Just over a week ago, Santos (STO) shares took a 10% thumping on the news the company had sold a 15% stake in its Gladstone CSM LNG project in Queensland to Total at a price some 20% below market expectation.
While the sale itself provided further confidence Santos could reach financial investment decision (FID) status on a second train at GLNG by year-end, the sale price, and sUBSequent foregoing of a $500m milestone payment from 45% stakeholder Petronas, was a big disappointment.
The cheap sale highlighted the fact Santos is in a desperate race against time. The company risks being stuck with an expensive white elephant if it can't get GLNG's train-2 off the ground before the window of global demand for LNG closes.
And while the increase in Total's stake from 5% to 20% showed faith in the project, the net price meant Santos would need to raise a further $2-2.5bn, according to analysts, with a dilutive rights issue being a more than likely component. It was this realisation in particular which had the market running scared.
Analysts nevertheless suggested at the time that Santos could raise some of that funding through an equity/debt hybrid issue while still hanging on to its BBB+ rating from Standard & Poor's. And that's exactly what Santos announced on Friday.
Santos has successfully put away a E650bn (A$900m) high-yield hybrid issue in Europe. The fact the issue was twice oversubscribed provides yet more confidence that the world values Santos' CSM LNG aspirations.
But it was the structure of the hybrid which most impressed analysts. While high-yielding and not actually convertible into equity, the issue's low seniority means S&P has declared the debt to be a 100% equity equivalent. This means existing holders of common equity will not have their earnings and dividends per share diluted.
It also means Santos hangs on to its BBB+ rating, albeit there's not much room to maneuver anymore. The reality is Santos will still need to raise more equity capital and this will most likely come in the form of a dilutive rights issue, although analysts expect existing shareholders to be rewarded with a discount.
Santos can still look to sell more equity in the project (analysts believe a 5% sale to KOGAS previously flagged will go ahead), could tie up some third party leasing deals, or could restrict equity dilution by holding back on the dividend.
As to how much Santos still needs to raise, analysts are not in agreement. That is, all of BA-Merrill Lynch, Macquarie, UBS, and JP Morgan assume around about $1bn, but Citi is still assuming $2.3bn due to “credit agency conservatism”.
The problem is that S&P is assuming an average oil price of US$70/bbl in 2010 and 2011 and US$65/bbl thereafter. With oil having traded in a range between US$70-80 for all of 2010 to date, it would have to spend the next three months well below US$70 to reach that average. And S&P is assuming latter prices to be lower when analysts are expecting latter prices to be higher. Santos has little choice but to put up with this conservatism if its BBB+ rating is tenuous.
The equity raising is not the only hoop left for Santos to jump through before reaching FID on train-2. There is still a small matter of proving up sufficient gas reserves to make GLNG T2 viable, the company is yet to provide a final capital expenditure estimate, and the project must pass federal government environmental approval.
The latter hoop-jump may be delayed now that the cabinet has been reshuffled. All of the above are cited by analysts as reasons why the market has been nervous on Santos shares, albeit the hybrid news did spark around a 3% pop on Friday.
Analysts nevertheless remain a lot more positive than the market.
They point out that Santos has indicated it could feed T2 with gas from its other projects if necessary, that management is sticking to a “conservative” $18bn capex expectation (meaning there's room for surprise), and management is looking at further asset sales and third party infrastructure agreements which could reduce the net equity raising requirement.
They also suggest the government probably won't muck around too much on environmental approval.
But Santos also noted it might review its dividend policy. This is not good news for shareholders, but then a reduced dividend would still be a better net result for existing shareholders than a too-dilutive rights issue.
Management remains confident the returns on T2 will be greater than the company's net cost of capital, so in theory a dividend cut could translate into offsetting capital appreciation for the patient investor. Santos also noted it was still confident of making its year-end FID deadline.
So the hybrid issue is another incremental step along the excruciating path of de-risking GLNG T2. Analysts remain more confident than the market and continue to point out the re-rating expected if FID is achieved.
The additional interest expense from the hybrid has nevertheless meant forecast earnings per share are reduced by circa 4%.