It has been fascinating to sit back "quietly" the past week and read the speculative articles and comments about why Sirius XM Radio (NASDAQ:SIRI) and Liberty Media (NASDAQ:LMCA) should be pushing for a share buyback by Sirius XM. I read about how it is better if the share buyback starts quickly while the shares are still "cheap." I read about how the share buyback will cause a run-up in the price of the shares to $4 or more, or about its impact on the 7% exchangeable notes, or how Liberty wants to take de jure control, but will be satisfied to sit at an ownership position of less than 50%, or about the cost of a buyback, or how Liberty wants to protect the price of Sirius XM - its most valuable asset, or.... And, then I foolishly try to apply my own sense of logic to these scenarios.
Start the Buyback Quickly
It appears that analysts and Sirius XM investors want a share buyback to begin as quickly as possible. They focus on quotes by Liberty executives Greg Maffei and John Malone at Liberty's recent investor conference where they indicated that Liberty would be willing to participate in a buyback to keep their ownership from going above 50% - a stumbling block that had served as a deterrent to Sirius XM starting a buyback. The statements by the executives brings to mind a frequent comment made by an attorney I used to work with while negotiating contracts: "Ignore it. It's like giving them the sleeves off your vest." Ignore the Liberty statement. It's a forward-looking statement, and can change at any time. Assuming Liberty is given FCC consent to go to de jure control, what happens? Liberty is NOT going to stay at 49.6%. Why? Because Liberty has already stated to the FCC in its application for consent to go to de jure control that:
...it will have purchased sufficient shares of Sirius' common stock and will convert its Preferred Shares such that the transfer of control will be completed within 60 days of Commission consent. However, Liberty Media will not convert its Preferred Shares in sufficient quantities to own more than 50% of the outstanding common stock of Sirius until the Commission grants its de jure transfer of control applications.
The point is, if Liberty is granted the right to go to de jure control, they are committing to go over 50% ownership within 60 days. Granted, Liberty may not stay there very long because going over 50% invokes the fundamental change of ownership bonus provision on the Sirius XM 7% Exchangeable Senior Subordinated Notes. The bonus shares could be the incentive that drives the conversion of the notes into more than 300 million newly issued shares of common stock prior to their December 1, 2014 maturity and the total of newly issued shares would push Liberty ownership back below 50%.
The 7% Exchangeable Senior Subordinated Note
The 7% note was going to disappear, one way or another, by December 1, 2014. Each of the 550,000 $1,000 notes is convertible into 533.3333 shares of Sirius XM (293 million total shares), or, at the equivalent price of $1.875/share. In the event of a "fundamental change" of ownership, a bonus provision is triggered. That change would occur if Liberty gets FCC approval AND Liberty takes either of the following actions:
- files a Schedule TO or any schedule, form or report under the Exchange Act disclosing that [Liberty] has become the direct or indirect "beneficial owner," as defined in Rule 13d-3 under the Exchange Act, of Sirius's common equity representing more than 50% of the voting power of the Sirius common equity, or
- the first day on which a majority of the members of the board of directors of Sirius does not consist of continuing directors (in other words, If Liberty replaces the board at the next annual meeting).
One or both of these actions seems likely to occur, and the number of bonus shares would increase the number of new shares from 293 million to approximately 320 million shares depending upon the price and timing of the fundamental change. There are some investors that view this as a positive for Sirius XM because it makes it more expensive for Liberty to proceed with its takeover. I fail to see the logic in this view. Liberty executives have made a number of statements about the share purchases, including this one by Maffei in response to a question about using a Reverse Morris Trust ("RMT") to spin out the Liberty stake in Sirius XM:
...I would note, if we pursued that path, something that would weigh on our mind is, we got the first 40% of the company for free virtually. The next 11 points have cost us well over $1 billion something if we got to 51. We would probably like to get the bait back on the 11 points.
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. We'd probably including this Starz transaction, we'd probably be wanting to get that cash back. So, that would be the biggest consideration in our minds, a major one.
If Liberty wants to get its cash back from the purchases of the "11 points" and doesn't want to spin out "high basis stock," how does this benefit Sirius XM investors? It makes the takeover a bit more expensive, but that should not be a deterrent to Liberty at this point. What else does Liberty want?
The Reverse Morris Trust
If Liberty is looking to eventually spin out Sirius XM using a Reverse Morris Trust, it must own more than 50% of Sirius XM and distribute that stake to Liberty shareholders. The RMT has been used before by Liberty to avoid taxes, so it seems logical that it is the path they would choose to take. And for those investors that think Liberty might not want to eventually spin out its stake in Sirius XM, consider this statement by Malone:
If I'm in control, I like to have separate companies, run independently, with public shareholders investing in that business ...There is no question eventually Sirius will be an independent company. The question is, in what time frame and in what circumstances?
