The Proxy Battle Is Over, What's Next?
There has been a lot of wishful speculation in the blogosphere that with the change of control that has just effectively occurred at SandRidge (SD) (please see the text of the press release at the end of this note), the company may now be on a direct and short path to be sold at a premium. While this may certainly be one of the desired outcomes for the activist investors who have just gained a significant degree of strategic control, it is difficult to bank on such expectation. More likely, the stock's journey towards a meaningfully higher price level is going to be longer and more jittery than optimists might expect, with no guarantees of positive returns attached.
Despite its single-digit stock price, SandRidge is not a small company. Its equity market capitalization is ~$3.4 billion (based on 588 million of fully diluted shares and $5.71 stock price as of March 14 close). On top of that, even after the planned repayment of the $1.1 billion in bonds from the recently closed $2.6 billion sale of the Permian assets, SandRidge would still have ~$3.2 billion in debt (net debt is ~$1.5 billion after subtracting pro forma cash on hand). The resulting ~$4.9 billion Enterprise Value compares to only ~$400 million in Adjusted Cash Flow from Operations that SandRidge has guided to for 2013 (which is dependent on the very aggressive $2.3 billion total investment plan for the year).
(Source: SandRidge Energy March 5, 2013 Investor Day Presentation)
It would be logical to assume that if any potential strategic acquirer is interested in SandRidge, it would be for its core position in the Miss Lime. A meaningful premium to current stock price (let's use 40% for purposes of illustration) would imply a total consideration of ~$6.2 billion (this does not include likely premium that may be triggered on the outstanding bonds and other transaction costs). As part and parcel of the hypothetical transaction, the acquirer would be paying for SandRidge's mature, fast-decline Gulf of Mexico oil properties (the value can be as high as $1.4 billion) and would be assuming ownership - and associated liabilities - of the currently low-economic West Texas Overthrust gas assets. These other assets are an obvious deterrent to the majority of potential acquirers, representing significant financial outlay and disposal headaches.
Moreover, at a 40% premium to current stock price, the deal may not even be acceptable to the activists. Given the steep decline in SandRidge's stock price since October, a higher premium may be needed for the deal to clear a minimum return threshold. In the absence of a high-premium offer, the activists may end up holding out for better operating results from the Miss Lime in order to be able to sell at a higher price, rather than flip their investment quickly at a low return.
Long Operating Journey
As I have written repeatedly in the course of the past several months, one thing that the activist shareholders cannot bring to the table is the "silver bullet" that would instantaneously crack the operating code of the Miss Lime's geology and extraction technology. With all the initial excitement about the play and heavy promotion by the sell side of the spectacular drilling returns (some reports still put the Miss Lime as the most profitable play in the U.S.), in reality, the play is geologically and technically complex and not homogeneous from area to area. In fact, it would probably be correct to think of the Miss Lime as a variety of plays that morph into each other (and provide a stacked pay opportunity in many areas). Discussion during SandRidge's recent Analyst Day was a vivid testimony to that point.
(Source: SandRidge Energy March 5, 2013 Analyst Day Presentation)
To provide an illustration of how much trial and error the play will likely involve before optimal operating algorithms are established: among many operating case studies, SandRidge highlighted how a 15-foot distance in the position of the lateral can completely change the outcome of a well (from uneconomic to highly successful in this case).
(Source: SandRidge Energy March 5, 2013 Analyst Day Presentation)
In another case study, SandRidge provided an update on its assessment program in the Hodgeman/Ness area where, despite historical success of vertical drilling, their horizontal program has encountered geological problems (water).
(Source: SandRidge Energy March 5, 2013 Analyst Day Presentation)
There is little doubt in my mind that Miss Lime holds great promise and one day may become one of the most prolific sources of oil and liquids on the continent. However, it may take years before the play is adequately mapped out and technical approaches are found to optimize well and completion designs so that the Miss Lime's potential is fully proven and the high productivity contour is defined.
A 40% premium to current SandRidge's stock price would, in my estimate, value the company's undeveloped - ex existing production - Miss Lime acreage at ~$3 billion (please see my previous detailed note "SandRidge Energy: Value Gap Not Obvious, Leverage Remains A Challenge" for an explanation of various valuation components and discussion of operations). The valuation may seem not exorbitant for a large position in a major liquids-rich play (SandRidge's position could be as large as 800,000 net acres even if the extension area acreage is fully excluded). However, in the market saturated with JV and asset offerings, it is difficult to take for granted that a potential acquirer can be easily found even at this price level. The disappointingly low price accepted by Chesapeake Energy (CHK) after many months of its marketing effort for the Miss Lime JV - with acreage in the core of the play in Oklahoma which in many areas is contiguous to SandRidge's - is a clear signal that the M&A market is currently very challenging for asset sellers (see detailed discussion of the Chesapeake transaction in the same previous note).
What to expect?
There are several components related to SandRidge's strategic course going forward that the new Board will likely be considering in the next few months. The pace of capital spending in the Miss Lime is, in my opinion, the largest variable and may come under immediate review.
