I recently reminded investors of the bull case for SandRidge Energy (UNKNOWN:SD.DL) . As important as it is to know why you own a stock, I feel it's even more important to know what can go wrong. Given SandRidge's history, it's wise to be extra vigilant with this company.
SandRidge is a company that many market participants really hate. It doesn't help that shares are down nearly 90% over the past five years. That lackluster performance is one of the many reasons why many investors are convinced that there's more downside to come and at last count nearly 15% of its shares were sold short. Let's drill down into the three reasons why SandRidge might not be worth owning.
1. SandRidge has been dependent on selling assets to reduce its outsized debt position and fund its exploration budget.
The recent sale of its Permian Basin assets really helped the company to solidify its balance sheet. The deal enabled it to cut its leverage ratio in half to just two times. Further, it provided the necessary funding to see the company's capital program through the end of next year. Unfortunately, the sale was not without great cost as the Permian assets were oil levered cash flowing assets. However, SandRidge believes that it will received greater value by reinvesting those funds into its Mississippian acreage.
The problem here is that SandRidge has been dependent on asset sales and its running out of assets to sell. In addition to the Permian sale, SandRidge has now taken three royalty trusts public. One consisting of Permian Basin assets, SandRidge Permian Trust (NYSE:PER) and two consisting of Mississippian assets, SandRidge Mississippian Trust I (NYSE:SDT) and SandRidge Mississippian Trust II (NYSE:SDR). While SandRidge still owns a portion of each trust, it likely will continue to sell off its ownership stake in each trust as well as other assets it still owns. At some point SandRidge will need to live within its oil and gas cash flows, otherwise, its not worth owning.
2. SandRidge has a risk-seeking management team with a history of overextending the company's resources, leading to a number of serious financial constraints.
Since taking the company public in 2007, SandRidge has lost about 90% of its value. Over that time frame CEO Tom Ward has pulled in $116 million in compensation. This hasn't sat well with investors, which is one reason why the newly expanded board has set a June 30 deadline to determine his fate.
During Ward's tenure, SandRidge's business plan has been in a constant state of transition. That's cost a lot of money and over the past two years Ward and his team have loaded the company with nearly $4 billion in net debt and taken its leverage ratio to as high as 4.6 times. The good news is that the recent Permian Basin sale has taken that debt down to a net of less than one and a half billion and a leverage ratio of just two times. However, until management demonstrates that it knows what its doing, the risk is that its spending could get it into trouble again.
3. The Mississippian doesn't appear to be as oily as the company originally thought with a production mix that is 45% oil and natural gas liquids and 55% natural gas.
At the company's 2011 analyst day, Sandridge's Mississippian liquids content was at 52% of production. However, as it has continued to drill, that liquids content has slipped to 45% of production. That's a bit lower than Chesapeake Energy (NYSE:CHK) is seeing; its fourth-quarter Mississippian production was 54% liquids. The overall liquids production mix of the Mississippian is a lot less than Chesapeake is seeing in the Eagle Ford Shale, where its fourth-quarter production was 81% liquids. With natural gas prices still on the low end, this lower liquids content from the Mississippian is not good for SandRidge's cash flow.
SandRidge continues to appraise its acreage so it's possible that its liquids production could increase as its better able to determine the most profitable drilling locations. That's important because 80% of the company's Mississippian cash flow comes from oil production. However, if it finds that gas is more prevalent, it could take the company even longer to become cash flow positive.
Motley Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of SandRidge Mississippian Tr II and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake 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.