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The Next Home Run Energy Stock

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Investors can make big money from misunderstood companies. Recently, I’ve zeroed in on a company that the market is unfairly punishing with a 40% drop in the share price in the past month -- compared to a 5.4% drop in the Dow Jones (INDEX: ^DJI) -- after two spinoffs, a joint venture announcement, and an earnings miss. The company’s strategy, management team, and assets have me excited that this stock could produce huge returns over the years ahead.

The company is SandRidge Energy (NYSE: SD  ) . Founded in 2006 by Tom Ward, a co-founder of Chesapeake Energy (NYSE: CHK  ) with Aubrey McClendon, the company initially focused on natural gas before switching its focus to oil in 2009 and 2010 with the acquisitions of oil assets Forest Oil’s Permian Basin Assets and Arena Resources.

SandRidge is currently trading for $3 billion. It has preferred stock of $765 million and a large debt load of $2.9 billion but no maturities until 2014 ($350 million in 2014, $350 million in 2016, the rest not till 2018 and later). As of the end of 2010, SandRidge’s reserves had a net present value (PV-10) of $4.5 billion. Its reserves mainly come from two large assets, 900,000 acres in the Mississippian and 220,000 acres in the Permian Basin. SandRidge currently has 16 rigs operating in the Permian Basin and 14 rigs operating in the Mississippian, making it the third-largest operator of rigs in the U.S. dedicated to oil drilling, behind Chesapeake and EOG Resources (NYSE: EOG  ) .

The company’s strategy has been to spend heavily on drilling its properties, so heavily, in fact, that capital expenditures have been significantly higher than cash flow for the past few years and are expected to continue to be higher until 2014. Earlier in the year, the company planned for $1.3 billion in capital spending for 2011 versus $400 million in cash flow last year, and $1.8 billion to $2 billion for 2012-2014.

However, in its second-quarter earnings announcement, SandRidge stated, "we have identified and established an acreage position in a new area that is similar in size, characteristics and cost to our first Mississippian play." As such, they increased this year’s CAPEX by $500 million to $1.8 billion, with $275 million for land acquisitions in the new play, an additional $200 million for drilling expenditures, and $25 million for oil-field services.

The market pummeled the stock, as it is wary of SandRidge’s debt load and would rather the company spend cash on drilling instead of acquiring land. However, if SandRidge has indeed found a promising new play and is buying land very inexpensively, it could prove to be a boon to shareholders in the next few years.

The large capital expenditures on drilling will lead to quickly expanding cash flow with EBITDA expected to be $730 million in 2011, $1 billion in 2012, and $1.35 billion in 2013. Until the company can fund all its drilling with cash flow, it plans on funding capex through debt and alternative financing (asset sales, joint ventures, and royalty trusts).

This year’s capex will be funded with $450 million in cash flows from operations, the cash from two spinoffs of royalty trusts -- the SandRidge Mississippian Trust I (NYSE: SDT  ) and the SandRidge Permian Trust (NYSE: PER  ) -- and asset sales of some smaller fields. For 2012 to 2014, the company plans on funding its capex with $3 billion in cash flow from operations, a joint venture with Atinum Partners, $1 billion in alternative financing, and $1.4 billion in debt.

The company’s huge capex spending should lead to comparable growth in cash flow from operations. By the end of 2014, Ward expects to achieve EBITDA of more than $2 billion, to grow production annually by double digits, to fund its capital expenditures with its cash flow, and to achieve a debt-to-EBITDA ratio of less than 2:1.

SandRidge’s competitors trade at varying valuations, but as you can see below, they average roughly nine times EBITDA.



Chesapeake Energy 9.9
EOG Resources 9.1
Southwestern Energy 8.5
Pioneer Natural Resources (NYSE: PXD  ) 10.1
Average 9.4

Source: Capital IQ, a division of Standard and Poor’s.

