I'm of the opinion that it's always important to consider what is possible when looking at investments. It's important to consider both positive and negative viewpoints and not shut oneself off from ideas that do not agree with our personal sentiment. This is not only healthy but in fact necessary if we wish to maintain a level perspective in the market.
Likewise, and in my opinion even more important, is considering the probable. An investor's ability to consider the probable is where an investor makes money. It's all well and good to discuss the various possible scenarios that could play out a week, month, year, and decade from now, but it's the ability to make the right bet on the probable side that is the most important.
I like to take an approach when investing that asks a simple question. "If I were _____, what would make the most sense?" Fill in the blank with an person or entity that you expect to take action which will have a material effect on your investment. I've done this with regards to my only investment I hold at the moment, Sirius XM (SIRI), by filling in that blank with Liberty Media (LMCA).
As many investors in Sirius XM know, the company is in the middle of a potential takeover by Liberty Media. This year Liberty has taken its stake in Sirius XM from 40% to 49.6% and is currently awaiting FCC approval to go to over 50% control. Many questions abound as to what course of action Liberty Media will be taking once Liberty has control of Sirius XM.
It's important to question what will happen because if you are a Sirius XM investor, Liberty's actions after going to control will have direct consequences on the share price of Sirius XM, and thus the value of your investment in the company. As of now there's a lot of talk and really no "right" or "wrong" answers. Anything is possible. It's my job as an investor to decide what is probable.
And what is probable, to me, is whatever is most lucrative for Liberty Media. Because of this I must put myself in Liberty's shoes for a bit and ask "what makes the most sense?"
Let's examine some important points of reasonable expectation based on common opinion and knowledge:
- Liberty Media will likely pursue a Sirius XM share buyback plan.
- This share buyback plan will be funded through current Sirius XM cash and future Sirius XM cash flow, as well as increased Sirius XM debt.
- 24 months from control, or roughly the end of 2014, should be the longest duration of this plan
- After the share buyback, Liberty Media may pursue a reverse Morris trust transaction to gain a tax free spin of Sirius XM.
- Liberty Media has stated it prefers not to spin high basis stock in an RMT and would likely participate in the buyback to get the cash back on the high basis shares (currently around 10% of Sirius XM's cap).
Because the purpose of this article is not specifics, but rather a general idea, I am using rounded numbers where I can for simplicity sake as they will not change the concept I wish to communicate.
When thinking about the probable instead of the possible, I'm required to make some assumptions.
- Liberty Media will do what is best for Liberty Media, not Sirius XM
- Liberty Media will be careful with Sirius XM as Liberty's investment in Sirius XM is worth nearly $9 billion, or around 73% of Liberty Media's market cap.
I believe both assumptions are fair assumptions to make. If one assumes that both assumptions are true, then the result should be the following :
- Before an RMT is performed, Liberty Media will do what is best for Sirius XM, because what is best for Sirius XM is best for Liberty Media.
- Within an RMT, because Sirius XM is still spun out to Liberty Media share holders, Liberty Media will wish to spin a healthy company.
If this makes sense to you, then we're on the same page. If it doesn't make sense, or you disagree, I'm sure you will let me have it in the comment section.
Because of this I expect a Sirius XM share repurchase program initiated once Liberty Media goes to control to keep Sirius XM's credit rating stable. I do not expect this program to introduce debt beyond what Sirius XM can handle in terms of repayment. In other words, I do not expect that Liberty Media will increase leverage to the point that Sirius XM receives a damaging credit rating downgrade within the next two years. I expect that leverage will be brought up considerably, but I do not believe it will be brought up to the point that S&P downgrades Sirius XM's credit rating.
Is it possible that Liberty Media over leverages, brings down Sirius XM's credit rating, and then spins the company after extracting as much cash as possible? Of course it's possible. Is it probable? No. Why? It goes right back to the fact that Sirius XM is such a giant part of Liberty and because I hold the assumption as true that Liberty does not wish to damage Sirius XM.
