Liberty Sirius XM: The (Discount) End Is Near

| About: Liberty Sirius (LSXMK)

Summary

Liberty Sirius XM trades at an unreasonable discount to its underlying value.

Liberty management will have many tools at its disposal over the next 12-24 months to narrow the spread.

The relationship between LSXMK and SIRI varies widely on an intraday basis, allowing for trading opportunities.

Liberty Sirius XM (LSXMA, LSXMB, LSXMK) has never been cheaper compared to NAV than it is right now. Not only that, but the timing of a resolution to close this gap gets closer and closer as we approach 2018. There are many levers that parent company Liberty Media (LMCA) can pull and all of these levers will be available to them by next year. These actions can drive a discount, which currently stands at 16% down to the low-single digits while provide safety and trading opportunities along the way. As such, I recommend buying LSXMK and selling short Sirius XM Holdings (NASDAQ:SIRI) in a trade described in further detail below.

Liberty Sirius XM is one of John Malone and Greg Maffei's fairly recent offspring. The tracking stock was born out of parent company Liberty Media Holdings along with two other tracking stocks, Liberty Formula One and Liberty Braves (NASDAQ:BATRA) (NASDAQ:BATRK). In 2015, Liberty Media management was frustrated with the discount the media conglomerate traded for in the open market and decided to take steps to highlight the value of the individual securities and businesses held within the portfolio.

As a result, they split the company up into three tracking stocks (subsequent to the split, Liberty Media Holdings purchased Formula One, which is now attributable to the newly named Liberty Formula One tracking stock along with Live Nation (NYSE:LYV) and other media companies formerly held under the Liberty Media tracker).

The three tracking stocks were launched in April of 2016. The initial reaction was what one would expect - Liberty Sirius XM's discount to fair value tightened as it was the most liquid tracking stock and the simplest to understand.

The Liberty Media tracker (now Liberty Formula One) traded at a fairly large discount given a complex cross-ownership structure with Liberty Braves and the hodge-podge of media company holdings it tracked without any clear exit strategy. The Liberty Braves tracker sold off to a dramatic discount as it was the least liquid of the trackers and the Braves organization does not generate consistent cash. Then something funny happened along the way.

The market came to accept that the large mixed-use real estate portfolio around the Braves new stadium, also part of Liberty Braves, will help smooth out lumpy cash flows from the team operations. As such, Liberty Braves now trades fairly close to fair value for the franchise and associated real estate. Liberty Media bought Formula One and laid out an expansion plan that was applauded across Wall Street, driving that tracking stock much higher. But the most liquid and easiest one to understand, Liberty Sirius XM, has languished as the market discounts the tracker more and more with each passing month.

In the models below, I have taken a conservative approach in calculating the NAV of LSXM by assuming all options were exercised for the stock without accounting for the cash that would come into LSXM upon exercise. Under this methodology, on January 25th, the discount to NAV reached over 17%, its widest level since the launch of the tracking stock in April of 2016. On Monday, it closed slightly tighter, but still over 16% (note: the spike in June of 2016 was due to an index rebalance, nothing fundamental). Figure 1 shows the absolute discount to NAV in dollar terms (-6.64 equates to a $6.64 discount) and figure 2 shows the discount in percentage terms relative to NAV. As you can see from the charts below, both of them have moved almost in a straight line from September until now as SIRI's stock price has lifted and LSXM's stock price has not kept pace.

Figure 1: LSXMK absolute discount to NAV since the tracker was issued

Figure 2: LSXMK percentage discount to NAV since the tracker was issued (bottom graph with the red fill, -0.1681 refers to a 16.81% discount to NAV)

As shown in figure 3 below, Liberty Sirius XM is nothing more than Liberty Media's holdings in Sirius XM Holdings, $39mm in cash and a $250mm margin loan. There are no hard to value operating businesses, no funny offshore tax shelters and no massive management fees eating up huge swaths of cash every year. A very brief back story to how Liberty Media got its stake in Sirius XM is as follows:

In the depths of the Great Recession in 2009, Liberty Media bailed Sirius XM out by floating them a convertible loan that would entitle Liberty Media to about 40% of the shares outstanding upon conversion. The capital raise saved the company, Liberty Media converted their debt to claim 40% of the stock and through some additional purchases, reached the 50% threshold in January of 2013. Since then, between some additional purchases by Liberty and a substantial share buyback program at Sirius XM, Liberty Media now owns 65.5% of the shares outstanding.

