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Shares of Chesapeake Energy (CHK) have seen a fair bit of volatility in Wednesday's trading session. The natural gas and oil exploration development and production company released its first quarter results before the opening bell. Shares initially spiked up 2% to $20 per share to fall to lows of $19 later during the session.

First Quarter Results

Chesapeake Energy generated first quarter revenues of $3.42 billion, up 41.5% on the year before.

Adjusted net income rose 95% to $183 million over the past quarter. As a result of the dilution of the shareholder base, adjusted earnings per share were up by 67% to $0.30 per share. Adjusted earnings comfortably beat consensus estimates of $0.25 per share.

GAAP earnings came in at just $15 million, or $0.02 per share. Chesapeake lost $94 million on its hedging programs an took a $83 million charge related to retirement expenses and other employment termination benefits.

CEO Steven Dixon commented on the performance, "Chesapeake is off to a strong start in 2013. We are beginning to see the benefits of our operational strategy shift from identifying and capturing new assets to developing our extensive existing assets and entering a new era of shareholder value realization."

A Detailed Look Into The Numbers

Chesapeake had a decent quarter in terms of production. Average daily production came in at 4.0 billion cubic feet of natural gas equivalent, up 9% on the year, and up 1% on the previous quarter. The company produced 3.0 billion cubic feet of natural gas and 157,000 barrels of liquids, of which roughly two-third is oil.

Oil production is closely watched, as it is much more profitable compared to gas. Oil production was up 6% compared to the previous quarter, and up 56% compared to a year earlier as a result of increased production in the Eagle Ford Shale and Greater Anadarko Basin.

While a shift towards more profitable oil production and higher realized prices help, cost control is key as well. Production expenses fell by 18% on the year to $0.86 per thousand cubic feed of natural gas, while general and administrative expenses fell by 29% to $0.25 per mcfe.

For the full year of 2013, the company now expects production expenses between $0.85 and $0.90 mcfe, while G&A expenses are expected to come in between $0.30 and $0.35 per mcfe. The reduced cost guidance will aid full year cash flows by an estimated $130 million.

Valuation

Chesapeake Energy ended its first quarter with merely $33 million in cash and equivalents. The company operates with $13.5 billion in long term debt, for a net debt position of a similar amount.

For the full year of 2012, Chesapeake generated annual revenues of $12.3 billion on which the company net lost $769 million as a result of special charges, mostly on asset impairments. Based on the first quarter results and uncertain liquids and gas price developments, the company might generate annual revenues of $15-$17 billion for 2013. The company might generate adjusted income upto a billion dollar.

Factoring in a 2% price decline, the market values Chesapeake around $12.8 billion. This values the company at 1.2 times annual revenues and 13 times adjusted operating income.

Despite the financial difficulties, and the weak balance sheet, Chesapeake pays out a quarterly $0.09 dividend, for an annual dividend yield of 1.8%.

Some Historical Perspective

Shares of Chesapeake have seen a boom up to 2008 as the shale gas revolution boosted the prospects for US domestic oil and natural gas producers. Shares rose steadily from just $10 in 2003 to peak around $70 in 2008. Shares fell all the way back to $10 in that same year as the recession and overproduction resulted in plunging natural gas prices.

Shares did manage to recover towards $33 in 2011, but have hovered around the $20 mark for most of 2012 and 2013 as investors are worried about the liquidity position of the company.

Despite the lower natural gas prices and the financial difficulties, Chesapeake managed to expand its operations. Growing production resulted in a 60% jump in revenues between 2009 and 2012, coming in at $12.3 billion for the past year. Large write-downs on acquired assets and other one-time charges resulted in large losses in recent times.

Investment Thesis

Investors in Chesapeake are constantly in doubt. On the one hand, production is increasing and price stabilization results in increasing operating income. On the other hand, the debt position remains large and asset sales are not going smooth enough. Net proceeds fail to reduce debt as Chesapeake still targets a $6 billion planned capital expenditure budget for 2013. Lower asset prices continue to depress the valuation of Chesapeake's core assets as well.

So far in 2013, Chesapeake has already negotiated asset sales of $2 billion as the company aims to divest between $4 and $7 billion of its assets this year, to reduce its massive $13.4 billion net debt position. Yet the company has only received $321 million so far in the first quarter, with another $222 million hitting the bank account in the second quarter. As the company invested up to $1.5 billion in well costs in the first quarter, the net debt position actually increased by $1.1 billion over the quarter.

As a result of the lower and slower asset sales, the company now expects to have a $3.5 billion funding gap for 2013. Despite having almost no cash on the balance sheet, Chesapeake should have enough liquidity with more than $3.2 billion in cash available in revolver capacity. Chesapeake maintains that if it sells only $4 billion of assets, it will be able to fully fund its investments and maintain its long term debt below year-end levels of last year.

On the other hand, operating profits are increasing, mostly as a result of increased production. Natural gas prices recovered by 19% to $2.10 per mcfe over the past year, while oil prices actually fell modestly on the year ago. In this environment, Chesapeake reported an adjusted net income of $226 million, which is up from merely $137 million last year, and $196 million in the fourth quarter. The company aims for further improvements in profitability, as it allocates 85% of its capital to liquids plays. Chesapeake will back away from gas investments until prices recover to competitive levels.

Back in February, when Chesapeake announced a joint venture with Sinopec for its Mississippi Lime play in Oklahoma, I concluded that the long term risk-reward ratios remain good. The stabilization of natural gas prices and modest asset sales has resulted in an averted scenario of a liquidity crisis or a bankruptcy. Yet the divestiture strategy is painful, as it is dilutive to shareholder value and results to possible renewed impairments, especially if prices fall back. Yet operating trends, including oil production and cost reduction are promising.

I reiterate my stance, the long term prospects remain good, although investors should expect a lot of volatility in the meantime.

Source: Chesapeake Energy: As Operating Performance Improves, Debt Remains A Worry