LSXMB - Liberty SiriusXM: What Could Go Wrong

2023-10-26 14:42:54 ET

Summary

• While the elimination of the NAV discount seems a pretty safe bet, actually a few things could still go wrong.
• The financial outcome of an investment in the Liberty Sirius tracker mostly depends on your time horizon.
• In the short term, the outcome is anything but certain.

Deal Or No Deal

On 9/26 Liberty Media ( LSXMK ) ( LSXMA ) ( LSXMB ) finally released its proposal for a merger with Sirius XM ( SIRI ). Importantly, there is no certainty the two companies will agree on any merger at this time. That said, a merger still remains the most likely outcome, although it might obviously not happen as quickly as expected and under different terms.

The implications of the proposal have been explored in great detail by Gedas Dirkstys in a recent article . In a nutshell, Gedas says that, if a deal is approved, the current NAV discount of about 33% should be closed. On the other hand, SiriusXM will have higher leverage and this will pressure its share price. Overall, investing in Liberty SiriusXM (LSXM) right now seems to represent a high probability of a quick gain in the 40-50% range.

So why isn't LSXM trading higher already now? In this article, I will explore the remaining uncertainties hanging over the stock. Some are related to the infinite intricacies that have materialized over time in the pair trade: poor liquidity, short squeeze speculation, tax implications, etc.

The dangers of the Long LSXM/Short SIRI arbitrage

After Liberty Sirius had submitted its merger proposal to SiriusXM, many investors believed the elimination of the NAV discount in the very near term would be a pretty safe bet.

The arbitrage trade seems a no-brainer at first sight: If there is a deal, the discount will be eliminated for sure. If you short SIRI while going long LSXM, you capture the differential and don't need one stock to go up and the other to go down.

But then we got yet another (quite short-lived) short squeeze for SIRI stockholders, while LSXM shareholders got almost no benefit, highlighting the dangers of the simple discount arbitrage trade: You might eventually end up with enough SIRI shares to cover your short, but probably only in 2024 and in the meantime you might be required to post a lot more collateral and your LSXM stock might not move as proportionally as you probably wish.

In theory, the small liquidity of SIRI stock could produce a massive short squeeze without any immediate benefit for LSXM shareholders. So if you do the arbitrage trade you need to be prepared for a rocky ride until the merger is finalized.

The No-Deal scenario

While most investors don't believe a no-deal outcome is likely, it remains a possibility and would likely result in massive volatility. Most importantly, all those who are now doing the arbitrage trade would try to close their SIRI short quickly, resulting in a massive short squeeze and huge losses. In the meantime, the LSXM trackers would probably also move lower, i.e. more losses for the arbitrageurs.

That said, even in this case SiriusXM would likely continue to return capital to shareholders, i.e. mainly to Liberty Media, which would result in higher ownership and/or a higher cash balance at Liberty Media. Within about two years, Liberty would either own all of SIRI stock anyway through buybacks at the SiriusXM level or it would have enough cash to buy more SIRI shares itself. This is good news for simple (and patient) LSXM longs, but not so much for hasty arbitrageurs.

The Post-Deal scenario

Following the Liberty Live Nation ( LLYVK ) ( LLYVA ) ( LLYVB ) split-off the newly minted stock has experienced some pressure, which is likely due to many Liberty Media investors selling their new, small Liberty Live position in order to have more money to put into their Liberty Sirius bet, given that it looks more likely to result in a quick gain. (Liberty Live, in contrast, looks like it's almost certainly dead in the water for at least some time.)

The move likely resulted in that unusual LSXMA/LSXMK spread of 1-2% that showed up right after the LLYV split-off, as larger investors bid up the more liquid LSXMK tracker. (Thus creating a small arbitrage opportunity. Yours truly effectively switched his LSXMK holdings for LSXMA shares: the exposure remained the same, and the result will be identical, but my cost basis shrunk 2%).

So what will happen once LSXM shareholders finally get their SIRI stock? Will they sell it off regardless of fundamentals? Will LSXM shareholders anticipate such selling and therefore start selling already before the merger closes? Will SIRI shorts closing their trade bid up SIRI - and will LSXM follow suit or not (immediately)?

There are lots of unknowns for those betting on short-term results. Over the long-term, they hardly matter. If you simply own LSXM stock and wait out any storm that might materialize, you will likely do fine. So don't be too greedy.

Taxes

While most investors are convinced any Liberty-Sirius merger would be tax-free for Liberty-Sirius shareholders, there is actually some debate around this topic. However, even in this case, assuming the companies seek official guidance before closing any deal, a simple buy-and-hold strategy can help, since Liberty Media can own all of SiriusXM tax-free anyway thanks to continued buybacks at SiriusXM or if it buys more SIRI stock on its own.

Conclusion

I have always advised against overthinking this story and against being hasty and too greedy. You just need to know two things: what SIRI is fundamentally worth and how much the discount is at the LSXM level. Over time, the discount will close, very likely with no (or just a very tiny) gain for Uncle Sam, and buy-and-hold LSXM investors will capture the gain in my view. If you try to do better and/or faster than that, you may face some unexpected (and somewhat unpredictable) consequences. That said, we have to thank the short-term orientation of many market players for this opportunity that otherwise would likely have been much smaller.

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