As SIRI continues to execute on its buyback, of which it has $2.4bn currently authorized, LSXM will own a larger and larger portion of the company. LSXM's holding in SIRI now amounts to about 9.076 SIRI shares per fully diluted LSXM share including all options accounted for as stock, shown in figure 4.

Figure 3: Liberty Sirius XM's assets and liabilities

Cash (MM) $39.00
Price Shares Total
Holdings in SIRI $4.75 3,162.2 $15,020.45
Margin Loan Rate Amount Annual Int
Drawn Libor +175bps $250.00 $6.88
Undrawn 75bps $500.00 $3.75
Total NAV $14,809.45 $10.63

Figure 4: LSXM shares outstanding and ratios

LSXM shares outstanding
Class Exercise Px Price Outstanding Value
LSXMA $36.45 102.3 $3,728.84
Options $19.30 2.1 $76.55
LSXMB $37.80 9.9 $374.22
LSXMK $35.97 222.8 $8,014.12
Options $25.64 11.3 $406.46
Totals 348.4 $12,600.18
SIRI shares per diluted LSXM 9.076
Cash per LSXM share $0.11
Debt per LSXM share $0.72
Net cash (excluding options cash) ($0.61)
Net cash with options cash $119.26
Annual dividend received from

Why the discount exists

There are a number of theories floating around as to why the discount has widened the way it has over the last several months. The first argument is that the higher SIRI goes, the larger the potential tax liability to Liberty Media if/when a transaction occurs. Technically, this is true.

If Liberty decided to execute a taxable transaction of some kind, LSXM shareholders would incur significantly more tax leakage with SIRI at $4.75 than with SIRI at $4.00. In practice however, you can go back as far as you want and I don't think you will ever find a taxable transaction in which John Malone was primary decision maker. He might hate paying taxes more than anyone in the world.

The second item that might be driving the discount wider is SIRI/LSXM's publicized interest in Pandora (NYSE:P). Any transaction where LSXM buys P will be frowned upon as P is a loss maker. Liberty Media management is a very disciplined bunch however. They will not overpay for assets and they are not going to buy a cash-burning company unless they have a plan in place that will immediately turn the fortunes of the company around. For reference take a look at what happened to Liberty Formula One's stock (FWONA, FWONK) after they announced the purchase of Formula One in September of 2016.

The last, and likely the most accurate theory behind the widening discount, is exhaustion. LSXM is a tracking stock, but won't be forever. Traders have grown tired of trying to keep the discount in line and as SIRI's stock price has had a substantial move up in recent months, LSXM has not been able to keep pace. I am not the first person to identify this discount and I won't be the last, but as we approach 2018, I feel the timing of a catalyst becomes more concrete as more options are opened up to Liberty Media to close the discount.

The End Game

There are three big questions to consider:

What levers can Liberty Media pull to close the discount between LSXM and SIRI? How can it be done in a tax-efficient manner so LSXM holders are not stuck with a huge tax bill? When can any of this happen?

There are three main options that LSXM could use that would likely avoid taxation and could narrow the gap considerably (though not close it completely). One can be done right now, one can be done after January 15, 2018 and one can be done in late 2018 or early 2019 after LSXM gains control of over 80% of SIRI's outstanding shares. To learn more about what qualifies as a tax-exempt distribution, please see Internal Revenue Code 355.

The first option is to launch an exchange offer where LSXM offers to take out the 34.5% of SIRI stock that it does not already own using LSXM stock. The problem with this is that LSXM already trades at such a significant discount that using it as currency to take out minority SIRI shareholders is unattractive. LSXM will have to offer a reference price under where SIRI currently trades in the open market and hope that LSXM rises enough on the news to make the deal attractive to SIRI holders. When the discount to NAV was significantly smaller in 2014, Liberty Media tried this exact option.

They launched an exchange offer that gave a slight premium to existing SIRI holders, which valued SIRI at $3.68 vs. a $3.50 close the night before. The SIRI board recommended against the offer and it was dropped a couple of months later. While this option is clean and easy, it is not realistic at current market prices. LSXM would likely have to offer too much of a premium for it to make sense for LSXM holders. Also, it may not fully solve the discount issue because all of Sirius XM Holdings will be housed in a tracking stock within Liberty Media Holdings. There is no guarantee that LSXM will trade at a fair value to NAV.

