Description

Trade Recommendation:

Long LSXMK and short SIRI (1 share long of LSXMK vs. 9.36 shares short of of SIRI) at a $10.50 discount.

What is LSXMK?

On 4/15/16, Liberty Media (LMCA) created and spun out two entities, Liberty Braves and Liberty Sirius. Liberty Sirius represented over 75% of LMCA prior to spin and given the simplicity of their SIRI stake, John Malone and Greg Maffei likely thought isolating Liberty SIRI would result in a smaller discount. This thought process proved correct for the first few months, but a number of technical issues pushed the discount to 20% today from just inside 10%.

Liberty’s ownership as of 4Q16 now stands at 67.1%. This equates to an un-taxed Liberty SIRI NAV $50.25 or a 22% discount ($10.92/share discount) when marking Liberty SIRI to market, subtracting out the net debt and then dividing by 338 which is the combined shares across LSXMA/K (*** For this report I will reference LSXMK for this investment instead of LSXMA b/c LSXMK trades cheaper due to the non-voting nature discount***). I ultimately believe that LSXMA/K spread will collapse when SIRI/LSXMK combine at some point.

Source: 10K 2016

Target Return on Long LSXMK/Short SIRI

·         Base Case ~ 14% discount: ($3.50 gain on a $10 spread ~ 35% gross return) assuming LSXMK spread tightens to a more reasonable probability weighted outcome. This discount reflects its partially long-dated nature of trade offset by increased Liberty buyback at some point

·         Upside Case (LSXMK sold to Strategic at Premium): Discount turns to premium (10% premium assumed) in the event John Malone and Greg Maffei sell their 67% stake to a strategic (Apple, Google, Amazon, etc…). This results in a pick-up of $10 in spread compression plus $5 premium consideration on the $50/NAV, resulting in a $15 per share gain on $10 discount or 150% gross return.

·         Downside Case ~ 25% discount: Liberty looks to buy Pandora with discounted LSXMK stock resulting in selling shares into the market. In this event, I believe we could see the spread widen out to 25%, which would be 10pts above the average Liberty discount for a tracker of about 15%.

Hypothetical Probability Weighted Scenario Analysis (assuming long 1mm spreads and paths highlighted above):

Source: Internal Report

LSXMK Overview:

Liberty via LSXMA/K (voting/non-voting) owns a growing stake in Sirius XM (Ticker: SIRI) that stands at 67.1% as of 4Q16.

John Malone’s Liberty Media via Liberty Sirius (LSXMA/K) owns 67.1% of satellite radio operator SIRI as of 4Q16. So, the majority stake in SIRI held via LSXMK/A (tracking stock) is trading at approximately a 22% discount to its minority float (SIRI), I believe due to  a combination of technical issues between the two stocks and Liberty being preoccupied with the Formula One acquisition and Liberty Expedia spin. Now that Liberty is done with both of these distractions, we believe that Liberty is squarely focused on closing the discount related to its $17bn majority stake in SIRI.

Source: Bloomberg

Why does the Opportunity Exist and Spread Discount So Wide?

Multiple Technical Imbalance

o    Buyback Mismatch - The first technical issue is that SIRI is buying back close to 10% of its market cap while LSXMK isn’t reducing its float. As a result, there is upward support for SIRI, but not LSXMK. This will likely persist for only another year or so, because once Liberty’s ownership hits 80%, LSXMK will be able to upstream most of the SIRI FCF to Liberty to buyback LSXMK.

o    SIRI Retail Ownership – SIRI has a high retail/advisor ownership vs. LSXMK. The larger retail base exacerbates moves in either direction, resulting in more volatility in the spread.

o    2017 Annual Meeting Short Squeeze – Starting on 3/9/17, it appears that SIRI began experiencing a short-term technical squeeze b/c long-only investors sought to bring their loaned out stock back in so they can vote at the upcoming Annual Shareholder Meeting. Even though the 2017 Annual Shareholder Meeting hasn’t been set, if we look at last year’s meeting, the expected record date is close to the end of March. As a result, this technical short squeeze should abate in at most 4 weeks when the 2017 AGM record date is set.

Pandora Buyout/LSXMK Equity Issuance

o    Investors may fear that Liberty will issue LSXMK stock to buy Pandora even though Liberty Media CEO, Greg Maffei, publicly stated on the 4Q16 LMCA earnings call that there is a “near zero” chance Liberty issues stock.  As a result, investors may have applied some incremental discount to the LSXMK spread until the Pandora overhang is resolved.

