SandRidge Energy (SD) is an independent oil and natural gas company developing and producing oil and gas in the Mid-Continent area of Oklahoma and Kansas. The company has been battling activist investors on corporate governance issues and here is an examination of the settlement on the future of the company.
The settlement in brief
The company announced in the middle of March that it had reached a settlement with TPG-Axon Capital which has been running an activist investor campaign for change at the company. By the end of 2012, the hedge fund was the largest hedge fund investor in SandRidge with holdings of 33 million shares amounting to 10.8% of its equity portfolio. According to the settlement, the company has to add four nominees of TPG to the board of directors with the possibility of a fifth nominee this summer and review and decide the employment status of the present CEO, Tom Ward, by June 30th. TPG will control a majority of the board by then and will withdraw its consent solicitation to replace the entire board. The new directives are expected to push aggressively for more cost-cutting and debt reduction by way of asset sales.
The heart of the corporate governance issue
At the heart of the issue is the conduct of CEO Tom Ward. Since the company's IPO in 2007, he has seen the value of the company sink by 80% and yet he has been rewarded with the outrageous compensation of approximately $150 million during this time. In addition, the company has given him a free hand to strike his own private deals despite the potential conflict of interest with his position as CEO. For instance, he has the freedom to buy key parcels of real estate adjacent to company owned acreage and even sell this real estate to competitors without any disclosure to shareholders.
Cost reduction measures
The new Strategy and Planning Committee of the board has the task of reviewing planned capital expenditure and operating budgets and expects to complete its review soon. It is quite likely that substantial reductions to capital expenditure will be carried out and a sale of assets in the Gulf of Mexico which are the only easily sellable assets other than the core Mississippian Lime holdings. The danger about the asset disposal is that the company paid full price last year which they may not fully recoup from sale proceeds. There are very few other options left given the high degree of debt, the poor operating cash flow and the exploratory nature of the company's core operations.
Under the initial budget for 2013, the company planned to spend $2.3 billion during the year of which roughly $550 million would be funded with drilling carries from the joint ventures with Repsol (OTC:REPYF) and Atinum. This would leave an exceptionally high balance of $1.75 billion compared to the company's projected adjusted cash flow from operations of around $400 million. This plan would have resulted in burning up a substantial part of the cash balances and drilling carries of $1.4 billion. A sharp reduction in capital expenditure and a focus on establishing productivity in the most promising areas and prioritizing the joint ventures would certainly conserve cash and other resources. The disadvantages of this would be a surrender of substantially the entire exploration program and the risk that the company would have to take write-downs on the acreage that it is not using.
The future outlook
The Mississippi Lime play has not yet started generating cash flows and recent moves appears that this will become the major area of operation in the future. This is a bit of a gamble because substantial capital expenditure is planned before it has been proved that these expenditures can be substantiated with results. Management also has based its calculations on $100 a barrel prices for oil and $4.25 for natural gas, figures that seem optimistic at this point in time. If it is to carry through the development of this acreage, it will have to raise additional financing outside its operating cash flows which is not an easy job in the present condition of the company.
The bottom line
In pursuing control of the board, activist shareholders may in fact be pursuing value that is not attainable in the short term. The bet may well turn out to be worthwhile but the possible returns do not seem to justify the risk at this point in time. There are better investments to be pursued in the energy sector and I believe that the current stock price represents a full and fair valuation.