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SandRidge Energy: Will The Debt Restructuring Strategy Work?

Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.

Just two days after I posted a note where I argued that SandRidge Energy (NYSE:SD) needs to pursue more radical steps restructuring its liabilities in order to preserve some value for shareholders. Yesterday, the company announced another significant debt swap.

SandRidge will repurchase $100 million of senior unsecured notes for $30 million in cash. In addition, it will exchange $300 million of senior unsecured notes into convertible notes issued as add-ons to the existing convertible notes.

The structure that the company is using to mop up its senior unsecured notes via market repurchases may appear confusing. However, it is quite simple in its essence.

SD has not made an offer to purchase or exchange its senior unsecured notes. However, the message to the market is loud and clear: SandRidge welcomes unsolicited reverse inquiries. It is also possible that an intermediary or intermediaries accumulate blocks of unsecured notes and approach the company to negotiate the terms of repurchases or exchanges.

Based on the recent transactions which are very visible to market participants, holders of unsecured notes effectively have two options to choose from:

  • An outright sale for cash at a deep discount to face value. This latest transaction appears to be priced at 30 cents on a dollar. (I assume that any accrued interest will be paid in addition as per the bond quoting convention. Neither SandRidge's press release nor the 8-K filing states that explicitly. In the event the $30 million consideration includes accrued interest, the price paid would effectively be lower than 30 cents on a dollar).
  • An exchange into SandRidge's senior unsecured convertible notes ("add-ons" to the existing notes). While the convertibles are unlikely to be converted immediately, they do give the holder an option to receive a combination of cash and SandRidge's stock. For example, if the holder's option to convert was exercised immediately upon the closing of the exchange, the existing owner of the unsecured notes would receive ~11.3-12.2 cents on a dollar in cash (the early conversion incentive) and another ~18 cents on a dollar worth of SandRidge common stock, using the SD stock price on the day preceding the announcement. The calculation indicates that the exchange into the convertibles offers a slight premium versus the outright sale for cash, given that the option embedded in the convertible has tangible value.

The announced transactions are meaningful in size as they add on top of the $525 million of similar transactions announced in August. As a reminder, in early August, SandRidge disclosed that it had agreed to repurchase $250 million principal amount of its senior unsecured notes for $94.5 million cash (~37.8% of face value). In addition, SD exchanged $275 million of senior unsecured notes into new convertible notes.

I should note that the exchange into convertibles does not automatically guarantee that this portion of senior unsecured debt will be equitized. For SandRidge to use its right to force mandatory conversion of the convertible notes into newly issued shares of SD common stock, its shares must trade above $1.10 per share for at least 20 trading days during a 30 consecutive trading day period (see the description below). SD's shares are currently trading below $0.50 per share, a far cry from the mandatory conversion threshold.

On the other hand, the early conversion incentive that is built into the convertibles (the 11.3-12.2 cents on a dollar in year one, stepping down to 7.5-8.2 cents on a dollar in year two and to zero thereafter - see the description below) does not appear rich enough to guarantee voluntary early conversion.

There is one important benefit provided by the convertible structure relative to a buyback for cash: it uses a smaller cash component, enabling SandRidge to potentially exchange its entire remaining ~$2.2 billion of legacy unsecured notes with its cash on hand and even preserve some cash liquidity for other needs (I estimate that SandRidge will have just under ~$800 million in cash available at the end of the year, assuming no additional cash buybacks).

At this point, the balance sheet restructuring strategy chosen by SD is quite clear. The large-size second-lien offering in June was the first step in this...