Write-Up by JONATHAN DANIELSON (NOT Geoff Gannon)
Sandridge Energy (SD) is an upstream oil and nat gas exploration and production company with operations primarily in the Mid-Continent and North Park Basin in Colorado. The Company is an onshore driller and owns three principle assets: Mississippi Lime, NW STACK, and the North Park Basin. The Miss Lime is a mature asset that will continue to decline in production, while the STACK and N Park assets are newer, higher growth, and more economically attractive.
I believe SD to be one of the most demonstrably mispriced and most compelling E&P play around for a multitude of reasons. SD is not a stock for a concentrated investor and extreme caution in trading the name is urged by your author.
Despite being in a tough industry, there is no reason for this valuation discrepancy and it is very unlikely to persist. SD has cleaned house with a new management team in place which has shed unproductive assets, implemented tighter cost controls and will invest future cash flows into their more productive assets.
There are several factors at play as to why SD is currently trading so cheaply. For one, it’s a post-bankruptcy stock. With headquarters in Oklahoma City, Sandridge was founded by Tom Ward in 2006. Ward went on to accumulate over $10 billion from Wall Street investors and pursued strategies that entailed growing without regard to the underlying economics of the transaction in question (Empire building), leveraging the balance sheet with billions in debt, and subsequently entering Chapter 11.
SD emerged from bankruptcy in late 2016 and has seen its share price slide ever since. The reasoning reorg stocks face selling pressure is well documented in Greenblatt’s Stock Market Genius book, so i’ll be brief - as former bondholders now become equity holders there’s a mismatch in owners of the capital structure. Entities who specialize in distressed debt now find themselves owning equity, which they likely have very little interest in. Thus, selling pressure ensues.
Second, the past 5 years have been brutal for all E&P companies with the collapse in oil prices. Many of whom have subsequently filed for Chapter 11. That’s what happens when you take a commodity business notorious for cyclicality and add leverage. Upstream producer’s woes were exacerbated in the second half of last year as oil was again hammered.
Third - and most importantly - SD was on the bidding block last year as part of their “strategic review” and bids came significantly lower than what was expected. I believe many special situation-type investors owned SD last year in hopes of participating in a quick asset sale. As these hopes failed to materialize these investors likely dumped their shares in droves, as they were now stuck with a mediocre oil producer at a time when crude was crashing.
These factors have culminated in a stock that I believe is too cheap to ignore.
Upstream Oil & Gas producers represent the epitome of high risk business models - hundreds of billions of investor’s capital have been obliterated over the years - it is truly a terrible industry. The industry is notorious for the underlying companies being saddled with inordinate amounts of debt, which when added with extreme amounts of operational risk inherent in the business model and we see why so many producers went bankrupt when oil crashed in 2016 (MPO, SDLR, and even SD itself - I could go on). As investors have seen billions of their equity whipped out over the preceding 5 years, it becomes clear why the entire industry is seemingly trading cheap - no one wants to touch these things. Additionally I believe the sector is cheap for other macro headwinds, including:
● Alternative energy. The (un)likelihood of fossil fuels facing imminent replacement is well documented. Put simply, even the most conservative estimates of future oil production forecast fossil fuels being a major source of energy for years, possibly decades, to come.
● Global Warming. This ties in with the point above but it has become politically expedient for oil companies to receive the blame for damage we all do to the environment. Thus, we have investors overlooking the entire industry as it is possible that these companies face legislation.
Being fully cognizant of the risks involved, I still think SD presents investors with a compelling opportunity. As a value investor, I feel as if I come across an E&P company everyday that’s trading at a PE of 2. However, I think there are several factors at play that make Sandridge stand out, let’s go over them.
Reason #1 - Coattailing famous investors is a strategy which is always heavily debated. Whether copycating other investor’s ideas is a prudent strategy or not is a discussion for another time. What is undoubtedly an appealing strategy is coattailing activists. When other shareholders can shake up the board and operations when you can’t is an exercise worth pursuing. And with Sandridge Energy we have none other than Carl Icahn himself representing shareholders.
Icahn has been a shareholder since 2017. He didn’t go activist on the company until they surprisingly announced their intention to acquire Bonanza Creek (which went directly against what management had been saying they’d do). Icahn described the deal as “massively dilutive and overpriced”. In response to Icahn and another investment firm, Fir Tree Partners, Sandridge adopted a poison pill in attempts to keep the activists off the board. In an open letter to shareholders (linked below), Icahn laid out in his words what had transpired:
“To add insult to injury, the board tried to use an unorthodox poison pill to ram through the wildly unpopular Bonanza deal. The pill broke new ground for poor corporate governance, containing purposely ambiguous provisions that would make a totalitarian dictator blush. For example, it prohibited stockholders from merely talking or meeting with one another to discuss opposition to the Bonanza transaction (but conveniently contained a provision that explicitly gave management the right to campaign in favor of the deal). It appears that the board has never heard of the First Amendment. Does anyone believe that if the incumbent directors are re-elected they will not blatantly disregard stockholders’ rights again?”
Unsurprisingly, shareholders concurred with Icahn. In 2018, he won 5 out of the 8 board seats and replaced the CEO and CFO.
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