Long-Dated Investment (i.e. “Dead Money”)

o    Unlike a traditional merger arbitrage spread where there is an expected closing date, the LSXMK spread has no end-date even though all the non-Liberty owned SIRI shares could be bought back by the end of 2021. As a result, regular merger arbitrage funds find LSXMK less appealing given that they don’t want to wait 5 years (keeping in mind, however, that 80% consolidation will happen most likely next year though).  

Catalyst to make money:

1)       SIRI Buyback “Liberty LBO” – SIRI is in the process of doing a levered equity shrink of its shareholder base. SIRI retired 9% of the shares outstanding in 2016 and will continue to apply about $1.5bn to buyback shares. This strategy will continue to push LSXMK’s stake up by 5-10% per year depending on target leverage at SIRI). Based on conversations with our external tax expert, once Liberty gets to 80%, which is the threshold for legal consolidation, Liberty can then divert the free cash flow upstream to LSXMK to buy back its stock at a 20%+ discount in a very tax efficient manner.] This will swing the pendulum from SIRI with the upward technical stock bias to LSXMK.

Source: Internal Report

2) Unencumbered SIRI Stake – Highlighted in the most recent 10K, Liberty only has a $250mm margin loan outstanding ($1bn capacity) against its $17bn stake in SIRI. Liberty at some point will likely look to buyback stock via the margin loan or issue a typical exchangeable note into their stake similar to other Liberty entities. Liberty may also look to effectively monetize their stakes without selling them via the issuance of an exchangeable (CHTR is a recent example). Liberty will most likely use the proceeds from the exchangeable into their SIRI stake to buyback LSXMK at a 20%+ discount.

3) Reverse Morris Trust (“RMT”) with SIRI – With SIRI trading at a 20% premium to Liberty, SIRI could enter into an RMT transaction whereby SIRI issues equity to buy LSXMK. Given that LSXMK would have more than 50% of the pro-forma business, the RMT would be expected to be tax-free and put Liberty effectively in control of the cash flow and close the discount. The one pushback related to this RMT is that it pro-forma SIRI would be outside of the Liberty complex of funds, so they wouldn’t have access to the free cash flow to rotate into other non-SIRI investments. An RMT with SIRI could collapse the entire discount at LSXMK or might result in only a partial reduction in the discount in order to accrue value to SIRI shareholder.

4) RMT with Pandora into Asset Backed Security – Another option Liberty has with LSXMK is to enter into a combination with Pandora. Based on conversations with outside tax experts, it is possible that Pandora could issue stock to acquire LSXMK in a stock-for-stock transaction, resulting in a tax free conversion of LSXMK from a tracking stock into an asset-backed stock. The conversion should drive the discount lower b/c asset backed securities trade at tighter discounts vs. tracking discounts. Also, with the expected Liberty-driven expense cuts at Pandora, any incremental cash flow from Pandora could be used to buyback stock at the pro-forma business.

5) Sell LSXMK to a Strategic Buyer via Stock Swap looking for Auto Technology Exposure – SIRI rallied on 3/13 following the announcement that Mobileye was going to be acquired by Intel at 30x EBITDA. This news likely propped up SIRI b/c it is also an auto OEM technology. SIRI is not going to command a MBLY multiple, but SIRI could be the right strategic fit to an Apple, Google or Amazon seeking to combine its own fast growing music platform with an automotive interface.

Most recent Liberty Comments re: LSXM

Greg Maffei’s Comments from 4Q16 Liberty Call

Jason Bazinet Citigroup Inc, Research Division

Just a question for Mr. Maffei. I think at your Analyst Day in early November you sort of that LSXMA was trading at a discount to Siri. You said you are very focused on that. You were focused on taking steps to close that gap. And I was just wondering if you could elaborate a bit on what the impairments have been that have prevented you from closing that gap now 4 months or so elapsed?

