Chesapeake Energy: New Management And Cheap Valuation On A Strong Resource Base

| About: Chesapeake Energy (CHK)

Few companies have seen the highs and lows that Chesapeake Energy (NYSE:CHK) has over the last decade or so. The company was the first-mover in discovering several of the key North American land resource plays, and Chesapeake was integral in the development and enhancement of the vital horizontal drilling technology. These achievements were often overshadowed by a record of corporate governance that should go down in infamy, as some of the worst in recent history. During the financial crisis of 2008-2009, CEO Aubrey McClendon leveraged his own personal stock portfolio to the hilt in CHK, and had to become a forced seller to meet margin calls as the stock plunged. Then the following year, CHK's board of directors handed out one of the most egregious pay packages that I've ever seen to McClendon, which was a blatantly clear example of a board of directors enriching the CEO who gambled away much of his fortune at the expense of shareholders. While McClendon was a brilliant land-man in terms of identifying assets for development, he was a terrible steward of capital, and constantly leveraged the company beyond its means in spite of the fact that commodity prices decline in addition to going up. Fortunately, activist investors have taken control of the company and there are clear signs that the future of CHK will be brighter than the past. As the financial condition of the company improves and natural gas prices rise over the long-term, I expect CHK to be an excellent performing stock for long-term shareholders.

On May 20th, Chesapeake Energy announced that Doug Lawler from Andarko Petroleum (NYSE:APC) would be the new permanent replacement for former CEO Aubrey McClendon. I believe the decision to go with a CHK outsider is hugely positive for the company, due to the gambler mentality that has jeopardized the company's financial health, which was pervasive in prior management. The former board of directors are directly to blame for the obscene conflicts of interests that the company is still dealing with today, in terms of Aubrey McClendon's ability to buy a portion of each well the company drills despite starting a competing company. Lawler will be able to take a fresh look at CHK's assets and will be able to divest assets accordingly without any bias from having been a part of their initial acquisition. Chesapeake is unique in that it has its own substantial oil servicing infrastructure that is quite valuable, and new management might take a fresh look at whether or not it makes sense to monetize those assets to improve the financial flexibility of the company. I don't believe it is very likely CHK would divest these assets because they are essential to lowering the cost structure and enhancing Chesapeake's drilling competitive advantages, but at least the company can take a fresh look.

Through all of the extracurricular drama that Chesapeake Energy has endured over the last five years or so, it is easy to forget just how big the company is from a resources perspective. CHK is the 2nd largest natural gas producer on a net basis, and the largest natural gas producer from a gross perspective. Over the last several years the company has shifted its resources towards liquids production, which offer higher margins, and the company has now risen to be the 11th largest U.S. liquids (oil and NGL) producer. Based on 10 year average NYMEX strip prices as of 12/31/12, CHK has 19.6 tcfe of proved reserves to go with its 4bcfe/d production, and 14MM net acres of leasehold. On a PV-10 basis, CHK closed out 2012 with discounted future net natural gas and oil revenues of $17.773 billion, but it is important to note that due to the company's huge natural gas exposure, any increase in natural gas prices would adjust the number significantly upwards, and we are already seeing prices move in that direction. Chesapeake is now focused on refining its production to its most attractive properties where it has scale and competitive advantages in drilling costs. Much of the focus will be on liquids production still and then the company will look to sell non-core assets as attractive opportunities arise.

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Source CHK 2012 Annual Report

The goal of these efforts will be to leverage the company's massive investments over the years to finally achieve attractive returns on capital. This will mean less spending on new drilling projects, but instead capital will be allocated towards increasing drilling and completion activity, which offer a quicker cash payout than the land speculation business that the company had been engaged in under Aubrey McClendon. Over time, improved capital allocation should end the toxic funding gap problem that has plagued Chesapeake, where the company has regularly been spending more in CAPEX than it was generating through operating cash flow, requiring the company to take on additional leverage. In addition, management is now focused on more traditional asset divestitures in lieu of the joint venture structure that Chesapeake had been focused on so that the company can become less complex. This could ultimately set the stage for a sale to one of the large integrated oil operating companies that can leverage Chesapeake's huge acreage to grow production over the long-term.