If Liberty wants to get that cash back - and the amount of the cash spent keeps climbing - and Liberty wants to spin the shares using the RMT, what is the time frame, how big is the share buyback, and, most importantly, where does that cash come from? If Liberty wants to get its cash back within two years, and stay above 50% ownership, the only logical source for those funds is new debt - a lot of new debt. And how will this be good for Sirius XM shareholders?
The Cost To Keep Liberty Over 50%
Liberty has already purchased nearly 611 million common shares and spent nearly $1.4 billion. To go above 50% and stay there, it will need to purchase another 200 million shares to cover the potential conversion of the 7% note and the continued exercise of options. The incremental cost could approach an additional $600 million dollars and bring the total cash outlay by Liberty to nearly $2 billion.
Liberty management has expressed a desire to get their cash back for their share purchases. But does anyone really think that Liberty would sell their 611 million shares for $1.4 billion, or only $2.29/share when the market price would be $2.80-$3.00 or higher? And, if Liberty needs to purchase an additional 200 million shares, driving the total towards $2 billion, does anyone think Liberty would be satisfied to sell those 811 million shares for $2 billion, or only $2.47/share? Is that logical?
Take this one step further. The total number of shares that need to be repurchased to keep Liberty over 50% is more than 1.6 billion. What will be the average price paid per share? $3? $3.50? $4? Higher? This would be a total cost of $4.8 or $5.6 or $6.4 billion or more. The new debt required is significant enough to cause a downgrade of the Sirius XM debt rating.
And while you are thinking about this, consider the statements by Liberty about getting its cash out in 18 to 24 months and how that debt and the incremental interest expense might impact the share price.
Liberty Will Protect Its Most Valuable Asset - Sirius XM
Liberty will protect its most valuable asset, but that asset isn't Sirius XM. It's Liberty. Malone, as of Liberty's most recent proxy, despite owning only 2.1% of the common stock of Liberty, personally controls more than 40% of the voting power. What do you think is his primary concern? The future of Liberty or the future of Sirius XM? Here is a statement about Liberty's investment in Sirius XM from its 10-12B Registration Statement filed on October 19th:
On August 17, 2012, Liberty Media filed with the FCC an application for FCC consent to the transfer of de jure control of Sirius. Consistent with our previous public statements, we presently intend to acquire beneficial ownership of additional shares of Sirius common stock such that our beneficial ownership represents over 50% of Sirius' outstanding shares and, subject to receipt of FCC approval, seek to assert control over Sirius. By doing so, we believe we can enhance the value of our interest in Sirius for the benefit of our stockholders by, among other things, pursuing a transaction with or involving Sirius or our interest in Sirius.
The motivation to take control is to enhance the value of its investment for Liberty stockholders. Liberty stockholders clearly benefit from the RMT and Liberty avoiding a tax liability. Liberty stockholders could also benefit from extracting a premium from Sirius XM in the form of a larger ownership percentage for Liberty shareholders, or attaching debt or a dividend to the transaction as it is doing with Starz. Maffei made this comment relative to Starz:
Well, I think we are going to send [Starz] out with more leverage than it currently has today. Our expectation is that we'll pay a dividend of at least $1.8 billion up to between its existing cash at Starz and the availability of the revolver.
Liberty will focus on Liberty investors and worry less about its Sirius XM asset after it is separated from Liberty.
A Logical Scenario
If Liberty is to avoid taxes, Liberty needs to be granted permission to go to de jure control of Sirius XM and then Liberty needs to go to a majority position and set up a Reverse Morris Trust. How does Liberty accomplish this in 18-24 months? Liberty would begin loading Sirius up with debt to begin an expensive share buyback program. The buyback program needs to be significant enough to acquire the Liberty "high basis stock" and "get the bait back on the 11 points," as well as an equivalent number of non-Liberty shares to keep Liberty's ownership over 50%.
Liberty is no stranger to complex financial transactions, and its relationship with Sirius XM has many moving parts that are going to interact with each other. These include FCC approval, the fundamental change provisions of the 7% note, tax avoidance and the RMT. So, despite comments about participating in share buybacks to keep its investment below 50%, I don't see this happening unless their FCC application is rejected.
Overlay Liberty's objectives with the potential for changes in the tax laws, including bills that have been introduced to "restrict benefits of Reverse Morris Trust transactions by removing incentives to sell off assets tax free by creating spinoff companies that assume large amounts of debt," and there could be a desire to sell its shares into the buyback and spin out the Sirius XM asset quickly. And the faster it is spun out, the less time Sirius will have to generate cash and the more debt that will be needed for the purchase. Loading up Sirius XM with billions of dollars of new debt, while perhaps manageable, is hard to see as a plus for Sirius XM investors.
And none of this really addresses how the idea of a premium for Liberty would impact the share price of Sirius XM.
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 and $2.50 December covered calls. I may initiate (or close) a buy stock/sell option position in Sirius, at any time. Also, in addition to long term holdings, I have recently begun day-trading 10,000 share blocks of Sirius XM and may continue to do so. 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.