Why This Energy Stock Could Triple in Three Years

For a multitude of reasons, there are times when a company trades at a considerable discount to the value of the underlying business. Within the energy sector, I think I've found a stock that the market may be unfairly discounting. It's a small-cap oil-focused producer with some very valuable assets. And it could be significantly undervalued.

A natural-gas-focused beginning
I'm talking about Oklahoma City-based SandRidge Energy (NYSE: SD  ) . Before I get into the details of why I think it's undervalued, let's talk about some of the great moves the company has made since its inception six years ago.

CEO Tom Ward started SandRidge in 2006 after leaving Chesapeake Energy, where he served as chief operating officer. The company's first purchase was a gas field in West Texas. As Mr. Ward recounts, SandRidge was originally a natural gas story, predicated on the then-prevalent belief that natural gas prices would stay above $7/mcf.

The early shift to oil
But by 2008, the company's management believed natural gas prices were headed much lower. Later that year, SandRidge hedged all of its natural gas production for two years with a new and steadfast focus on oil. Since that time, the MMBTU price for natural gas has fallen to just a fraction of the price of oil. With the benefit of hindsight, this was an incredible strategic move.

Had it remained a natural gas company, it almost certainly would have languished. The few natural-gas-heavy companies that have managed to hang on despite the depressed prices are low-cost producers such as Ultra Petroleum (NYSE: UPL  ) , which manages to be profitable even at slightly under $3 per thousand cubic feet.

A focus on low-risk, conventional assets
While competitors like Kodiak Oil & Gas (NYSE: KOG  ) are banking on more costly, unconventional plays like the Bakken, SandRidge is zeroing in on lower-risk, conventional plays. Its main focus is the Mississippian Lime, an expansive carbonate oil play spanning parts of Kansas and Oklahoma.

SandRidge was one of the first movers into the Mississippian and one of the first companies to grasp the true scope of the play. As a result, it was able to scoop up a massive acreage position at a very appealing price. I think it's worth taking a closer look at just how valuable the company's Mississippian assets might be and why the company could be significantly undervalued.

The SandRidge strategy: Buying great assets at dirt cheap prices
SandRidge originally acquired 2 million acres in the Mississippian for $400 million, at an average cost per acre of $200. It then monetized roughly a quarter of this acreage, 550,000 acres, to be exact, through joint ventures and royalty trusts, the net proceeds of which brought in a whopping $2.33 billion at an average price per acre of around $4,200.

The four monetizations included the SandRidge Mississippian Trust I (NYSE: SDT  ) , which brought in $333 million, as well as two joint ventures with Atinum and Repsol, which brought in a combined $1.5 billion. And finally, the company brought in $590 million (as partial consideration for the royalty interests held by the Trust) through its most recent trust vehicle, the SandRidge Mississippian Trust II (NYSE: SDR  ) .

The Mississippian acreage that SandRidge still retains, roughly 1.5 million acres, has an implied value of some $6.35 billion. If you add up the proceeds from the sale of that 550,000 acres and the current value of its retained acreage, you get roughly $8.7 billion. That's $3.5 billion more than the company's current enterprise value -- from just one play alone!

While the Mississippian is its main focus, let's not forget the other assets SandRidge has. It scooped up some superb Gulf Coast assets through its acquisition of Dynamic Offshore earlier this year, once again at a very appealing price. It also maintains significant positions in the Permian Basin that have a PV-10 value (the present value of the future estimated revenues from its proved reserves) of $3.9 billion. And lastly, it still has the gas field in West Texas it bought way back in the day.

The long-term value of all these assets, in my opinion, isn't reflected in the stock price, which currently sits under $7.

Reasons to pause and final thoughts
Despite its attractive assets and value-accretive strategies, the company is certainly uncomfortably leveraged. SandRidge's capital spending consistently exceeds cash flow and liquidity. But management is well aware of this and improving credit and leverage metrics is a key focus of its three-year plan.

I think the company will eventually be able to bridge the gap between capex and cash flow and hopefully achieve its plan of tripling EBITDA and doubling oil production by the end of 2014. Oil prices still remain the biggest downside risk but the company is well hedged.

If it can continue to keep costs down and meet its production targets, I think this stock has tremendous upside. In an interview this year, CEO Tom Ward said, "I don't know when our stock will move, but you can't triple EBITDA in three years and not have your stock price double or triple along with it." For investors with at least a three-year time horizon, I think SandRidge presents an excellent opportunity.

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Fool contributor Arjun Sreekumar does not own shares of any companies listed above. The Motley Fool owns shares of Chesapeake Energy, Ultra Petroleum, and SandRidge Mississippian. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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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 July 20, 2012, at 4:09 PM, JoshYoung wrote:

    I think there is a better, cheaper way to play the Mississippian, which may be more likely to earn an even higher return than you're talking about. Austex Oil is in the core of the Mississippian, and its wells so far have generated much higher returns on average than Sandridge.

    I posted a blog article about it here. http://seekingalpha.com/instablog/739665-josh-young/876131-m...

  • Report this Comment On July 24, 2012, at 3:37 PM, Mitch67212 wrote:

    Sandridge is going to go down.....it's a house of cards, with bloated reserves and little production

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