Yesterday I sat down to listen to and review the Sandridge Energy (SD) 2012 Analyst Day presentation. I don't own Sandridge Energy but it is constantly on my watch list because it definitely trades at a significant discount to what I believe is the market and long-term value of its assets.
The discount the stock market is assigning to Sandridge's assets does not exist without good reason however. The company is very heavily leveraged with the highest debt to EBITA ratio of any American independent oil producer. Such a high debt level relative to cash flow leaves little room for error. I don't like it when a company's balance sheet can turn operational hiccups into disaster for equity holders.
Additionally Sandridge and its CEO Tom Ward don't exactly make many friends in the analyst community with their ever-changing and completely unpredictable business strategy. For example, consider Sandridge's recent acquisition of offshore Gulf of Mexico producer Dynamic Offshore for $1.2 billion. If anything, analysts had been led to believe that Sandridge's small offshore exposure would be reduced over time. Offshore assets were not expected to be a key or really any part of Sandridge's plans going forward. Instead of following its own script, Sandridge threw a curve at the analyst community and instead made a very sizable offshore acquisition.
How can an analyst get behind a company and recommend it to investors if that analyst has no idea what the long-term strategy of management actually is. I'm not saying being opportunistic is wrong, or that it doesn't create shareholder value. I'm saying it hurts Sandridge's reputation on Wall Street, which can impact short-term stock performance.
A further concern is that Sandridge's spending plans are always in excess of the cash and liquidity that the company has on hand. In order to carry out its operational plan, Sandridge has to regularly sell assets to raise cash. As we saw in 2008, there are market conditions into which selling oil and assets for anything close a fair price is not a given. This reliance on strangers for future funding will, and should create some concerns for investors.
I understand all of these concerns, the primary concern for me being the amount of debt that the company has. I like to be able to sleep well at night knowing unpredictable events can't turn an investment into a zero. Yet I am tempted to own Sandridge, because while CEO Ward is unpredictable, he has also led Sandridge to some incredible value creation over the past few years. And that value recognition has gone largely unrecognized by the stock market.
$400 Million Turned Into $8.7 Billion
The current enterprise value of Sandridge Energy is somewhere around $7 billion. I believe that the company has created that much value in just one play over the past two years.
The play is the Mississippian and it is found in Oklahoma, and Kansas. It is a shallow, carbonate oil play where Sandridge has accumulated 1.5 million acres. Sandridge believes that it has 7,000 drilling locations on this acreage with an IRR per well of 91%.
The key to the value creation is that Sandridge acquired all of these acres when the acres were not in demand, before the industry was on to the economics of the play. Here are the three phases that Sandridge has gone through in the Mississippian:
Phase 1 - Accumulation
Acres Acquired - 2 million
Average Cost Per Acre - $200
Total Amount Paid - $400 million
Phase 2 - Monetization
Acres Sold - 550,000
Average Price Received Per Acre - $4,236
Total Amount Received - $2.33 billion
Phase 3 - Retained Value
Acres Retained - 1.5 million
Value per acre based on monetizations - $4,236
Total value Retained - $6.35 billion
Let me recap what Sandridge has done because it is quite an accomplishment. Two million acres were acquired for $400 million. About a quarter of those acres were sold for $2.33 billion. And Sandridge retains acreage worth roughly $6.35 billion.
$400 million invested, with proceeds from sale and current value equaling $8.68 billion. Try to match those two-year returns with your equity portfolio.
There were four monetizations in total that amounted to $2.33 billion. Those monetizations were:
- SD Mississippian Trust I ($333 MM) - Closed
- Atinum JV ($500 MM) - Closed
- Repsol JV ($1.0 B) - Closed
- Second Royalty Trust ($500 MM) - Pending
For me, those four separate monetizations provide pretty good evidence of what the value of the remaining Mississippian acreage is. And if you buy into the idea that Sandridge's retained Mississippian acreage is worth $6.35 billion (which almost equals Sandridge's current enterprise value), then you will agree that buying Sandridge at the current stock price means you get all of the company's non-Mississippian assets for free.
Those other assets would include:
- The assets Sandridge just paid $1.2 billion for in the Dynamic Offshore acquisition
- Sandridge's Permian Basin assets that have a PV10 value of $3.9 billion
- Sandridge's West Texas natural gas assets that are likely worth a couple of billion dollars even at current natural gas prices, much more at more reasonable natural gas prices
Personally, I love Sandridge's Mississippian and Permian Basin assets. I think they alone over time are likely worth more than twice the current share price. And I'm also very attracted to the upside valuation potential that Sandridge has over the longer term should natural gas prices improve.
What continues to hold me back is that I have no confidence that Sandridge six months from now is going to look anything like Sandridge today. How can I make an investment decision if I don't really know what I'm actually going to be holding six months from now? Will Sandridge make another big Gulf of Mexico acquisition that dilutes the value of their Mississippian assets? Who knows?
Three years ago Sandridge was a natural gas company. Now the sizable natural gas assets barely even get mentioned in a detailed analyst day presentation. I'm not suggesting that what Ward and Sandridge have been doing isn't in the best interests of shareholders. I'm just suggesting that it is hard to make a buy and hold investment decision on a company that changes its long-term strategy every six months.