Assuming SandRidge is successful in hitting its goal of$2 billion in cash flow by 2014 and debt of $4 billion in debt, if it were to trade at a similar EV/EBITDA ratio as competitors, it would have an EV of $19 billion. Subtracting $4 billion in debt, $1 billion in alternative financing, and $1 billion in preferred stock, the company’s equity will be worth $13 billion, four times its current value!

This is obviously not without risks. A significant fall in oil prices or bad financial markets that keep SandRidge out of alternative financing markets could require the company to dilute shareholders. At this price, however, the risk-reward ratio is solid and definitely worth consideration.

Foolish bottom line
While I believe SandRidge provides a compelling opportunity, if you are looking for safer bets on oil and gas, The Motley Fool has created a new, special oil report, and you can download it today at no cost to you. In this report, Fool analysts cover three outstanding oil companies, including the stock Fool analyst David Lee Smith calls the "energy king." To get instant access to the names of the three oil stocks, click here -- it's free.

Dan Dzombak can be found on his twitter account: @DanDzombak. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. Motley Fool newsletter services have recommended writing puts in Southwestern Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (99)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 09, 2011, at 12:58 AM, kirkydu wrote:

    kirkydu search and review mark

  • Report this Comment On September 09, 2011, at 11:56 AM, mweinstat wrote:

    Sorry, I don't think so. Too much debt, negative free cash flow and IMO, just too many other energy companies that we can do well with, with lest risk.

    Give me a Royal Dutch Shell with its 5%+ dividend at a single digit PE and I am fine.

  • Report this Comment On September 09, 2011, at 12:39 PM, Wade32ru wrote:

    Too much debt won't matter when SD gets bought for $20 per share. SD can sell assets at virtually any time to service its debt.

    In general, comparing RDS to SD isn't an apples to apples comparison. The integrated names are attractive here, I agree. But, if you want to hit one out of the've got to look at some of the E&Ps with quality assets.

  • Report this Comment On September 14, 2011, at 12:40 PM, SkepticI wrote:

    Too much debt in the wrong environment wont get SD $20 a share, instead it will get SD panic selling of assets or draconian financing to bail out its sinking ship. Now its not that environment, with oil hanging up in the 80-100/bbl area. Now, it looks good and will attract $ from buyers of companies, stock and sellers of financing. But when the price of oil sinks to 50/bbl LOOK OUT. History has shown this can happen unexpectedly and on very short notice. Risky business, reward for risk...hmmm that seems right.

  • Report this Comment On October 15, 2011, at 6:38 PM, Teacherman1 wrote:

    I am 100% in agreement Dan. Too many people look only at the past financials, and not at the "big picture".

    Where they were, is not where they are, and is certainly not where they will be.

    They have the assets, if you look at their "very recent" SEC filings, you can see where the cash is coming from. They already have their "alternative" financing.

    Not for the "faint of heart", but for those willing to take a "calculated risk", this one will pay off huge.

    Investors can wait and see how it "plays out", but by then, they will have lost out on a very big part of the "opportunity".

    If it is out of your "comfort zone", then find something else that is in your "comfort zone".

    Follow the company, the stock price will take care of itself.

    JMO and worth exactly what I am charging for it.

  • Report this Comment On December 07, 2011, at 10:49 PM, HWY216 wrote:

    Thanks Dan for an informative article. I too am positive towards Sandridge Energy. I think Tom Ward can make this work!

    Long SD & PER.

  • Report this Comment On December 23, 2011, at 10:59 AM, OctoberSky wrote:

    Thank you for this early Christmas present! I bought after reading your recommendation a couple of weeks back. I don't know - perhaps it was "unfoolish" to sell today after a run up of 30% in two days, but I did. This is the first time I have owned a stock which ran up that quickly. Keep us posted on the progress of this stock. Perhaps any run down will just be noise?

  • Report this Comment On January 27, 2012, at 1:51 PM, ecm3131 wrote:

    Agreed, SD has way to much debt and a debt to equity ratio of around 2.

    Their operations are loosing money, and they posted gains only by recapturing amort after the sale of an asset. But one cannot sell off all its major assets as a business model. When I buy stock, I buy cash flow and/or earnings and this co has neither.

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