Sandridge Mississippian Trust II (SDR) units are currently trading at a low level given to their projected income stream. Specifically, one has the opportunity to purchase a unit $15.00 and with a very high degree of certainty receive $5.05 in distributions (because they are both preferred and hedged) over the next 25 months. We believe that an investor's effective net investment is $9.95 and that presents a favorable risk reward investment opportunity. The base case projected distributions in the prospectus called for payments of $3.2 for 2015, $3.02 for 2016, and $2.37 in 2017. Distributions should continue at a reduced level until the Trust's termination in 2031.
Sandridge Energy (SD) created a few Royalty Trusts as a method to finance the Company's rapid growth, including Sandridge Permian Trust (PER) and Sandridge Mississippian Trust I (SDT). SDR went public at a $1.04 billion valuation (49.7 million units x $21), an approximate 10% premium to its PV-10 value ($688 million for its proved reserves and $211 million for its probable reserves). The Trust receives a royalty from the sale of oil and natural gas from 67 wells that existed at the time of the IPO and 206 that will be drilled before 2016. The Trust's Royalty interest will terminate in 2031.
There are a few reasons why we believe the units have crashed in value:
- The Trust reported disappointing results on January 31st. In the prospectus for the Trust IPO, the sponsor Sandridge Energy had projected a distribution of $.60 fourth quarter of 2012. Instead, the distribution will only be $.532.
- Sandridge Energy , the operator of SDR, has faced a number of problems that are similar to Chesapeake Energy (CHK). For example, SD's CEO was paid $150 million in compensation over a time period when its shares lost more than 75% of their value. Shareholders in SD led by TPG Axon are currently waging a proxy battle to remove the Board of Directors.
- The oil and gas Royalty Trust segment of the market has come under pressure in general. Several Royalty Trusts were obviously trading a premium to the present value of their underlying cash flows. As Seeking Alpha Contributor Shane Blackmon correctly explained in his seekingalpha.com column, WHX was being valued on its past dividends instead of its future ones. As WHX declined in price by 75% following the article, there was selling pressure across the sector.
- Following Shane's article and WHX's dramatic price decline, Jason Zweig, the Intelligent Investor columnist for the WSJ, wrote an article that was critical of the sector.
- Following the earnings release, Raymond James downgraded the units to underperform.
SDR currently has a market value of $760 million, a discount to its likely current PV-10 value. Given that the Trust has distributed $65 million since inception and oil and gas prices are essentially unchanged (and part of SDR's production is hedged), its PV-10 value is roughly $830 million. Private market values for in the sector are between PV-10 and PV-5 and that is one reason that SDR could go public at a premium to its PV-10 value. Importantly, unit holders were given a preferred interest in the royalty stream until a year after all of the development wells are completed. SDR issued two types of units, 37 million common units that trade publicly and 12 million subordinated that are held by SD. If the Trust does not meet minimum distribution targets ($2.17 for 2013 and $2.36 for 2014), the subordinated units will not receive a distribution. Therefore, to the extent a larger shortfall in distribution payments develops in the near term, it will fall almost entirely on the subordinated unit holders. The holders of common units are highly likely to receive $5.05 over the next 25 months:
- Current Unit Price: $15.00
- Announced Distribution Q4: $ 0.53
- Sub. Threshold 2013: $ 2.16
- Sub. Threshold 2014: $ 2.36
- Effective Net Investment: $9.95
The January 31st Earning Miss
The Trust announced on January 31st a distribution $.53, a shortfall from its fourth quarter projected distribution of $.60. The shortfall itself does not concern us, as the third quarter distribution exceeded the projection. Quarterly projections are inherently subject to fluctuations. There was one item in the earnings release that we continue to monitor. The trust met its target for total energy production. Revenues were slightly lower than expected as production shifted from oil to gas. Arithmetically, it appears that the 98 development wells drilled to date of a planned 206 should have resulted in more total production.
If one applies the same 10% earnings shortfall that occurred in the fourth quarter to all future distributions, the units are clearly undervalued. One would expect to receive over a 10% return over the life of the investment in an environment where treasuries yield less than 2%.
The disaster scenario is that the Trust's offering was based on wildly inaccurate projections of oil and gas reserves. Even if this were the case, Montrose believe that an investor will still recover most of his investment over time at a $15 cost basis. Montrose believes that if a major shortfall exists (aside from a decline in energy prices), there are numerous parties that will have lawsuit liability to the trust. Potential defendants include Sandridge Energy, the underwriters (Morgan Stanley, Raymond James, and Merrill Lynch) and the auditor Pricewaterhouse.
- Highly Likely Distributions over next 25 months: $5.05
- Conservative Distributions from 2015-2021: $5.00
- Settlement proceeds from parties named above: $2.50
- Total Payments $12.55
The units have over reacted to the recent earning miss, falling by more than 20% even though earnings were only off by 10%. Again, the Trust's distributions are largely protected from shortfalls for the next two years by the subordination threshold. Therefore the valuation disparity between the recent unit price decline and the fourth quarter earnings miss is actually far greater.
Additional disclosure: Montrose Capital Group LLC is a private investor focused on reactive event driven investments. Montrose is in the business of actively buying and selling securities and other financial instruments for its own account. Montrose currently maintains an effective long position in the SDR. The presentation is not investment advice or a recommendation or solicitation to buy or sell any securities. Please consult your own advisor. Investing in SDR involves risk, including the severe loss of principal.