Description

 Sandridge Convertible 8.5% Convertible Perpetual Preferred Stock (SDRXP)

Background:

Preferred prospectus: http://www.sec.gov/Archives/edgar/data/1349436/000095013409000802/h65499exv3w1.htm

Second lien liquidity update: http://investors.sandridgeenergy.com/files/doc_news/2015/052915-SD-Updates-Shareholders-on-Enhanced-Liquidity-and-Improved-Flexibility.pdf

Not without risk, at $22.50 on a $100 par, shares of Sandridge 8.5% convertible preferred stock (SDRXP) present an investment with a reasonable expectation to be made whole through dividends in 2.5 years while maintaining substantial upside in an oil price recovery scenario.  Despite raising $1.25bn in second lien financing on June 10, which brought liquidity at May 29th to $1.4bn, the company’s entire capital structure is trading like it’s going BK next week.  In reality SD has at three year runway of liquidity in the current oil environment.

There are few unique features to this particular instrument that make it more attractive than your garden variety preferred issuance. While the dividend is deferrable and cumulative like most other preferreds, it contains a provision that allows for the dividend to be paid in common stock.  This mechanism is currently being utilized and diminishes the company’s appetite for deferring payment as it does not negatively impact their liquidity to make the payment.  Conversely, deferring the dividend could crush the capital structure, even at the current low market prices (see Miller Energy for a recent example).  As an added bonus, when the dividend is paid in common equity instead of cash the dividend is calculated based on 95% of the market value of the common stock, which increases the dividend above the stated $4.25 dividend.  Another unique feature is that the dividend is semi-annual.  This matters since Sandridge just declared the dividend on July 6 (two days ago), meaning shareholders of record on August 1st will receiving back approximately $4.46 in value in month representing about 20% of the current market value.  It was very surprising to me that the SDXRP did not appreciate substantially with the dividend declaration, which is a big part of the opportunity today.

However unlikely from today’s view, there is upside with appreciation toward par if oil prices rebound and credit quality improves. Perhaps more precient, there is potential upside in the convertible feature which converts into 12.48 common shares per preferred at the option of the preferred holder.  A Sandridge common equity price above $1.80 puts the preferred in the money (at its current $22.50 price), a price it maintained only two months ago.  

At its core, the debate about Sandridge boils down to management’s credibility.  Bears would describe SD in the following manner: Two years ago, TPG-Axon activists successfully threw out Tom Ward and took four board seats.  Sandridge subsequently divested its Permian assets in 2013 for $2.3 bn and sold its Gulf of Mexico assets in 2014 for $700mm. Since then current management has spent and is still spending way too much on Capex and acting arrogant about their economics that don’t always pencil out the way they should.  Basically, a new management is as bad as the old management. The final straw for stakeholders was the last quarterly report that revealed the company spent of 46% of their 2015 $700mm project Capex in the first quarter on top of taking $126mm hit to working capital leading to a consolidated $340mm cash burn over 3 months.  If that sounds brutal, it’s because it was brutal.  

All the negative sentiment above is accurate.  However, it ignores two important points: One, Sandridge just raised a massive amount of liquidity and, two, we should be at an inflection point with cash burn slowing dramatically.  The Q1 large cash burn phenomenon was wide spread across the E&P sector, including recent write-ups on VIC.  Goodrich Petroleum, Gastar and Magnum Hunter spent 48%, 44%, 44% of its projected 2015 Capex in the first quarter took a big working capital hits.  More importantly, as IR put it directly to me in an email last week, “With respect to any concerns surrounding the company’s liquidity position, I remind you of the recent $1.25B issuance of Second Lien Notes.  After service fees, paying down bank debt and adjusting the borrowing base on our Sr. Credit Facility from $900mm to $500mm, this leaves the company with right at $1.4B of total liquidity.  This issuance of reasonably price notes secures many years of liquidity for the company, regardless of the price environment.“

There are a few additional levers Sandridge can pull with respect to raising even more liquidity.  Their salt water disposal MLP received the IRS go ahead on May 29th (https://www.sec.gov/Archives/edgar/data/1349436/000119312515209262/d937443d8k.htm), which could raise cash in an IPO.  Management has also disclosed it would divest some additional assets on its Q1 call, “We mentioned several things in terms of options to monetize assets. We have some real estate holdings, we have some smaller non-core EMP properties, we have some infrastructure whether it's a water gathering or electrical or other infrastructure, those would be the potential sources of monetizations this year.”

Compelling (or not?) narratives aside, what matters here is a cogent liquidity analysis.  Below are my numbers, but first a few items to note and my assumptions. Oil is substantially hedged in 2015, even though 60% of its hedges are 3-way collars with sub floor puts.  With respect to 2016, depending on how much production one assumes (I assume a 30% decline based on very low Capex), they continue to have a significant amount of oil hedged. Even at today’s oil prices, I project Sandridge with near $1bn in liquidity by the end of 2016 and over $500mm by the end of 2017.  I assume working capital ceases to be a drain on cash after Q2 2015 as it has largely been driven by laying down rigs which accelerates payables.  Rigs came down from 35 at 12/31/14 to 13 rigs at 3/31/15 and only 7 active rigs at the time of the Q1 call on 5/7/15.  Reasonable people can debate how much more Capex management will spend past 2015 than I modeled, though that would increase EBITDA, even if it would lower my liquidity outcome in 2016/2017.  At $22.50 with $4.46 being paid out in a month, the Sandridge 8.5% preferred issue is compelling.

For the VIC members that will inevitably comment about the illiquidity or inactionability of this issue, I have two comments. Congratulations on managing a much larger fund than mine! Alternatively, a very similar case can be made for the Sr. Unsecured bonds at current prices of 40 and under, which we also own.  There are $3.15bn of face value outstanding and they trade with regularity.

Risks

It’s E&P which means everything can go wrong

Oil stays depressed for years

Fracking causes a large earthquake that effectively blows up the industry

Management throws their cash in a dumpster and sets it on fire

Catalyst

Upcoming dividend payment

Second quarter liquidity update

Management spending within their guidance paramters

Upside with an oil rebound