What I feel makes the most sense, is for Liberty to leverage Sirius XM to reasonable levels.
Some of you may be asking at this point how Liberty will be able to manage keeping leverage at reasonable levels while simultaneously selling back all of its high basis stock on a 1:1 ratio within a buyback plan. Under current share counts this will require nearly 1.3 billion shares to be repurchased, or 20% of the outstanding share count. At today's price of $2.82 this would require roughly $3.67 billion. While this should easily be handled, it is unreasonable to expect that Sirius XM will be able to purchase all 1.3 billion shares at $2.82. Prices will increase, generally, under a share buyback program, as well as over time due to expected performance of Sirius XM.
If it is assumed that a $4 price target is reached, and used as a median for the price at which shares are repurchased, 1.3 billion shares now will cost $5.2 billion to buy back. Does this number present concern? Certainly, if you are under the assumption that Liberty's intentions are to, under all circumstances, sell back 100% of its high basis share count. Adding the majority of $5.2 billion to Sirius XM's debt total would over leverage the company by most standards.
But I think a bit differently here. I don't believe that Liberty would over leverage and damage Sirius XM simply to get back 100% of its high basis stake. I believe Liberty may be content in stopping short on a share buyback program in order to preserve the health of Sirius XM, and thus the health of 73% (or what may eventually be an even greater percentage after Liberty is spun from Starz) of Liberty Media. At an average price of $4 per share on a buyback, in order to get its "bait" back on the high basis shares, Liberty does not actually have to sell back 100% of its high basis stake.
That's very important.
If one figures Liberty's high basis stake has a cost basis of roughly $2.25 per share, at $4 per share Liberty only has to sell back around 56% of these shares to get its "bait" back. Considering corporate taxes will be placed on the gains over $2.25 per share and must be covered, this figure increases to around 70% of bait shares that need to be sold to get back said bait. As the share price of Sirius XM increases? Less shares must be sold back! Why is that important? This erases the problems associated with an increasing share price (and what a wonderful "problem" that is to have!) What's important is the total cost of the bait shares, and not the total shares purchased as bait.
Keep in mind this is a very general approximation and used only to convey the idea that Liberty has some breathing room. The numbers are not the important part here, but I believe the concept is extremely important. Liberty Media is virtually ensured that it will get 100% of its bait back, and quite possibly more, without selling back 100% of the bait. That gives Liberty Media and thus Sirius XM a very large margin of safety and flexibility within Sirius XM's buyback plan.
To put it simply, Sirius XM's share price can go to the moon, and Liberty Media can extract its "bait" money, and spin the rest.
Liberty Media may even make the choice once it has its bait back, to stop participating in the buyback plan and instead allow the buyback plan to purchase and retire shares only from the common float. This option is available to Liberty especially if it believes the share price to be low and allows them to reap additional rewards of appreciation and grow its stake in Sirius XM.
Thus I believe the following to be the most probable scenario for Sirius XM for the next two years.
- Liberty Media will obtain control of Sirius XM.
- Liberty Media will institute a share buyback plan within Sirius XM.
- To accomplish share buybacks, Liberty Media will use Sirius XM cash on hand, future cash flow, and loans to reduce shares outstanding.
- Liberty Media will participate on a 1:1 basis in this plan in order to extract the funds paid on the high basis "bait" shares.
- Liberty Media will protect Sirius XM as its greatest asset, keeping leverage to levels which do not impact Sirius XM's credit rating in a negative fashion, even if this means not selling back every single one of its high basis shares.
- Liberty Media will eventually spin a healthy Sirius XM in a RMT tax free transaction on its remaining stake.
Because of this I expect considerable appreciation in the value of Sirius XM shares over the next two years. This is because of the performance of the underlying company which will be kept healthy and perhaps even accelerated under Liberty Media, and the increases in share price brought on by a reduction in the share count through a buyback plan.
What's good for Sirius XM, is good for Liberty Media.
Disclosure: I am long SIRI.