One of the less understood aspects of Sirius XM Holdings (NASDAQ:SIRI) is the 7% Exchangeable Notes ("Notes") due to mature on December 1st of this year. $550 million dollars of Notes were issued in August 2008, with the holders having the right to exchange each $1000 Note to 533.3333 shares at any time, equivalent to an approximate conversion price of $1.875. The Notes had two significant contingencies that affected the exchange ratio - provisions for a change of control and issuance of dividends - both of which have occurred (more on this below).
These Notes are often cited when the issue of the short interest of Sirius is brought up. Investors should be aware that:
To facilitate the offering of the Exchangeable Notes, we [Sirius] entered into share lending agreements with Morgan Stanley Capital Services Inc. ("MS") and UBS AG London Branch ("UBS") in July 2008, under which we loaned MS and UBS an aggregate of 262,400,000 shares of our common stock in exchange for a fee of $0.001 per share.
Those shares have since been returned, although it has been widely speculated that they were replaced with other borrowed shares and represent a significant portion of the short interest posted every two weeks by NASDAQ. As of April 30th, the short interest for Sirius was 215,116,208 shares. So, how many shares are currently "behind" the 7% Notes?
Originally, when the $550 million was issued, there were 533.3333 shares behind each Note, or a total of 293.3 million shares. This number increased when Sirius issued its $0.05 dividend in late 2012. That dividend altered the exchange ratio to 543.1372 shares per Note and the equivalent conversion price to approximately $1.841 per share.
Then, in early 2013, Liberty Media (LMCA) went to majority control of Sirius and put its own board in place, triggering the change of control provision. The provision required Sirius to offer the holders of the Notes the right to redeem the Notes for cash plus accrued interest (highly unlikely since the Notes were trading at more than $1800 at the time) or an exchange rate premium. The premium was based on a predetermined calculation that took into account time to maturity and the then current share price. That premium was to offer the holder of the Notes the right to:
...exchange his or her Notes for the Company's common stock, par value $0.001 per share (the " Common Stock "), at an exchange rate of 581.3112 shares per $1,000 principal amount of Notes...
As you can see, the premium was 38.174 additional shares per Note. Holders of the Notes were unimpressed, and
only $47,630,000 in principal amount of the Notes was exchanged, and it resulted in the issuance of 27,687,850 shares of Common Stock. The $47,630,000 represents 8.7% of the $550 million debt issue.
The window to take advantage of the premium lasted only 30 days and has long since expired. There is currently a balance of $502.37 million worth of Notes than can be converted into approximately 272,855,835 shares.
This debt is shown on the 10Q balance sheet under two line items in the current liabilities section:
- Current maturities of long-term debt: 497,516,000
- Current maturities of long-term related party debt: $10,970,000
(You will find that the total of these two lines is greater than the principal amount due to the unamortized discount. The long term related party debt refers to $11 million of Notes held by Liberty, net of the unamortized discount.)
Is that confusing enough? We also have comments by Sirius CFO David Frear, who has discussed the impact in of these Notes when considering the leverage targets for Sirius:
Our leverage at the end of quarter stands at 2.8 times including nearly half a turn related to our deep in the money 7% exchangeable notes. We are likely to tap periods of opportunity in the bond market to issue new debt and to replace the 7% notes that will convert into equity in December of this year.
Since those statements were made, the company borrowed an additional $1.5 billion of new debt.
Are the 272,855,835 shares part of "diluted shares outstanding"?
In addition to the Note redemptions, changes to the exchange rate and the portion of the current short interest tied to the Notes, there is the issue of whether or not the shares underlying the Notes are included in the diluted sharecount. How often have you read that these shares are part of the dilution, implying that they are included in the diluted sharecounts shown on the income statement? There have been times when the shares underlying the Notes have been included and there have been other times when they were not. The determining factor is whether their inclusion would be dilutive and is determined by considering what happens if the debt is converted into shares.
Earnings per share, or EPS, is measured with and without the debt being converted. If the EPS increases, after taking into account both the inclusion of the additional shares (underlying the debt) in the denominator and the reduction of interest expense (associated with the debt), those shares would not be included in the calculation of diluted EPS shown in the income statement, as the calculation would be considered anti-dilutive.
