If You Own this Energy Stock, Then It's Time to Sell NOW

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When looking at the actions of Sandridge Energy's (NYSE: SD ) CEO Tom Ward, the phrase "heads I win, tails you lose," comes to mind.

He's overseen an 80% plunge in his company'sstock since Sandridge's 2007IPO , yet has been rewarded with roughly $150 million in compensation since then. Adding insult, he has been given a free hand to buy up key parcels ofreal estate that are adjacent to company-owned acreage, and sell this land to company rivals, without the need to disclose such transactions to shareholders. (A practice that should be quite illegal, or at least quite discouraged.)

Dissident shareholders have had enough. A pair ofhedge funds , each owning more than 5% of the company have asked other investors to support theirproxy efforts to oust the board and management, in a vote to be held on March 15. These hedge funds contend thatshares are quiteundervalued in the context of Sandridge'sasset base and would likely rise in value if a new board and management team wereput into place.

In light of recently announced quarterly results that show Sandridge's real estate holdings to have a much greater bias toward low-priced natural gas and much smaller exposure to pricier crude oil, it's not clear whether these activist investors are even on the mark when looking forupside .

In a very cogent analysis, the author of this article makes a strong case that shares are indeed fully valued orovervalued in the context of recent industry real estate transactions.

Yet there is an even better reason for this management team and board directors to hand over the keys to new leadership: On its current course, Sandridge may burn through almost all of itscash , so shares may head to just $1.

At least that's the view Canaccord's John Gerdes holds.

A ticking time bomb
Sandridge made the same mistake as many energy drillers: overpaying for shale-focused real estate a few years ago, only to see plunging gas prices create much weaker cash flows once the oil and gas started flowing. Like its peers, Sandridge has been forced to unload various assets (targeting $2 billion worth of assets in the process), but the companywill still carry more than $3 billion in debt on itsbalance sheet when those asset sales are complete.

And as far as Gerdes is concerned, thisdebt load will create real trouble.

As he sees it, Sandridge's capital spending plans, which have not been reduced despite the company's weak balance sheet, are foolhardy. "The company now outspendscash flow by $1.3 billion per annum." (Not just this year, but every year until 2017.) He adds that whilenet debt seems manageable now, at around three times projectedEBITDA , he expects "this criticalleverage statistic to rise to over 4x at year end '14, and an untenable 5x by year-end '15." This math even comes with the assumption that Sandridge will realize full value for the assets it has recently put on the block.

How does Gerdes arrive at that $1price target ? That price equates to amarket value of $600 million, which is what he says the company's asset base and cash flow generation potential will be worth after the company's debts are accounted for.

CEO Ward acknowledges the projected cash flow deficits that willaccrue from his spending plans, but he appears to be counting on an eventual strong rebound in natural gas prices to sharply improve theeconomics of Sandridge's major shale plays. To be sure, gas prices have nearly doubled since hitting bottom a year ago -- recently hitting $3.58 per thousand cubic feet ( MCF ) -- though it seems foolish to simply bank on furthergains to rescue thisbusiness model .

Other views
To be sure, Gerdes is the mostbearish analyst following the company. Otheranalysts take a somewhat brighter view and see shares closer tofair value at a recent $5.80.

  • UBS rates the stock as "neutral" with a $6 price target, noting that "SD offers investors meaningful unbooked resource potential from the Horizontal Mississippi but is burdened with continuing high financial leverage and a significantFCF deficit over the next few years. In addition to the high financial leverage and organic FCF deficits, investors have a new concern: Its crown jewel asset in the Horizontal Mississippi is performing below type curve expectations and appears to be more gassy than initially expected."
  • Goldman Sachs also has a $6 price target but rates it a "sell," noting that they trade for 6.5 times projected 2014 EBITDA. The company's peers trade at amultiple of 4.6.
  • BMO recently downgraded the stock to "underperform ," with a $4 price target. They suggest that "the stock remains significantly overvalued as rates of return in the horizontal Mississippian play aren't strong enough to support the currentequity value."

Risks to Consider: As an upside risk, firming natural gas prices, more robust real estate transaction valuations, or a change in management could help boost shares.

Action to Take --> Though the activist hedge funds correctlynote that this is a company headed for deeper trouble under current management, they appear to be overestimating any potential upside, even if they can bring in new leadership. This company has been boxed in by a string of badinvestments , so a sharp reduction in capital spending appears inevitable. Yet this would make it harder to generate the cash flows required by the company's debt covenants.

Short sellers alsospot more downside ahead. They currently hold 13% of thefloat , or 50 million shares, in short accounts. This stock has been a slow motion train wreck for several years, and the train isn't slowing down.


-- David Sterman

P.S. -- The abundance of natural gas in the U.S. could lead to a third industrial revolution. One analyst is predicting a stock could rise 1,566%. Another stock has already jumped over 1,000% and is expected to keep going. To learn more about investing in the natural gas boom, click here.

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Commodities

Referenced Stocks: MCF , SD

David Sterman

David Sterman

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