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Fairfax invests 200 million in SD preferred converts


oldye
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http://investors.sandridgeenergy.com/phoenix.zhtml?c=196066&p=irol-eventDetails&EventId=2577951&WebCastId=939817&StreamId=1407174

 

Was listening to the conference call; If I'm not mistaken these are 200 million dollars 5 year converts thats pay 6% and convert @ 10.85 a share.

"The buyer of the proffered will not short the common"

 

Cheers!

 

The options are worth about $4.4/share, making the deal the equivalent of paying $80mm for an option and $120 mm for a preferred with a $200mm face and a 6% coupon.  The option-adjusted yield is about 10%.

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Preferred Stock Placement

 

On November 30, 2009, the Company entered into an agreement to issue and sell 2,000,000 shares of its 6.0% convertible perpetual preferred stock, par value $0.001 per share and liquidation preference of $100 per share (the “6.0% Convertible Preferred Stock”), to Fairfax Financial Holdings Limited in a private placement exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”). The Company expects to receive net proceeds of approximately $200 million from the sale of its 6.0% Convertible Preferred Stock. The issuance and sale of the 6.0% Convertible Preferred Stock is to a single accredited investor and will be effected pursuant to the exemption provided by Regulation D under the Securities Act and/or Section 4(2) of such Act. The closing of the private placement of the 6.0% Convertible Preferred Stock is expected to occur on or about the same time as the closing of the Permian Basin Acquisition.

 

Each share of 6.0% Convertible Preferred Stock will be convertible at any time on or after February 1, 2010 at the option of the holder into a number of shares of the Company’s common stock equal to the liquidation preference of $100 divided by the conversion price, which is initially $10.856 per share, subject to adjustments in certain circumstances. The initial conversion rate for the shares of 6.0% Convertible Preferred Stock is approximately 9.2115 shares of common stock per share of 6.0% Convertible Preferred Stock. Based on the initial conversion price, approximately 18,422,992 shares of the Company’s common stock would be issuable upon conversion of all of the shares of 6.0% Convertible Preferred Stock to be issued in the private placement.

 

On the fifth anniversary of the date of issuance of the 6.0% Convertible Preferred Stock, all outstanding shares will be converted automatically into shares of the Company’s common stock at the then-prevailing conversion price if all dividends are current as of such date.

 

The annual dividend on each share of 6.0% Convertible Preferred Stock will be $6.00 and will be payable semiannually, in arrears, on each January 15 and July 15, commencing on July 15, 2010, when, as and if declared by the Company’s board of directors. The Company may, at its option, pay dividends in cash, common stock or any combination thereof.

 

Read more: http://www.faqs.org/sec-filings/091130/SANDRIDGE-ENERGY-INC_8-K/#ixzz0Z2ZjiRHS

 

 

I think the first 70% of dividend income from preferred stock is not counted towards taxable income, meaning the effective tax rate on this interest is only 10%.  So, 5.40% after-tax yield, or 8.3% pre-tax equivalent yield (right?).

 

Also, these aren't options, but rather a convertible feature... and on the 5th year, the conversion is mandatory.  It seems a little riskier than usual for a Fairfax investment.  The PV of their proved reserves were 2.3 billion at YE 08, and the company had 2.4 billion in debt, plus a market cap of 1.5 billion.  Then again, the company has been adding to reserves at a very healthy pace.  I'm sure FFH has done its homework.

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"Also, these aren't options, but rather a convertible feature... and on the 5th year, the conversion is mandatory.  It seems a little riskier than usual for a Fairfax investment.  The PV of their proved reserves were 2.3 billion at YE 08, and the company had 2.4 billion in debt, plus a market cap of 1.5 billion.  Then again, the company has been adding to reserves at a very healthy pace.  I'm sure FFH has done its homework."

 

Good call Nick - I did not see the mandatory convertibility feature here. They aren't as good as the initially looked. 

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I like the deal from Fairfax's point of view...it also makes SD less risky/rewarding...they'll actually have Equity again!  Cashflow from the new fields should be around 40-60 mil w/ upside.  Not sure I would do this type of deal if I was 6 months away from a homerun 50% increase in production...management must feel apprehensive.  From the sound of it everyone is going to be ramping up production...where all this nat gas will go...the salt mines are already packed!  

 

If gas prices are 6+ by 2012-2013, this company should generate about 1 billion dollars a year..7% will belong to Fairfax...on a net investment of about 155 million.  I think their stock portfolio as a whole has a good chance of doubling over the next 5 years x a good hard market sometime in the next 5 and we'll be happy w/ the results

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The Company may, at its option, pay dividends in cash, common stock or any combination thereof.

 

I'm not familiar with Sandridge, but if they have a good future and they didn't have a liquidity issue, then why not simply purchase the stock? Even if Fairfax liked the Permian Basin transaction, why couldn't they demand a higher interest rate?

 

Interesting purchase.

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They raised capital at 8.88 a share or something like that.  Fairfax effectively gets the same stock 5 years late at a net cost of 8 or less.  SD is using the proceeds to buy an 800 million dollar field next to their existing projects. 

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The PV of their proved reserves were 2.3 billion at YE 08, and the company had 2.4 billion in debt, plus a market cap of 1.5 billion.

 

From the Seeking Alpha transcript of the Feb. 27, 2009 conference call:

 

For 2010 we have 80 Bcf hedged at 770 per Mcfe. At year end our hedges were worth $247 million and using the strip today, the value is $392 million and January and February are now closed out. This is important when considering the current PV-10 and our current asset value. Our current PV-10 which includes hedges and uses the commodity strip price is $4.33 billion versus the PV-10 used in the 10-K of 2.259.