Gregory Maffei Chief Executive Officer

Well, I think, Jason, thank you for the question. I think we've talked in the past about when is the right time to do that. We have a case as I mentioned in the past where Sirius is reducing supply of stock at a faster rate than we're reducing in LSXMA because frankly, we're not reducing any of LSXMA during the past quarter. They have cash flows, $1.51 billion for the year of free cash flow at SXM to going to attack about $7 billion or now I guess, about $8 billion of market cap. We have very limited cash flows at LSXMA. We have quite a lot of balance sheet capacity, but we have a $14 billion or $15 billion underlying value there in stock. So we're attacking with less cash flow larger problem. I think the market continue to think we're going to do something that we'll use the LSXMA stock to take in SXM. That's the market I think the odds we do it in some way which is highly diluted or virtually 0. So think away but it ain't going to happen. So you want to that. You're welcome to that's the markets my breath. Unless you got a hell of a lot capacity. So I talked about the ways we might do that, and I've also talked about the impairments doing meet. And then I've talked about when it would make the most sense. While that's all happening, SXM is continuing to increase of ownership in SXM because we're not sellers, we're believers in the business. And it is nice too see the endorsement of holders like buying both LSXMA stock and SXM stock. So look, it's an opportunity for us. It's 1 we'll take an advantage of the time and place of our choosing.

Risks to Spread Widening – The biggest risks to the spread are time value (IRR of holding an accreting 5 year SIRI equity shrink buyback story), Liberty issuing stock at a discounted level, and the technical pull between SIRI buyback/no LSXMA buyback.

Sirius XM

SIRI Fundamentals

[Despite worries about connected cars competition and streaming services, SIRI continues to grow subscribers and average selling price (ASP). On the 4Q16 earnings call, SIRI added over 1.75mm subs for the year ending with 31.3mm subscribers. ASP continues to climb with recent monthly pricing of $13.16 vs. $12 4 years ago (2.5% increase per year).

Sirius is a very sticky, recurring revenue product, is installed in 75% of new car sales in the U.S., and is growing trials on used cars 20% per year and converting 30%+. On the Sept 15, 2016 conference call, CEO James Meyer, highlighted that the used car market opportunity is much bigger than their current new car OEM market (2.5x larger) and we believe this growth is underappreciated by the investment community today. Additionally, James Meyer sees SIRI’s 90mm enabled cars growing to 180mm overtime, providing a larger addressable market to source paid subscriber conversions.

As a result of its advantaged business model with high operating leverage, SIRI produces a steady EBITDA ($1.8bn) and FCF ($1.5bn). SIRI uses the FCF and resulting excess balance sheet capacity to buyback stock (10% of shares or 25% of float per year). Liberty does not participate in the buyback, so its ownership percentage accretes about 10% per year.

SIRI Valuation – Applying a 17.5x multiple to SIRI’s fully taxed 2020 FCF/share of $0.33 cents, SIRI is worth $5.77/share in value in 2020. If we discount that back 2 years at 5% per year, we arrive at $5.25/share. SIRI today is trading at $5.36, resulting in less risk of SIRI running and the spread widening further from here. Any hiccup in sub growth or the used car market conversion rate for SIRI could take the stock lower, which has historically been good for the spread.

Source: Internal Report

SIRI Risk/Reward Based on the current SIRI price, the market appears to be giving full credit to SIRI’s consistent business and steady free cash flow at a 16x current multiple or 20x+ fully-taxed for 2017 FCF. Unless one thinks that SIRI is going to be sold ($6-$6.60 share on 18-20x FCF multiple), then the downside of being short SIRI on spread is low. Providing additional support to the risk of the spread trade is that in the event of a SIRI sale, investors should see spread compression as the buyer of SIRI would most likely be a larger technology company with a more liquid currency than SIRI.

Disclaimer:

The write up is not investment advice or a recommendation or solicitation for any investment fund or to buy or sell any securities. The author and/or related persons may hold a position in the subject company; however, no representation or warranty, express or implied, is being made that the author and/or related persons will continue to hold a position in the subject company. The view expressed on the subject company or its investment positions therein is subject to change at any time, for any reason or no reason. This includes buying, selling, covering or otherwise changing the form or substance of its investment. The author and/or related persons disclaims any obligation to notify the market of any such changes. The information and analysis presented in this write up is based upon publicly available information only. While the author has tried to present the facts it believes are accurate, no representation or warranty, express or implied, is being made as to the accuracy or completeness of the write up, and the author expressly disclaims any liability relating to the write up (or any inaccuracies or omissions therein). The author undertakes no obligation to correct, update or revise the write up or to otherwise provide any additional materials.

Catalyst

- SIRI Shrink Shrink to 80% tax consolidation ownership level (90% minority squeeze out the most likely next step)

- LSXMK buyback with unencumbered $17bn stake in SIRI

- RMT with SIRI

- Asset-Backed Merger with Pandora