues will add approximately $100 million of expenses in the third quarter, mostly under the early extinguishment of the debt line item.
Disclosure: I am long SIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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, at any time. I have no positions, or any plans to open positions in the next 72 hours, in any of the other companies mentioned in this article.