The second scenario is LSXM could wait until January of 2018 and execute a Reverse Morris Trust transaction where Liberty Media could spin off their holdings in Sirius XM into an asset-backed security and simultaneously merge it with minority SIRI holders. The company has to wait until January of 2018 because that is the 5-year anniversary of when Liberty Media crossed the 50% ownership threshold in SIRI, giving it technical control under section 355 of the Internal Revenue Code. Again, LSXM would likely have to incentivize SIRI holders to agree to this transaction, but depending on where LSXM is trading at that time relative to SIRI, this adds another arrow to their quiver.

The third possibility is that LSXM can wait until SIRI buys back enough SIRI stock in the open market to give LSXM 80% ownership of Sirius XM Holdings. This would allow LSXM to spin off their holdings in SIRI into an asset-backed security which will drastically narrow the discount to NAV. Based on data from the table below in figure 5, if SIRI continues to repurchase shares at the pace they have been over the last three years, LSXM will reach the 80% threshold around the end of 2018.

Figure 5: SIRI share reduction over time

SIRI shares outstanding 4,795.6
Liberty's ownership in SIRI 65.9%
2013 2014 2015 2016
SIRI shares out 6,096.2 5,646.1 5,147.6 4,795.6
Share reduction 450.1 498.5 352.0

We have a precedent to try to project what might happen to the NAV discount in this scenario. Near the end of 2014, Liberty Media spun out its minority holdings in Charter Communications (NASDAQ:CHTR) into an asset-backed security, Liberty Broadband (LBRDA, OTCQB:LBRDB, LBRDK). Generally speaking, LBRD has traded at a mid-to-high single-digit discount ever since. With LSXM owning 80% of SIRI by the end of 2018, LSXM will obviously exert a lot more control over the company and as such, would deserve to trade at an even narrower discount of low-to-mid single digits.

The Trade

Sirius XM has proven itself to be a very resilient company in the face of a massive land grab for listeners. Free, freemium and premium services are everywhere, but SIRI continues to grow all operating metrics at a steady, yet unspectacular, pace in the face of all the competition. It is a levered equity play whose management is buying back stock at a blistering pace, leaving more earnings to be divided among fewer shares. There are any number of resources one can use to dig into the fundamentals of SIRI so I will not go into a deep dive here.

Suffice it to say I am comfortable having some exposure to SIRI over the next two or three years while waiting to capture the corporate event that will close the discount LSXM trades at relative to SIRI. As shown above, each LSXM share is basically made up of 9.076 shares of SIRI and net debt of $0.61 (again, this is conservative as it does not take into account option cash or SIRI dividend cash received).

Since I have a neutral-to-positive opinion on SIRI, and the NAV discount tends to contract when SIRI's price drops, and expand when SIRI's price rises, the optimal hedge is to buy one LSXMK and sell short about 2/3rds of the amount of SIRI that would be required to completely hedge the position out. By shorting 6.0 shares of SIRI per LSXM share instead of 9.076, a number of things are accomplished:

In a scenario where LSXM pays a premium to buy out minority SIRI holders, we are only stuck paying 2/3rds of the premium while the NAV discount disappears, more than making up for the premium paid. By shorting only 6.0 SIRI shares, the position has an implicit positive dividend carry (cash received from SIRI dividend is allocated to the cash position at LSXM). If SIRI continues to move higher, the discount may widen, but the unhedged LSXM position will offset the widening discount.

If SIRI drifts lower, the discount will likely narrow offsetting losses on the unhedged LSXM position. The absolute discount moves substantially on a day-to-day basis, offering low-risk trading opportunities. For instance, on January 26th, the nominal discount to NAV varied between $6.45 and $7.05. Establishing a core position and trading around it can add significant value while waiting for the end game.

As added value, I also recommend selling SIRI puts below the current stock price and calls above the stock price a few months out. They can act as an incremental dividend as long as you only write call options up to the full hedge ratio of 9.076 SIRI per LSXM share. On the put side, I am comfortable being longer SIRI the lower it goes, so I am willing to take on the incremental risk of having to buy some SIRI stock at $4.00 or $4.50.

Disclosure: I am/we are long LSXMK, LSXMA AND SHORT 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.

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