 

So the PV of their reserves is actually higher than $2.3 billion.  If you take the PV-10 from the February conference call, add cash held from last quarter, subtract total liabilities from the end of last quarter, and divide by diluted share count, you get a liquidation value that is close to the conversion price of the FFH convertible preferred. 

 

I think it's safe to assume that the convertible preferred and common were issued as part of a value enhancing transaction.  It sure sounds like it based on the press release.  And FFH is involved, so that's a good sign too!

 

This preferred buy looks like quite a safe investment to me with a lot of optionality involved.

 

I'm not familiar with Sandridge, but if they have a good future and they didn't have a liquidity issue, then why not simply purchase the stock? Even if Fairfax liked the Permian Basin transaction, why couldn't they demand a higher interest rate?

 

Sandridge is led by Tom Ward, co-founder of Chesapeake Energy (Aubrey McClendon was the other founder of CHK).  His involvement with SD means that there could indeed be a bright future for this company.  They are mostly focused on E&P in the West Texas Overthrust, and I believe they are the largest leaseholder in that area.  The main reason that the WTO hasn't been utilized to the fullest extent possible is because something like 60% of the stream coming from wells in that area is made up of CO2, which nobody knew how to deal with until now.  SD and Occidental Petroleum have signed a 30 year contract to process the nat gas/CO2 stream coming from their wells, where SD will get the nat gas and Oxy will get the CO2 for enhanced oil recovery operations in their Permian Basin assets.  There will be tax credits and cap and trade benefits involved, as they will be using carbon sequestration in their operations.

 

My theory is that FFH wants to participate in the upside as a common equity owner but that they do not want to have their BV affected by a potential collapse in energy prices due to the reversing of the dollar/yen carry trade and due to a potential glut of natural gas in the U.S. for the next couple of years.  With this transaction, BV will increase from collecting dividend payments and in five years time, FFH will get their SD common without having to go through the aftermath of all this commodity speculation nonsense.

 

 

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Actually since these things are pretty much the common @10.85 a share + 60 million in dividends over 5 years so they will fluctuate in value w/ the the stock...but this represents just 10$/ a share so I'm sure they can live with the volatility :).  Sd isn't hedged past 2010, they're betting prices will go up but the problem is that if we shut down 100% of the U.S production, We'd  have enough to last more than a year.  Now add companies like this that have plans to ramp up production in 2010, I think that they'll likely push prices down further!  I hope there is a lot of money being put into new NGL plants...Luk was way ahead of the curve on this! 

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Thanks for the intro, Txlaw.

 

Your volatility seems reasonable, although, as Oldye stated, much of the value is in the conversion option. And if Fairfax wanted to manage the duration of its portfolio, why would they accept common stock in lieu of cash?

 

The structure of the transaction--mandatory conversion, management discretion of payment method, and low interest rate--suggests that SandRidge had other financing options.

 

They raised capital at 8.88 a share or something like that.  Fairfax effectively gets the same stock 5 years late at a net cost of 8 or less.  SD is using the proceeds to buy an 800 million dollar field next to their existing projects. 

 

If Fairfax buys SD now at $8.80 and the price in five years matches the conversion price, you have 4.2% annualized. That seems like a fair discount to the 6% after-tax return after adjusting for the loss of liquidity. I'm not saying this is a poor transaction; it just doesn't look substantially better or worse than the purchase of common stock. I think it's an interesting case study on private market deals.

 

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Oldye, I thought that since this was a private placement, these preferred shares would just sit on FFH's balance sheet at cost.  I can understand why the preferred would fluctuate if they were publicly tradable, but are they in this case?  From the press release, it looks like they didn't have to register the transaction with the SEC.

 

With regards to the stock dividend, I think FFH would be happy to get SD common stock dividends if the price is below their conversion price and definitely if it stays at $8 or below.  Like, say that nat gas prices fall to $3.50 and the common goes down to $6.  Then FFH could potentially get a tax favored distribution of SD stock that would actually be worth a lot more than what they would be able to sell it for as soon as it was distributed.  If they get SD common stock dividends that are overvalued, I'm thinking that they would be able to sell it immediately at favorable tax rates.  The small dividend amounts in comparison to the principal amount ($200 M) would mean that the entire investment would be less volatile than if they just bought common stock, assuming that the principal amount would be held at cost on the balance sheet.

 

That's what I'm thinking at least.  More thoughts about whether I'm right or wrong about the above?

 

By the way, I don't own SD or any oil and gas companies at the moment.

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GAAP encourages fair value accounting when a marketable price is readily available. Sounds like it would fit in with 1) asset under FASB 157 accounting (came out after I finished school so I might be wrong).

 

 

With USG they simply converted right away at a higher price than market...they might do the same thing here..they might not but for all practical purposes 200m they got 18 million shares of SD and a 60 million 5 year annuity. 

 

SD also sold 24 million shares at 8.85 a share so if Fairfax wanted to buy 18.4 million they would of paid 163 million dollars.  Thus effectively they paid 37 million dollars for 60 million dollars in cashflows over 5 years. 

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SD also sold 24 million shares at 8.85 a share so if Fairfax wanted to buy 18.4 million they would of paid 163 million dollars.  Thus effectively they paid 37 million dollars for 60 million dollars in cashflows over 5 years. 

 

That's too optimistic, I think. The interest might simply be a hedge against company performance; i.e., if the stock doesn't move at all, then Fairfax pays 4.2% of compounded appreciation in exchange for 5 years of 6% interest.

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