By Paul Rickard

In the absence of a spirited rebound in the oil price, it was inevitable that Santos would raise capital. It was just a question of ‘when’ and ‘how much’.

When you are carrying too much debt and your revenue becomes dependent on a variable that you have absolutely no control over - the oil price - the only choices facing a Board are either to sell assets or raise capital. Selling assets is hard, takes time, and when you do, the chances are that you will be criticized for selling too cheaply and giving the farm away. The short sellers and the market know this, and when they get their teeth into a company, 9 out of 10 times the company’s Board buckles and reaches for the telephone to call the brokers to arrange for a rights issue.

With 8.29% of Santos’s ordinary shares (or approximately 86 million) in short positions and time running out before Christmas to get an issue away, Santos’s Board did exactly this on Monday and announced a $2.5bn capital issue. How the short sellers must now be celebrating!

Debt will be reduced by $3.5bn

Santos will reduce its net debt by $3.5bn through a $2.5bn pro-rata capital issue, a $500m private placement to China based private equity firm Hony Capital and the sale of its 35% interest in the Kipper gas field located in the Gippsland basin for $520m. Net debt will fall to $6.2bn, leaving the Company with a gearing ratio of just over 50%.

The pro-rata capital issue is via a 1 for 1.7 entitlement offer at $3.85 per share. For example, a shareholder with 1,000 shares will be entitled to buy 589 new Santos shares at $3.85 per share, or $2,267.65. The $3.85 price represents a 25.2% discount to Santos’s theoretical ex-rights price of $5.15, which is calculated using the closing price last Friday of $5.91.

The first part of the issue, the institutional offer, was completed yesterday with stock not taken up clearing at $4.60 - a 10.5% discount to the theoretical ex-rights price. The second part, for retail shareholders, opens today. They can elect to do one of the following:

  • Take up their entitlement. Payment is due by the offer closing date of Monday 30 November; 
  • Sell their entitlement on the ASX, which will trade under code STOR. Trading commences today and ceases on Monday 23 November; or 
  • Do nothing, in which case their entitlements will be auctioned, and depending on the auction price, they may receive a payment on 9 December of any excess over $3.85 per share.

Hony Capital’s investment is interesting. Founded in 2003, the Chinese firm manages around $11bn of funds. Investors in Hony Capital include Chinese entities Legend Holdings, the National Social Security Fund and China Life Insurance, and offshore investment institutions such as Goldman Sachs, Temasek, and Canada Pension Plan Investment Board.

Although they are paying $6.80 per share for the private placement of 73.5 million shares, they will also be able to subscribe for 43.2m new shares at $3.85. This brings their average entry price for the 6.5% share of the company down to $5.33 per share - just a 3.5% premium to the theoretical ex rights price. With an existing holding of 1.4%, they will own 7.9% of Santos following the offer.

Hony has undertaken with Santos not to go over a 9.9% interest for 3 months, and not to divest any of the shares acquired in the placement for a period of 12 months.

Santos also confirmed the appointment of a new CEO, Kevin Gallagher. Formerly the CEO of engineering services at Clough, he will take over in dearly 2016.

Dividend cut - lower payouts to come

Santos announced that the final dividend for FY 15 (which ends on 31 December) would be 5c per share, payable on the expanded capital base. This means shareholders will receive an effective 8.5c, compared to the 15c payable for the final dividend in 2014. Perhaps more importantly, they have also re-cut their dividend policy. Gone is the progressive dividend policy of 2014 - now it will pay a minimum of 40% of underlying net profit after tax.

Predicting underlying profit after tax at Santos is fraught with danger, particularly with the volatility in the oil price. However, if we assume that the 5c estimate for this half is any guide,  then  a 10c pa full year dividend on a $3.85 share offer price is a yield of just 2.6% - on the ex rights price, it falls go just 1.9%. The key take for shareholders is that for the foreseeable future, Santos is no longer a high yielder.

Control premium gone? A pure play on the oil price?

There has also been comment in the media that Santos sold the stake to Hony too cheaply. Although their effective holding is only 7.9%, some argue that this could be used as a “blocking stake” and may dissuade other bidders emerging from the woodwork.

Maybe. But I am not so sure that a 7.9% stake would stop others from bidding, notwithstanding Santo’s strong retail shareholder element. What probably can be argued is that it has reduced the prospect of Santos’s share price sustaining any material takeover premium.

Perhaps more importantly, I am not yet convinced that this may be Santos’s last capital raising. It all depends on the oil price. 

While S&P is expected to affirm Santo’s credit rating at BBB, its gearing ratio is still relatively high. Santos has warned of the potential for a non-cash impairment in its 2015 accounts due to lower oil and gas prices. They have provided some indicative levels of impairment and under one scenario, this could be up to $2.4bn post tax. This would see the gearing ratio rise to around 60%.

Santos looks and feels to me now as being largely a bet on the oil price. Long term, it is probably fabulous buying in the $4 area - but there might be some further pain in the short to medium term if oil prices stay down, or worse still, fall further. If you like oil, add Santos to your shopping list, otherwise I think time is on your side.