On May 1st, Chesapeake Energy reported adjusted net income per share of $0.30, which was up 67% YoY. Adjusted EBITDA increased to $1.13 billion from $1.09 billion in the 4th quarter, and $838MM YoY. 1st quarter net production grew 9% YoY and 1% sequentially to 4 bcfe per day. The company's liquids production increased to 24% of total production from 19% one year ago. Oil production of 103,100 barrels per day was up 6% sequentially and a staggering 56% YoY. NGL production of 54,300 barrels per day was up 8% sequentially and 14% YoY. Importantly, combined production and G&A costs decreased 26% YoY to $1.1 per mcfe. Production costs by themselves were $0.86 per Mcfe, down 18% YoY, while G&A expenses averaged $0.25 per Mcfe during the quarter, down 29% YoY. The company believes there is further room to improve and believes it can save approximately another $100MM from previous guidance, which would flow directly to 2013 operating cash flow. Chesapeake has thus far signed or closed on $2 billion of asset sales on its way to the company's target of $4 billion to $7 billion. Management also outlined that it was in advanced discussions regarding other E&P and midstream divestitures to get the company closer to those goals. The company's current funding gap is estimated to be about $3.5 billion, so even if the company only completes $4 billion more in asset sales this year, Chesapeake should be able to fully fund its operations.

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Source-CHK May 2013 Investor Presentation

Like most North American E&Ps, Chesapeake is allocating the vast majority of its drilling completion capital to liquids plays in 2013, in Chesapeake's case 85%. This means that the company is deferring drilling on its dry gas plays until prices recover to levels, which make them more economically attractive. The company operated an average of 83 rigs in the quarter and invested approximately $1.5 billion in drilling and completions, which is right on pace with the company's $6 billion midpoint guidance for 2013. CAPEX in the quarter was $345MM, including $62MM of CAPEX that was spent on the two remaining midstream systems that the company is divesting, which will likely be recovered once the assets are sold. Chesapeake is receiving three additional rigs during this quarter, but after that the company has no additional plans for material growth of its oilfield services assets, which is a clear sign that the company is finally getting the picture that it needs to cut down on its spending to be more in line with its cash flows. 80% of the company's total 2013 CAPEX will be spent on drilling and completion activities versus an average of just 50% over the last three years.

Due to the strength of the company's performance in its Eagle Ford and Greater Andarko plays, Chesapeake increased its overall 2013 production guidance by 1MM barrels to a new range of 37MM to 39MM barrels. This was offset partially by a reduction in 2014 NGL production guidance by 1MM barrels to between 23MM and 25MM barrels. This reduction was largely due to a shift in rig allocation to more oil plays and processing infrastructure delays in the Utica and Niobrara plays. Chesapeake also increased its natural gas production guidance to a range of 1.06 to 1.09 Tcf, which is up 2% from the prior range. This increase was largely due to stronger than expected production from the company's key Marcellus play.

As of March 31st, CHK had a total debt balance of $13.4 billion, including $832MM drawn on the corporate revolver. On April 1st, the company took advantage of record low interest rates through issuing a $2.3 billion senior note offering the lowest interest rate in Chesapeake's history. The proceeds of this issuance will be used to refinance existing debt, as opposed to increasing the overall leverage of the company. On April 15th, the company used a portion of the proceeds to complete tender offers for approximately $594MM of debt, which represents portions of the company's 2013 and 2018 notes. The company also paid off its revolver. Management is targeting a reduction in long-term debt to $9.5 billion pending asset sales, so the timing is variable based on the completion of those asset sales. This would greatly reduce the pressure on the balance sheet and allow Chesapeake to focus on building out its existing assets, instead of having to worry about divesting them at potentially unattractive prices.

For 2013, CHK has put in place downside protection on 78% of its projected natural gas production at an average price of $3.72 per Mcf. The company also has downside protection on roughly 88% of the company's expected volumes at an average price of $95.43 per barrel. For 2014, the company has taken advantage of the recent climb in natural gas prices to hedge around 13% of projected gas production at $4.33 per Mcf. The company has also initiated 2014 oil hedges that protect downside on approximately 40% of projected production at an average price of $93.63 per barrel.

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At a recent price of $20.92 and with approximately 651MM shares outstanding, Chesapeake has a market capitalization of roughly $13.62 billion. This is a substantial discount to both what I view to be an understated PV-10 valuation and shareholders' equity. While the total debt balance of $13.4 billion is higher than I'd like to see, I fully expect the company to continue to improve its financial condition under new management. I believe the company can grow production by 7-10% per annum over the next 3 to 5 years. In addition, the increased liquids production will have a positive impact on margins. Chesapeake's enterprise value is roughly $26 billion and I believe that within the next two years the company can generate adjusted EBITDA of $6-$7 billion, with considerable upside beyond that. The stock could easily trade at $30-$35 per share, as further signs of progress occur in terms of capital allocation. I believe the recent approvals of LNG export facilities is a huge positive for natural gas prices and Chesapeake should be one of the biggest beneficiaries over the long-term. Smart businessmen buy assets and businesses when they are out of favor and natural gas is fertile ground for the deep value investor. I'm not buying CHK stock for short-term gains, but instead I'm buying the stock and selling long-term puts based on the belief that natural gas prices will be substantially higher over time, and management will be effective in more efficiently monetizing the vast resource base.

Disclosure: I am long CHK, APA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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