Sanchez Energy: Market Hates A Plan That Is On Track

Summary

• The stock is up nicely over the last two weeks. Now will that finally break the long downtrend?
• Cash flow in the second quarter moved sharply in the right direction. Now will the third quarter follow suit?
• Increasing well productivity appears to allow for a lower-than-anticipated capital budget.
• Management alluded to "un-sub" generating cash in the conference call.
• The market wants to see the vaunted great well results translate into greater cash flow and higher production.

Mr. Market celebrated when Sanchez Energy (SN) made the latest acquisition.

Source: Seeking Alpha Website November 4, 2017

As shown above, back in January, the market loved the idea of the acquisition. But ever since management announced the actual strategy for integrating this purchase and taking advantage of the assets, Mr. Market has hated the execution every step of the way. The quarterly conference calls, production announcements, and earnings results have provided some small positive bumps along the way. In fact, the stock is up nicely over the last two weeks or so.

But clearly the market has been heading for the exits and is not yet about to change its strategy. Still, Sanchez Energy management has a sound, if speculative, strategy. So even though I was stopped out of this investment idea early, I am waiting for the freight train to stop to get back on. Maybe this time around the stock will level off and finally begin its climb.

Sanchez Energy First Quarter 2017 10-Q

Source: Sanchez Energy Second Quarter 2017 10-Q

Part of the problem may be the cash flow. This company has about $1.9 billion in debt and another $400 million mezzanine equity that needs to be dealt with as of the third quarter. Yet, management really did not discuss cash flow. As discussed in previous articles, the corporate structure is a little complex at the current time.

But the market wants to know how that debt will be paid. While management has a plan, they are not really good at explaining the plan so the stock continues to take a beating. Cash flow from operations in the first quarter was negative. The second quarter needed about $78 million to erase the negative cash flow and get to the balance shown above. That eclipsed the second-quarter cash flow from operations of about $62 million in the previous year.

Management never discussed the third-quarter cash flow and has yet to file the 10-Q. Clearly, the company needs to generate about $200 million a quarter in cash flow from operations. The 10-Qs above show that cash flow is headed in the right direction at a pretty good speed. But confirmation from the not yet 10-Q for the third quarter is badly needed. So despite the positive reaction from the market after the conference call, there could be another tumble on the way when the market realizes that cash flow from operations probably has a way to go yet.

Source: Sanchez Energy September 27, 2017 Investor Presentation

The unrestricted subsidiary (click on the presentation) has got a fair amount of production but not a lot of growth at the present time. Any cash flow generated will be used to eliminate the credit line at the unrestricted subsidiary. So Sanchez Energy, the parent company, cannot use the cash flow generated by the unconsolidated subsidiary. That cash flow is accounted for at the subsidiary level.

For the time being, there will be no cash available to the partners. Management did allude to the idea during the conference call that the unrestricted subsidiary was beginning to generate cash. But with no 10-Q, investors really have no idea how well it is going. Management is not big on providing cash flow details for the complex structure. It is early in the game, but some clarity would help Mr. Market.

Instead, management spent a great deal of time emphasizing that the liquidity of $629 million showed that the company had plenty of flexibility. Still, some unease was shown by the conference call questions centering on what property may be for sale next. Heavily leveraged companies often have credit lines they don't use because banks have enough restrictions on those credit lines to keep them from being used. That does not appear to be the case here, but the lack of cash flow information and cash flow planning may have spooked the market.

Instead, management spent a fair amount of time referencing the second slide trying to assure everyone that all was well. Let's give management credit. The plan was ambitious, but it appears to be on-track using one less rig than originally planned. The market got all bent out of shape when drilling slowed down. But well completions have never slowed. The backlog of DUCs currently is still pretty impressive. Management went to great pains to emphasize that the completion crews were not cut.

