The Next Home Run Energy Stock


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 (NYS: SD) . Founded in 2006 by Tom Ward, a co-founder of Chesapeake Energy (NYS: 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 (NYS: 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 (NYS: SDT) and the SandRidge Permian Trust (NYS: 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


EOG Resources


Southwestern Energy


Pioneer Natural Resources (NYS: PXD)




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
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At the time thisarticle was published Dan Dzombak can be found on his twitter account:@DanDzombak.Motley Fool newsletter serviceshave recommended buying shares of Chesapeake Energy.Motley Fool newsletter serviceshave recommended writing puts in Southwestern Energy. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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