It is important to understand this concept and realize that the current share price of Sirius being above the approximately $1.841 implied conversion price is not enough for the 272,855,835 shares to be automatically included in the diluted sharecount reported in the income statement. This can be clearly seen in item "(4) Earnings per share" of 2013 10K:
|Allocation of undistributed income to Series B Preferred Stock||(3,825||)||(1,084,895||)||(174,449||)|
|Dividends paid to preferred stockholders||-||(64,675||)||-|
|Net income available to common stockholders for basic net income per common share||$||373,390||$||2,323,132||$||252,512|
|Allocation of undistributed income to Series B Preferred Stock||3,825||1,084,895||174,449|
|Dividends paid to preferred stockholders||-||64,675||-|
|Effect of interest on assumed conversions of convertible debt||-||38,500||-|
|Net income available to common stockholders for diluted net income per common share||$||377,215||$||3,511,202||$||426,961|
|Weighted average common shares outstanding for basic net income per common share||6,227,646||4,209,073||3,744,606|
|Weighted average impact of assumed Series B Preferred Stock conversion||63,789||2,215,900||2,586,977|
|Weighted average impact of assumed convertible debt||-||298,725||-|
|Weighted average impact of other dilutive equity instruments||93,356||150,088||169,239|
|Weighted average shares for diluted net income per common share||6,384,791||6,873,786||6,500,822|
|Net income per common share:|
You can see that during the past three years, only in 2012 were the shares underlying the Notes included in the diluted sharecount. This is despite the fact that the shares of Sirius never traded below $2.95 all of 2013, well above $1.841 exchange ratio. You will also note how the interest expense is added back to determine the hypothetical 2012 diluted EPS.
So, are those shares included in the 6,173,848,000 diluted "Weighted average common shares outstanding" shown on the most recent income statement? From the first quarter 10Q:
During the three months ended March 31, 2014 and 2013, the common stock reserved for conversion in connection with the Exchangeable Notes was considered to be anti-dilutive in our calculation of diluted net income per share.
Since the inclusion would be anti-dilutive, those shares are not included.
Does it matter?
Is it important? It is, if one is more interested in calculating free cash flow per share rather than EPS for 2014 as a valuation metric. In that case, looking at the current level of the diluted shares on the income statement could distort one's perception of the total shares that will be outstanding at year-end.
Weighted average shares outstanding is confusing enough without the added complication dilution. Under ordinary circumstances, the treasury method of accounting used in calculating dilution due to incentive stock options awarded to employees and directors is complicated. Layering on the complexity of the what happens with convertible debt raises the confusion to another level.
One of the reasons this is currently quite important is that Sirius is in the midst of its second $2 billion share repurchase program. Trying to determine the free cash flow per share generated in 2014 requires an understanding about where the sharecount will be at the end of the year. That requires that one have a correct starting point for their calculations.
Rather than using the somewhat misleading terminology and numbers of the weighted average number of basic and diluted shares on the income statement, investors could be well advised go to the balance sheet and start with those figures. The next step would be adjusting that total in accordance with subsequent events noted in the 10Q:
Stock Repurchase Program
For the period from April 1, 2014 to April 25, 2014 , we repurchased 25,247,342 shares of our common stock for an aggregate purchase price of $81,318 , including fees and commissions, on the open market.
Stock Repurchase Agreement with Liberty Media
On April 25, 2014 , pursuant to the terms of the share repurchase agreement with Liberty Media, as amended, we repurchased 92,888,561 shares of our common stock for $340,000 from Liberty Media at a price of $3.66 per share.
As of April 25, 2014, $1,687,640 remained available under our stock repurchase program.
Understanding the Notes and their impact on the sharecounts, the share buyback, leverage calculations, EPS and anticipated free cash flow per share should be important to Sirius investors. Fortunately, these Notes will be gone by the end of the year. At that time, investors should have a clearer understanding of sharecounts, short interest and leverage at the company.
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. I have $3.50 and $4 January 2015 covered calls written against a portion of my SIRI positions and will also frequently trade shares of Sirius.