Tuesday, June 27, 2006

Shaeffer's Research on SIRI and XMSR Short Interest

June 28, 2006

Shaeffer's Research discusses hedge funds, convertible bonds and their relation to short interest, (ie, large short positions do not necessarily reflect negative sentiment).

Tuning into Satellite Radio
Bill Feingold--> 6/27/2006 2:37 PM ET

Let me start with an admission--I love satellite radio. I've always enjoyed radio programming, but most of the commercials you hear these days grate on me more than fingernails scraping down a chalkboard. Satellite frees you from that tyranny on the music stations, and even the ones you get on the talk stations are pretty easy to take.

O.K., now to the markets. Mel Karmazin of Sirius Satellite Radio was on the tape yesterday, saying he'd like to buy XM Satellite Radio Holdings at the right price, but that he would expect regulatory issues because of the duopoly status of the industry. That generated some good feelings in a couple of stocks that have been having a rough go of it.

Coincidentally, the most recent Nasdaq short-interest data were published today. They indicate that Sirius has the second-most short shares outstanding, with more than 147 million shares of short interest, behind only the Nasdaq-100 Trust. Now, a large reason, of course, is that Sirius is a $4 stock, so the number is a touch misleading. Still, that's a lot of short stock. To illustrate this, Sirius' latest 10-Q indicated 1.4 billion shares issued and outstanding (also known as "the float"), so more than 10 percent of the float has been sold short . By comparison, Yahoo!, one of the most heavily shorted companies, has 1.4 billion shares outstanding, of which 81 million have been shorted, representing less than six percent of the float.

But here's the catch. Sirius hasn't been getting the money to pay Howard Stern from the money it earns from its subscribers--not yet, anyway, and not for some time to come. Who's been paying Howard? Mostly, it's been the convertible bond market. In the past three years, Sirius has issued three convertible bonds, raising proceeds of more than $700 million even after giving the investment bankers their cut. Even with the stock's poor performance during the past 18 months, the bondholders as a whole can't complain too much--all of the convertibles are trading above the issue price. In fact, the first of these convertibles, issued nearly 18 months B.H.S.(Before Howard Signed), is now quoted around 340 percent of par, even with the stock down about 50 percent from its all-time high.

As you may have gathered by now, a lot of convertible bonds are held by hedge funds, who sell short the underlying stock and try to profit from mispricings between the convertible and the stock as well as from the stock's volatility. I conservatively assumed that half of Sirius' convertibles are held by hedge funds. Because all of Sirius' convertible bonds trade with fairly small conversion premiums (the difference between the bond's market price and its value if immediately converted into stock), the bonds are relatively easy to hedge and thus are particularly attractive to hedge funds as long as they are able to short the stock. Based on the approximate theoretical hedges of the bonds, I have estimated that about 75 percent of the short interest in Sirius is related to convertible bonds.

The moral of the story is that if you were tempted to run out and buy Sirius stock expecting to benefit from a huge short squeeze, think again. Most of the short interest is actually hedging the convertibles. In fact, the nature of convertible arbitrage requires hedge funds to short more stock as it goes up, so that you could easily get the opposite of a squeeze--you are more likely to run into additional supply from hedge funds adjusting their positions.

A couple of other things are worth mentioning. First, the short-interest table published today shows a large increase from mid-May to mid-June in Sirius' short interest, from 119 million to 147 million shares. Sources in the convertible market tell me that much of this increase was caused by selling pressure from outright (unhedged) accounts. Outright convertible accounts seek to profit mostly from directional stock moves as opposed to the small discrepancies hedge funds often look for. But when they sell their bonds, they rarely sell directly to other outright holders. Rather, the bonds end up with hedge funds, who will only buy them if they can establish an offsetting short position. So, the increase in short interest, while still attributable to worsening sentiment (the outright seller, after all, must have decided he didn't like the stock any more), probably does not represent a big new risky bet that could lead to covering at inflated prices.

Let's close by taking another look at XMSR, Sirius' competitor. XMSR too is among the short-interest leaders, with 37 million shares shorted in the latest report. Interestingly, XM's most active convertible security is a busted (i.e., not currently stock-sensitive) bond that matures in three years. One might assume that the short interest is thus entirely fundamental, since busted convertibles are not typically hedged with much stock.

But XMSR issued some convertibles privately about three and a half years ago when its subscriber base was just beginning to build. You or I could not have bought these bonds--they went to several of XMSR's suppliers and partners (including GM) as well as to private-equity firms. The bonds had a 10-percent coupon, were secured by XMSR assets, and were convertible at $3.18 per share. Even with the rotten year the stock is having, the convertible is worth well over four times its original value, not even considering the 10-percent coupon. Because of the private nature of that deal, it's hard to know who owns those bonds now, but it's a good bet that at least some of the holders have shorted stock to hedge them or have sold the bonds to someone who did.

Now, if Sirius were to buy XMSR, they'd either need to raise about $5 billion cash that they don't have or give the XMSR holders Sirius stock. The latter is a lot more likely. In that event, we could see a very interesting situation. One of the best-known hedge-fund strategies is merger arbitrage, where the hedge-fund manager buys the stock of the company being acquired and shorts the stock of the acquirer, assuming the deal is a stock swap. When the deal closes, the position unwinds automatically, as the long position is replaced with by stock in the surviving company, which in turn covers the short position.

So, the hedge funds, if such a deal were to be announced, would buy XMSR and sell short SIRI. The idea would be that they would essentially be buying SIRI, via XMSR, at a lower price than they were simultaneously selling it. The trade makes money as long as the deal is consummated, although the longer the deal takes to close, the lower the annualized returns are.

But there might be a problem with availability of Sirius stock to short, since so much of it has been shorted against the convertibles. Since the two companies have fairly comparable market values, this would not be a "drop in the bucket" to Sirius by any means. Instead, you would likely see a mad scramble to get or keep the borrowable Sirius stock, a fight between the convertible and merger hedge-fund managers. If this all does come to pass, two consequences are likely.

Sirius convertible bonds would lose some of the premium to their pure stock value since they would become much more difficult and expensive to hedge. A convertible hedge-fund manager will naturally pay less for a position that he's in danger of being unable to hedge. So, if this happens and you like Sirius stock, think about asking your broker if you can swap it into some convertible bonds. You might be able to pick up some income without giving up any real upside, courtesy of some panicking hedge fund.

The "risk-arbitrage" spread would be fairly wide. In other words, because of the difficulty in establishing a hedge, you might be able to buy $100 worth of Sirius stock for $85 or $90 via XMSR.

6/27/2006 05:34:00 PM

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