Description

SD 

Thesis:  SD is the lowest risk vehicle for smaller investors to own natural gas assets and, to a lesser extent, the deep value available in all Energy assets.  Despite the much lower risk, I believe the upside is likely as great as any non distressed gas opportunity in the public market.

SD is well known to many investors and has been written up on VIC in the past.  Since the initial write up, I believe the company’s transformation warrants another look as its prospects have evolved.  SD’s assets are generally low quality and merit little development so I won’t spend too much time on a detailed analysis of their Mid Con assets. Within the Mid Con, the company’s Miss Lime position is a gassy formation that is in terminal decline but throws off a tremendous amount of cash flow.  In addition, the company has acreage in the NW Stack which is slightly higher quality and merits development if oil is above $80 and gas is above $4.  This acreage gives the company optionality to bring on limited new production when prices rise and it can hedge 6 months of prices above those levels.  Why is SD interesting given its terminal outlook?  I will list the virtues of SD vs. other smaller and even larger E&Ps:

1. SD has the lowest G&A costs per BOE in the public space.  This is an area that I feel doesn’t get enough attention from investors.  G&A is only $8M per year vs $191M in EBITDA and $121M FCF in 2022 or less than 4% and 6.7%, respectively.  This allowed the company to convert ~63% of its EBITDA to FCF in 2022 while spending enough on cap ex to keep production flat.  (This EBITDA to FCF compares favorably to even the best in class giants such as PXD at a  66% EBITDA to FCF conversion rate in 2022)

2. SD had a net cash balance of $257M at year end and likely generated $15M in FCF in the 1st qtr.  Its cash balance is currently sitting at ~$275MM.  With 37MM shares it currently has an EV of $~290MM.  I estimate 2023 FCF of ~$70-$75MM at $75 WTI and $2.50 nat gas or a roughly 25% FCF yield!

3. SD has $1.6B in NOLs that will shield its FCF from cash taxes but, more importantly, gives the company a huge advantage in purchasing other FCF flowing assets and utilizing its enormous war chest..

4. The company’s board is controlled by Carl Icahn appointed directors who act as his agents scrutinizing any strategic use of its cash and NOL’s.  Management is young and comprised of an operationally oriented CEO and a CFO who are likely not involved at all in making any strategic decisions (it has been painful to hear investors ask them strategic questions on conf call when it's clear they have zero input and are hired hands to run day to day operations)

5. Private energy assets trade at lower valuations than publics despite the extremely low multiples we see in public markets.  OVV recently announced the purchase of what is considered a high quality private E&P for 2.8x EBITDA and 19% FCF at 3/30 strip pricing.  Lower quality private energy assets are trading at 2.5x EBITDA and 25-30% FCF levels.  This sets up for an enormously accretive acquisition, especially with Nat gas prices collapsing.

6. SD has set up a tax asset preservation plan to prevent anyone from acquiring the company at a low premium and triggering Section 382 change of control provisions that would eliminate its NOLs.  This plan also prevents Icahn from boosting his stake by more than 50% of his current 13.1% stake and as such the shares have remained relatively cheap as the 50% increase for him would mean very little for him monetarily and would likely trigger a big surge in the stock.

Modeling the company’s financials is fairly straightforward and highlights the company’s enormous resilience to lower prices.  

As we can see, the projections above show the enormous FCF potential at current strip prices which includes $2.50 gas strip.  It is my belief that at $2.50, 10% of the US gas production from dedicated Nat Gas shale regions will fade as these prices are not profitable at the margin.  It will likely take 6-12 months for operators to adjust production lower as the record production we are seeing is being produced by cap ex plans made 6 months ago when prices were triple current levels.  For illustration I have modeled FCF at $60 oil and $2 gas which I don't believe are sustainable.

At $60 WTI and $2 nat gas and SD continues to remain highly cash generative.  

The latter pricing scenario above where crude drops dramatically would actually serve longer term shareholders better as SD would likely be able to deploy its cash in a highly counter cyclical way and purchase assets in distress.  

Conclusion

SD shares offer investors a highly predictable FCF stream that is very resilient to lower energy prices. Public investors are getting an opportunity to partner with a counter cyclical operator that is strategically run by disciples of one of the best investors in the world in Carl Icahn.  The company is run by owner operators who convert as much of its EBITDA to owner FCF as possible in the public space.  One need not be bullish on Nat gas prices to achieve a very high return.  

The investment thesis here condenses into whether we believe Icahn’s disciples will make wise use of its huge and growing cash hoard in a world where energy assets trade like stranded assets with no value beyond the next 5 years.  

Risks

Demand for oil and gas is at a peak and falls dramatically over the next 5 years

Catalyst

Large acquisition of profitable, likely private, energy assets to utlize NOLs and its cash hoard followed by large stock buybacks