Some Sirius XM Investors Just Don't Get It

| About: Sirius XM (SIRI)

Some Sirius XM Radio (NASDAQ:SIRI) investors still refuse to grasp some of the risks surrounding their investment. They look at Liberty Media (NASDAQ:LMCA) buying more than 600 million shares of Sirius XM and seeking permission from the FCC to go to de jure of the company. They think that if John Malone, chairman of Liberty Media, is willing to spend well over a billion dollars to gain control Sirius XM, there must be a great deal of value in Sirius XM stock. After all, self-made billionaire Malone has personal wealth estimated to be $5.6 billion and he must know what he's doing.

The issue is not whether he knows what he is doing. I'm fairly certain he does. The issue is why he is doing it and what are his motives. In an article written more than two months ago about share buyback risks and debt, it was noted that Standard and Poor's had the following reaction.

There is significant uncertainty in relation to the financial policy that Liberty would pursue if it controls the board of Sirius XM.

...Without potential debt-financed share repurchases, we believe continued improvement in profitability will result in a further reduction in gross debt leverage to roughly 2.75x by year-end 2012, which we view as one element of an upgrade scenario to 'BB+'.

S&P went on to state that a near term upgrade would be unlikely until Liberty's financial strategies were better understood. In fact, although "not currently expected" S&P could possibly lower the Sirius XM rating to BB- if it believes Liberty would significantly increase leverage to 5.5x. The 5.5x is double the 2.75x leverage stated above.

The article recently drew a flurry of additional comments. The most recent one was by a frequent critic of the author, Gabriel Borenstein, who wrote:

Compared to whatever your exposure is in the Sirius,Malone is long the company . Do you think that he is a "masochist"?
Again your nonsense about the S&P - they were the first agency quoted as the market was declining in price as the Mel haters became Mel lovers and have utilized Mel's departure as a bearish argument. S&P's confirmation of the rating is a constructive reflection on Sirius which has now momentum of its own.
In fact Mel confirmed his belief in Sirius after his departure.
Reference to the leverage parameters basically defines the lever
which S&P thinks is business conducive .You just continue with your slanted Donald Duck conclusions .Let's give a spotlight to Malone and see his initiative . He has more at stake than you are .

I think Borenstein is one of those that choose to ignore the risks. Several points for Borenstein and others to consider:

  1. Malone, as a percentage of his personal wealth, has less at stake in Sirius XM than I - and I suspect many others - do. He owns 2.1% of Liberty, and at current share values, that represents about $266 million or 4.75% of his personal wealth. With Sirius XM reflecting about 2/3's of the value of Liberty, that indirectly puts Sirius XM at approximately 3.1% of his personal wealth. Currently, Sirius XM represents a significantly higher percentage of my personal wealth, so from that perspective, I have more at stake.
  2. No, I don't think Malone is a masochist. I think he is intelligent and predictable. (More on this later).
  3. S&P's "constructive" rating issued this week, included the following comments with respect to Mel Karmazin's departure: A) its rating and outlook on Sirius XM (BB/Stable/--) is currently unaffected by the announcement, B) Liberty could pursue a more aggressive financial policy, C) S&P does not think leverage will increase above S&P's 4.5x target, D) S&P currently measures the leverage at Sirius XM at 3.2x, adjusted for the redemption of the two debt issues, and E) the S&P measure is based on Gross Debt and is adjusted for leases. S&P could lower the debt to BB- if the leverage is going to increase above 4.5x on a sustained basis. This is a clear warning that S&P is concerned about a significant increase in leverage at Sirius XM, and it is probably measuring leverage in a manner that is far more conservative than Liberty's measure of leverage. I don't view this as particularly "constructive."
  4. As to "Mel confirmed his belief in Sirius after his departure." Since Mel still has 30 million options left to vest, and since he owns another 8.8 million shares, does anyone really think that he would state anything else? (For the record, I do not think Karmazin's staying or departing has any impact on the stock.)

"Let's give a spotlight to Malone and see his initiative."

Investing is all about the future. It is about the future prospects of a company. It is about the future sustainability and growth of dividends. It is about the future price of the company's stock. In this case, it includes the future plans of Malone for Sirius XM. And, often, those plans can be gleaned from looking at history or simply listening to the leadership.

Malone and Greg Maffei, Liberty CEO, have been quite blunt about wanting to get back the money that was (and will be) spent to get to a majority stake in Sirius XM. That figure is roughly $1.5 billion to acquire nearly 611 million shares. Maffei has also stated that "we would be unlikely to want to spin out high basis stock." Finally, they also stated that the time frame to recover the funds could be 18-24 months.

Investors need to consider that time frame and why Liberty wants to get the cash back that was spent to go to majority. If Liberty intended to keep Sirius XM or acquire the entire company, there would be no need to pull the cash out. And if Liberty does not want to keep Sirius XM, investors should ask, "Why doesn't that astute investor, John Malone, want to keep Sirius XM?"

"Do you think that he is a "masochist"?"

No, I don't think he is a masochist. More importantly, I don't think he wants to take any more risk with his investment in Sirius XM or pay large taxes on the gain. His objectives may be very different than mine.

Earlier this week, headybaldguy wrote:

I look forward to your prognostications on the direction that Liberty takes once it obtains de jure control of SXM.

For both Borenstein and headybaldguy, my view of the Liberty/Malone plans are as follow:

Malone has an asset - Sirius XM - that he can NOT monetize without serious additional capital infusion or incurring a substantial tax liability. Were he to sell the asset, Liberty would have a large tax liability. If Liberty distributed Sirius shares to Liberty shareholders, Liberty incurs a large tax liability. So, what does he do?

He goes to a majority position to set up a Reverse Morris Trust. The RMT is a tax avoidance scheme that allows the shares to be distributed to Liberty shareholders in a tax-free transaction. But to qualify, Liberty needs to get to a majority position and be there at the time of the RMT. Why else does anyone think Liberty is spending more than a billion dollars to increase their ownership?

Malone has also indicated that he wants a premium and that he wants to get his money back on the high cost shares that he had to buy to get to that majority position. Do you think he wants to wait forever? I don't. I think he feels he has waited long enough -- it's getting close to four years.

So, as quickly as it can possibly be done, I anticipate that Liberty will purchase enough additional shares to go to majority. At that point, Liberty can take control of the board, leverage up the debt (way above the levels that S&P would like, but a figure easily handled by the free cash flow generated by Sirius XM), and begins a share buyback with Liberty participating. Liberty will be careful to keep its ownership above 50%. Once Liberty has sold its 611 million (or more) shares of "high basis stock," it will quickly move for the implementation of a Reverse Morris Trust, and spin the remaining shares to Liberty shareholders. As part of the RMT process, I expect the Liberty shareholders to get a premium.


Assuming the FCC grants Liberty the right to go to de jure control, Malone and Liberty will begin actions that maximize the return for Liberty shareholders. These actions would lead to a significant increase in the debt and interest expense at Sirius XM, and potentially cause a downgrade by S&P, but will be easily handled by the company's free cash flow. Long term investors in Sirius XM will likely see higher prices in the future, but the actions by Malone and Liberty can be expected to cause significant volatility.

I view this as a financial engineering transaction, rather than some long term strategic action by Liberty or Malone. Will this benefit Sirius XM shareholders? It is difficult to know, but I suspect that investors will find that Sirius XM will overpay for the shares purchased in the buyback. On the other hand, I expect that Liberty and Malone will do quite well.

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 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.