The most radical course change could be summarized as follows:
- A drastic reduction in capital spending (by up to $1 billion relative to the current $2.3 billion plan, which includes $0.55 billion of carries), with the remaining capex focused on perfecting well productivity within the most prospective areas already identified and priority given to spending within the Repsol JV and Atinum JV to take advantage of the remaining drilling carries. This approach would essentially sacrifice the exploration program and put the majority of the extension area acreage at risk of being a write-off. It is also important to understand that capital spending has certain lead time and cannot be ramped up or down instantaneously - a course change often translates in material costs.
- Sale of the Gulf of Mexico assets. The obvious risk is that the divestiture may not recover the amount that SandRidge paid last year in full.
- Substantial (to the order of $2 billion) debt paydown. Clearly, the flexibility to re-accelerate investment would be lost (it is easy to repay debt but difficult to raise new funds). However, the paydown would eliminate the risk that the cash will be spent quickly and without true operating improvement.
All the steps combined can be carried out within six months after a strategic review has been completed and decisions been made - i.e., by the end of this year. The much simplified company would obviously have a somewhat smaller footprint, but would carry a manageable debt level and, most importantly, be more focused on value maximization through geo-science and drilling learning curve rather than continuous flipping of recently leased acreage. In my opinion, it would also have a much greater chance of delivering a success in the Miss Lime and be more "digestible" for a potential acquirer. Several hundred thousand net acres in the core of the play, if properly exploited, can be more than sufficient to drive SandRidge's stock price to a much higher level.
The activist shareholders most likely have their own vision of the strategic course. It may, in part or its entirety, be soon adopted by the Board and made public.
Appendix: March 13, 2013 Press Release by SandRidge Energy
The text below has minor abbreviations from the original version. Please use this link for the full version of the press release.
OKLAHOMA CITY, March 13, 2013 /PRNewswire/ -- SandRidge Energy, Inc. (NYSE: SD) today announced that it has reached a settlement agreement with TPG-Axon Capital. Under the terms of the agreement:
- Four of the TPG-Axon Group's nominees - Stephen C. Beasley, Edward W. Moneypenny, Alan J. Weber and Dan A. Westbrook - will be added to the Board of Directors effective immediately.
- The Board of Directors will complete a review by an independent firm of the related-party transactions that have been outlined by TPG-Axon, and expects the results of that review to be completed no later than June 15, 2013. Mr. Ward will remain Chairman and CEO while the Board completes its review.
- The Board of Directors will decide by June 30, 2013, whether or not to terminate Mr. Ward's employment. If the Board does not terminate Mr. Ward by June 30, 2013, three current directors will resign, and one additional TPG-Axon nominee will be elected to the Board, resulting in a majority of the Board being TPG-Axon nominees.
- In the event that Mr. Ward is no longer CEO, James Bennett will be appointed interim CEO, and the Board will conduct a search for a successor CEO. Mr. Bennett has been appointed President and Jeffrey Serota has been appointed lead independent director. In the event Mr. Ward is no longer Chairman of the Board, Mr. Serota will be appointed interim Chairman, for a term of six months.
- The Board will also conduct a comprehensive review of the Company's strategy and costs, with particular focus on reducing corporate overhead and optimizing capital expenditures. As a symbol of its commitment to improving efficiency, the Board has reduced compensation for directors, effective immediately, from $375,000 to $250,000 per year.
Mr. Serota stated "We believe these actions open a new chapter for SandRidge. Going forward, the Company will focus on maximizing the potential of its existing assets, particularly its valuable position in the Mississippian formation. In addition, we remain committed to creating long-term value for all stakeholders including our shareholders and employees and the communities in which we operate. We look forward to the immediate contribution of our new directors."
Dinakar Singh, founder of TPG-Axon, commented: "We are pleased to reach agreement with the SandRidge directors, and look forward to working together to build shareholder value. We believe the actions taken by the Board address our concerns, and are a promising start to a bright future for SandRidge. We all believe that SandRidge has tremendous asset value, and we expect that the Company will relentlessly focus on growing and realizing that value through a particular focus on execution and efficiency."
TPG-Axon Group has agreed to terminate its consent solicitation and withdraw its notice to the Company of its intent to present certain proposals and nominate certain individuals for election as directors at the Company's 2013 annual meeting.
The Company noted that while the Board's review to date has not revealed any improper conduct by Mr. Ward, the Audit Committee of the Board is conducting a further review, with the assistance of independent counsel, and expects the results of that review to be completed no later than June 15, 2013.
Separately, SandRidge also announced today that Matthew K. Grubb, the Company's President and Chief Operating Officer, has informed the Company of his intent to resign to pursue other opportunities. Mr. Ward commented, "I want to thank Matt for his tireless work over the last seven years. He has been instrumental in helping SandRidge transition to a liquids rich company with a solid financial footing. We wish him the best in his future endeavors."
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.