I recently wrote an article about the supply of cash building up at SiriusXM (SIRI) and the issues surrounding a potential share buyback. The article referenced two studies that showed most of the time companies undertaking share buybacks do a disservice to shareholders. The shares initially get a short term pop in price, but over the longer term, the shares will resume trading on the fundamentals of the company and most will trade lower. Why is this?
The primary reason for trading lower appears to be that companies are using the cash to buy shares because there is no better use for the cash. Investors buy stock in companies for income, capital appreciation or some combination of both. If the cash generating capacity of a business is not used for increasing dividends or reinvesting in the business to grow future earnings, why should investors be satisfied and bid up the price of shares?
In spite of the two referenced studies, there were comments on the article from investors bullish on the prospects of Sirius essentially stating that it would be different for Sirius:
In the case of Sirius XM, where the share count may be as high as 6.5 billion shares, share buybacks would be the most logical solution. Such amount of outstanding and preferred shares is unprecedented, ... and harms the share price and company image tremendously. Even with future profits in billions, the siri's share count would still be detrimental to the company.
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Share buyback. IMO the stock price is undervalued and one of the big problems is that most analysts think there are too many shares outstanding (dilution ). By eliminating dilution, it may also kill off the short interest in this stock.
If the number of shares outstanding were the only concern of investors, a simple reverse split would address that issue. What ultimately drives share prices is earnings. One of the most common metrics used to assess the value of a stock is its Price to Earnings (or P/E) ratio. Investors are buying a portion of a company and as owners are looking to earn income on their investment, both now and in the future. So, what is the Sirius P/E ratio?
Seeking Alpha showed the P/E at nearly 43 when the share price was at $2.14. But that's a backward looking or historical measure and it does not take into account the share dilution effects. Sirius has forecasted 2012 adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (or EBITDA) of $860 million, a growth of 20% over the 2011 projected EBITDA figure of $715 million. Considering the company's 2011 interest, taxes, depreciation and amortization through the first three quarters of 2011 totaled $430 million, and that a full year total would be about $585 million, we can derive earnings of roughly $130 million for 2011. With $860 million of EBITDA for 2012, and holding the interest, taxes, depreciation and amortization constant at $585 million, 2012 Earnings would be around $305 million. Using a diluted share count in the 6.5-7 billion range, you are still under a nickel a share in 2012 and the forward diluted P/E is still in the low 40's. That indicates an expectation of a lot of growth going forward beyond 2012.
2012 Free Cash Flow (FCF) is another important metric. Sirius guidance of $700 million FCF in 2012 is substantially better, but still only about a dime per diluted share with shares trading at more than 21x the forward FCF.
There is the potential for continued growth in both metrics. A price increase began rolling out in January and is likely to have some negative impact on subscriber activity with churn increasing and conversion rates declining. It remains to be seen whether or not the negative impacts are more than offset by the increased monthly rates. One positive about the price increase is that it did not create the type of negative headlines that occurred after the price increase at Netflix or the institution of the $5 monthly debit card fee at Bank of America.
In addition to the price increase, there are strengthening car sales and an expanding used car program that could help FCF, top line and bottom line growth. Does a share buyback help these numbers?
Share buybacks do not magically increase the earnings of a company. Everything else being equal, one would expect the earnings per share (EPS) to increase if the number of shares - or denominator, is reduced. However, it is impossible to hold everything else equal. The cash used from a buyback comes from somewhere - the current FCF, new debt or cash already invested in marketable securities.
Cash can be used to lower debt (my own preference) and improve earnings in two ways. Not only would there be less interest expense because there is less debt, but there is also the likelihood of higher debt ratings. Higher debt ratings also translate to lower interest rates and lower interest expense. And lower interest costs means more EPS. And if debt isn't to be lowered, what is the next best use of cash?
If Sirius uses cash for a share repurchase program, it indicates the company is foregoing other projects. Management has made a decision not to advertise or develop a new product or to acquire other content. When management makes these decisions, we could assume that they believe that the return on these alternate uses won't drive EPS higher than a lower share count would. If that's the case, is the investor better off owning a larger percentage of Sirius (through a reduced share count) or receiving the cash through a dividend?
Ignoring some of the tax implications, I would maintain a dividend is a better use of cash from an investor perspective than a share buyback. With a dividend, the investors can decide where to put their money to work. Investors that like Sirius can reinvest the dividends and increase their ownership percentage. If they think there are better investments, they also have that option. More importantly, a dividend shows investors that management foresees continued FCF and earnings to support future dividend payments and dividend increases.
Management may be reluctant to pay dividends for several reasons. Instituting a regular quarterly dividend becomes an obligation on the part of management to continue those payments, since dividend cuts typically result in share prices being punished. Dividend payments mean cash is being used for purposes other than reinvestment in the business, curtailing the ability to take advantage of future growth opportunities. Instituting dividend payments tells investors that management sees fewer growth opportunities going forward. Growth typically results in capital appreciation, and management compensation in the form of options (or restricted stock) is tied very much to growth and capital appreciation.
And all of this ignores the situation with the Liberty Media (LMCA) ownership stake in Sirius. If Liberty does not participate in a share buyback, they will eventually grow into a majority ownership position of Sirius. Greg Maffei, Liberty CEO, has stated selling the Sirius shares is not a logical option for Liberty. While this means that a buyback eventually places Sirius under Liberty control, it would take quite a bit of time before that happens. This is because the number of shares that would need to be repurchased (more than 1 billion shares) and the cash required to make those purchases is quite large.
Summary
A share buyback often sends a message that a company has no better internal uses for cash. Those investors looking for capital appreciation and growth in the share price, are being told that there are limited growth opportunities. Those investors looking for dividend income and increasing dividends to keep up with inflation won't be satisfied. Sirius investors hoping for a share buyback should be careful about what they wish for.
Disclosure: I am long SIRI, BAC.
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