However, the comparison of the second-quarter production of 2 MMBO out of 6,674 MBOE with the third-quarter production of 2 MMBO out of 6,788 MBOE can be a little unsettling when there are relatively large debts to pay in the future. After all, a large increase in production was supposed to bail this company out of its debt problems. Still, the announcements of record breaking wells at ever higher levels should ease fears of lower drilling activities.

In fact, those higher record producing wells should ease fears of lower oil prices.

Source: Sanchez Energy September 27, 2017 Investor Presentation

Higher production will decrease that enormous $7.32 BOE of dividends and interest. It will also decrease depreciation and amortization going forward because the increasing production spreads the well costs over more product. Lease operating cost and general and administrative costs are already spectacularly low, but they could decline more. Fewer, but larger producing wells should lower costs.

So future wells should lower the company breakeven more and assure profitability at (probably much) lower commodity pricing. The hedging program will at least provide a cushion to get to that profitability. If management has time to layer in all the hedges to "guarantee" a certain profitability level, then the hedging program could do more. Contrary to some concerns, a raging commodity price bull market would just be met with more drilling. The banks and probably the market too would be happy to cooperate.

Where We Are Now

Source: Sanchez Energy September 27, 2017 Corporate Presentation

Management has announced continuing improvements in addition to what is shown above (click on presentation). If that is the case, then the coming lower capital budgets should produce a robust rate of growth in line with what was originally forecast. Cash flow breakeven may come sooner than forecast. Most likely depreciation charges would decrease. But there may also be increasing efficiency for the continuing expenses as well. The market appears to be a nervous wreck waiting to get to that cash flow breakeven point.

Management appears to be on-track with their goal of raising production. They have been raising some cash by selling off some leases so they can concentrate on the joint venture. Those cash raises are not necessarily a sign of stress. Instead, maybe management could get a decent price to take the cash and reduce future loan balances while production is ramping up.

For the time being, the liquidity appears decent and the partnership appears to have the time to carry out its plan. The long-term debt is not due for awhile. In fact, the first step is to pay down the unconsolidated subsidiary credit line and then probably redeem the preferred stock to gain access to that cash flow. If the stock market continues to ignore the partnership progress, that preferred stock redemption could potentially result in a lot of common stock dilution.

Between now and that potential redemption is a lot of time for management to increase production and cash flow. Management is forecasting double-digit production growth and has begun to hedge production four years out. Locking in certain profits may be a necessity with all the future preferred stock redemption and eventually debt requirements.

The IRRs shown above should lead to a rapid cash flow build. Mr. Market is definitely looking forward to more cash flow. So, in the current atmosphere, the common stock will probably remain weak a while longer. But the speculative future still appears on track. The real quandary is the value of that future success. If that originally forecast value is still attainable, the return from the current stock price could be every bit a home run. Maybe at current levels, the timing of the purchase is not that important. However, earlier buyers have already been through a gut wrenching downward spiral. That is why stop loss orders (and maybe puts) are very important. They usually enable one to sleep at night in case something like this happens.

But if the joint venture succeeds as planned, eventually this stock will respond. I am not one to stand in front of runaway trains. So as long as the stock continues its current downtrend, I can definitely watch and wait. Once the stock levels off, then it may be time to get back in. That is especially true if the production is well hedged and rising. After the last well received conference call, the stock resumed its downward trend. Time will tell if that happens this time. Management could help the situation with a whole lot more detail and clarity during the conference calls.

In the meantime, the preferred issues may be interesting. They pay dividends one way or another. So at least you are getting paid to wait. In some ways, the market would have been better off not celebrating the initial deal. Ever since the initial announcement, the stock has skidded lower on fears of failure. It is a little soon for those fears to be realized. The way things are going right now, management is on track to succeed with a lower-than-anticipated capital budget. Investors will just have to wait to see when that realization clicks with the market. This stock could still be a home run even from much higher levels. But right now the market clearly is not sold on a home run.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents, and press releases to see if the company fits their own investment qualifications.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SN,SCAZP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.