If you are a long term investor in Sirius XM (SIRI) you are well aware that Liberty Media (LMCA) is on the cusp of gaining control of the company. In most circles the goal of Liberty Media has been to conduct a Reverse Morris Trust (RMT) and garner the tax advantages associated with such a move. In essence, an RMT is when a larger company merges into a smaller one with the smaller one being the surviving entity. With Liberty and Sirius XM it would involve the lager SIRI stake Liberty holds (let's call it LSAT) with the smaller SIRI.
As Liberty has moved closer, it appears that many investors were taken by surprise when Liberty indicated that it could be patient with its moves on Sirius XM. The reason behind the surprise of many investors seems odd, given that Liberty has stated several times that it could be patient. In addition, there are some very good and compelling reasons why Liberty can be patient.
Liberty Wants To Participate In Leverage
For months now Liberty Media has indicated that Sirius XM is under levered. What this means is that Liberty Media feels that Sirius XM can add debt. That is not necessarily a bad thing. It all depends on whether the company can handle the debt, what the terms of the debt are, and what the company does with the funds collected from issuing new debt.
"...we've increased our shares, we find them, we've bought at attractive prices, we find the increased ownership and influence at Sirius rather attractive and we'll decide ultimately how we wish to proceed with that stake. Our view is that Sirius is under-leveraged and there's plenty of opportunity for share repurchase and other financial actions of the Company, which we deem as ultimately positive and being a shareholder, an increased shareholder in Sirius is a good thing." - Greg Maffei at the Liberty Media Q2 Conference Call
The popular reason that most conclude from this information is that Sirius XM will take on more debt in order to conduct share buybacks. Essentially, there are some moves that can be made by Sirius XM that will increase value. Liberty Media wants to participate in that increase for a few reasons.
If we assume that Liberty Media gets control at 50.1% of the shares, there are still dilutive activities that can happen that would jeopardize the Liberty majority position. Sirius XM has, among other things, 7% convertible notes out there that have about 300 million shares attached to them. If those notes were to convert, Liberty Media would no longer be in a majority position.
One way to alleviate that problem is for Sirius XM to conduct a share buy back and for Liberty Media to not participate in that move. This is where additional leverage comes into play.
Let's assume that Sirius XM borrows $2 billion for the purpose of a share buyback, and the company guides to EBITDA in 2013 as being $1.1 billion. The debt to EBITDA ratio would be right around 4 to 1 ($4.4 billion in debt to $1.1 billion in EBITDA). This is higher than Sirius XM CEO Mel Karmazin likes to see (he prefers 3 to 1), but in line with statements made by Liberty Media (they said the company was under levered when the ratio was 3.5 to 1).
If Sirius XM were to combine the $2 billion in debt with $800 million in cash, it would have $2.8 billion to conduct share buy backs. If the company were to buy back shares at an average of $3, it could remove 933 million shares from the market. If Liberty did not sell any shares, its stake would be 55% instead of 50.1%. This would provide insulation from any dilutive activities (such as the 7% convertible notes) taking Liberty under 50%. In addition, it would increase a theoretical premium (on an absolute basis) that Liberty can receive when an RMT is conducted (more on that later).
Liberty Wants $1.5 Billion Back And SIRI Is Generating Lots Of Free Cash Flow
Liberty Media has also expressed that it wants to recapture some $1.5 billion that it had to invest into common shares in order to get a majority position in Sirius XM. Essentially, using round numbers, Liberty will have bought 700 million common shares. Liberty CEO Greg Maffei has indicated that the company wants to get that money back, so it is only natural to figure out the path by which that happens.
"There's not only borrowing capacity today. Our anticipation is over the next several years there generate billions of dollars shielded by the NOLs with decreasing leverage and the bulk of the CapEx necessary for the satellite launches and the like are having already been spent. So, this is going to be a huge free cash flow generator. So I think this is not a case where we look and say, we need to be conservative with our cash or their cash by issuing stock, it's quite the opposite." - Greg Maffei at Liberty Media Q2 Conference Call
As you can imagine, Sirius XM is doing quite well and is generating a lot of Free Cash Flow (FCF). Combine that comment with the one below and you can begin to understand what might happen:
"We've noted that there is flexibility in the capital structure at Sirius, there's plenty of availability for them over the next short-term to lever further and return capital to shareholders including ourselves, and whatever we did, we would be unlikely to want to spin out high basis stock, we'd probably, given how much we've already shrunk Liberty Media over the last several years... including this Starz transaction...be wanting to get that cash back. So, that would be the biggest consideration in our minds, a major one." - Greg Maffei at Liberty Media Q2 Conference Call
So what does this mean? In my opinion it means that Liberty still needs to be patient for a bit longer before doing a Reverse Morris Trust. In step one above, Liberty Media used share buybacks to cement its position as the majority holder. Step two is getting back the $1.5 billion it invested into common. That can happen with another round of share buy backs.
This new round of buybacks can be accomplished by Sirius XM using Free Cash Flow and debt. If we assume that in the second half of 2013 that the company is able to generate $75 million per month in FCF, then over 12 months the company could get close to another $1 billion to buy back shares with. If the company guides to EBITDA in 2014 of #1.4 billion, then another $1 billion could be borrowed and the debt to EBITDA ratio would remain at 4 to 1.
At an average price of $3.50 per share, the company could buy back another 533 million shares with $2 billion (half from cash, half from new debt). If Liberty were to sell at a 50/50 split with the common holders, it would get back about $1 billion of its investment and still be the majority holder in the company. In fact, Liberty will never have to sell all of its 700 million common shares that it purchased on the market to get to a controlling position in the first place.
At This Point Liberty Has Options
Once Liberty gets its cash back out, and the company is levered to the level that maximizes potential, Liberty can evaluate its position and take any number of paths. One could be a Reverse Morris Trust where Liberty exacts a small premium for its stake. Another is to continue to wait. A lot can happen in the next 12 to 24 months that could change the Liberty strategy on a dime.
The bottom line is that Liberty can be patient because it wants to maximize its position. Part of that position is the common stock Liberty bought, but the golden egg is in the 40% preferred stake Liberty essentially got for free.