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Introduction

In my earlier article on the oil and gas sector, I compared two oil exploration and production companies, Apache Corp. (NYSE:APA) and Anadarko Petroleum Corp. (NYSE:APC), with three oil and gas diversified companies. While oil and gas diversified companies were recommended for income investors, Apache was considered undervalued among the two exploration and production companies (although Anadarko was not totally ruled out, either). This article further compares these two companies with another company that is currently considered a bargain in this sector, Chesapeake Energy (NYSE:CHK).

Tracking Financials

Anadarko is selling at Price to Sales ratio and Price to Book ratio above the industry averages, while the dividend yield is almost 33% below the industry average. Chesapeake seems to be selling cheaply as far as price multiples and dividend yield are concerned. Apache is also inexpensive, although its dividend yield is nowhere near as attractive as Chesapeake's, making Chesapeake the better choice.

Price/Sales ttm

Price/Book

Price/Earnings ttm

Dividend Yield

Anadarko Petroleum

2.8

1.9

21.5

0.46

Chesapeake Energy

1

0.9

-14.9

2.0

Apache

1.9

1.1

12.9

0.82

Industry Average

2.7

1.7

526.3

1.6

Data from Morningstar and Financial Visualizations on January 12, 2013

If we compare the three companies by trying to assess how much cash they have generated for their shareholders, Apache still seems to be the most undervalued, as it has actually been generating positive cash over the last five-year period. The cash generated by the owners is assessed by using the metric owner's earnings. Owner's earnings are calculated as Net income + Depreciation & Amortization - all Capital Expenditure (including working capital).

(All numbers are in dollar millions).

Owner's Earnings

2007-08

2008-09

2009-11

2010-11

2011-12

TTM

Anadarko

2,202

1,467

-1,160

-761

-4,732

2,202

Chesapeake

-6467

-6486

-11943

-10406

-11173

-6467

Apache

153

2,350

1,089

967

1,404

153

Analysis of Return on Invested Capital (ROIC) for the three companies also favors Apache, as its profitability has been the highest for most of the past five-year period, particularly over the last two years.

ROIC

2007-08

2008-09

2009-11

2010-11

2011-12

Anadarko

7.80%

6.67%

-0.27%

1.48%

-5.12%

Chesapeake

4.72%

1.88%

-19.49%

4.77%

4.16%

Apache

9.82%

2.44%

-1.01%

6.98%

8.81%

To further understand the profitability of these companies, let's consider the breakdown of ROIC into turnover and margin. Apache has better turnover as well as better margins than both Anadarko and Chesapeake.

ROIC = margin *turnover

2007-08

2008-09

2009-11

2010-11

2011-12

Anadarko

Margin

23.79%

20.74%

-1.50%

6.93%

-18.97%

Turnover

32.78%

32.14%

17.96%

21.30%

26.97%

Chesapeake

Margin

18.60%

6.22%

-75.69%

18.94%

14.97%

Turnover

25.38%

30.25%

25.75%

25.19%

27.81%

Apache

Margin

28.18%

5.78%

-3.30%

25.07%

27.14%

Turnover

34.85%

42.24%

30.56%

27.85%

32.45%

ROE, another measure of profitability, favors Apache as well. Apache has been more profitable than its competitors for the last three years, although Anadarko did perform better in the 2009-09 period.

ROE

2007-08

2008-09

2009-11

2010-11

2011-12

Anadarko

23.11%

17.35%

-0.68%

3.68%

-14.63%

Chesapeake

11.96%

4.44%

-50.94%

11.62%

10.48%

Apache

18.29%

4.31%

-1.80%

12.44%

15.81%

Considering that the industry's average debt equity is 0.9, Apache seems more comfortably financed than its two competitors.

Anadarko

Chesapeake

Apache

Debt / Equity

0.6

1.3

0.4

Interest Coverage Ratio (Average CFO / Interest Paid)

-3.1

66.5

19.7

Average market value of firm / debt

(On balance sheets)

3.92

7.33

12.11

Assuming that these energy companies would be comfortable with a coverage ratio of 4 and that a company can service this debt at a 10% interest rate (a very conservative figure given typical coverage ratios), we can estimate the value of a company by calculating its debt capacity. Take, for example, Apache: the average cash flow from operations has been approximately $6.7 billion, so we can assume the company is able to comfortably service approximately $1.68 billion in interest (coverage ratio of 4). The company's debt capacity is $16.8 billion, since it can pay $1.68 billion in interest (which is an approximate 10% coupon on debt of $243 billion). Using the formula that the value of the company has 175% debt capacity plus cash on the balance sheet, (an old valuation rule from the value investing school of thought), the value of the company can be estimated to be $29 billion, which is 6% less than the current value. This calculation is summed up for all three companies in the table below (all dollar numbers are in millions). Using this analysis, Chesapeake comes out as the most undervalued of the three (and by a huge margin).

Anadarko

Chesapeake

Apache

Typical interest coverage ratio in the sector

4

4

4

Maximum Interest Paid in Last 5 years

1092

406

433

Average Cash flow from Operations (NASDAQ:CFO)

4,204

5,108.8

6,729

Interest rate on debt issued by corporation

10%

10%

10%

Last five year average CFO / Typical Interest Coverage ratio (Interest that can be readily serviced)

1051

1277.2

1682.25

Debt service capacity (Interest that can be readily serviced/ Interest rate on debt)

$ 10,510

$ 12,772

$ 16,822.50

Value of business ( 175% debt capacity + Surplus cash)

$ 19,660.50

$ 22,352

$ 29,565.38

Value of business ( 175% debt capacity + Surplus cash) as percentage of market capitalization

50.28 %

191.04%

94.16%

In addition to the quantitative ones discussed earlier, both Chesapeake and Apache have several qualitative arguments in their favor, as well. Both companies have initiated a variety of restructuring efforts over the last few years. Chesapeake's investors have been pressing the company to cut costs and spin off assets. Although the company received a lot of negative press last year for the alleged wheeling and dealing ways of its CEO, Aubrey McClendon, he is one of the most competent people in this sector. The bad press will continue if he stays in the position much longer, but the presence of McClendon in the company is, by most accounts, a good thing for shareholders (as well as for possible investors, for bad press for poor ethics may create buying opportunities). Apache has also been restructuring its business by reducing exposure to liquid assets.

Final Words

Our analysis suggests that there is little difference in choosing between Chesapeake and Apache. Chesapeake is selling at lower multiples, has better dividend yields and seems most undervalued by other measures. Apache, on the other hand, is also selling cheaply (though not as cheaply as Chesapeake), in addition to being profitable. Unless one has a very strong inclination to pick only one company from a given industry, an investor could add both of these stocks to his portfolio. Adding two or three companies like Chesapeake and Apache from seven or eight different sectors to one's portfolio should produce good results over the next two to three years.

Source: Too Many Oil Bargains: Which Is The Best Bet For Now? - Part 3