Chesapeake Energy - Long-Term Appeal Remains After Solid Momentum In 2013

| About: Chesapeake Energy (CHK)

Chesapeake Energy (NYSE:CHK) continued progress attracts analysts attention as well. On Thursday, the oil and gas company received a buy rating from analysts at Citigroup (NYSE:C), prompting shares to rally some 4%.

The continued operational progress in terms of profitability, focus on oil production and asset sales, results in a healthier balance sheet and share price. I continue to be upbeat about the long term risk-reward proposition in the stock.

Upbeat Citigroup

Analyst Robert Morris upgraded the rating on Chesapeake from "Neutral" to "Buy" while raising the price target from $27 to $35 per share. The price target implies a decent 29% potential from Wednesday's closing price.

Note that Chesapeake named Robert Lawler as CEO in May after ousting former CEO McClendon. Morris believes new management will focus on restructuring and cost reductions, realizing efficiency improvements at the core operations of the firm.

Combined with a rise in oil production, which is underappreciated by the market, this should provide meaningful returns to shareholders.


Note that Chesapeake is scheduled to release its third quarter results on the 6th of November. The company ended its second quarter with $677 million in cash and equivalents, while operating with total debt of $13.06 billion. As such, Chesapeake holds nearly $12.4 billion in net debt on its books.

Revenues for the first six months of the year came in at $8.1 billion, up 39.5% on the year before. Net income attributable to common shareholders nearly halved to $473 million, coming in at $0.72 per share. Note that last year's earnings were aided by gains on asset sales.

Note that an extrapolation of these results would result in annual revenues of around $16 billion, with earnings approaching $1 billion.

Trading around $28.50 per share, the market values Chesapeake at $19 billion. This would value the equity in the business at 1.2 times annual revenues and 19 times earnings.

Despite the continued difficult financial times, Chesapeake still pays a quarterly dividend of $0.09 per share, for an annual dividend yield of 1.2%.

Some Historical Perspective

Long term holders in Chesapeake have seen volatile returns as the company had overly optimistic plans to grow its operations in the US over the past decade. The high level of leverage employed, in combination with the collapse of natural gas prices during the crisis, has caused severe stress on the company and its share price.

Shares peaked at nearly $70 in 2008 to end the year around $10 per share. Ever since, shares have traded in a $15-$35 trading range, currently trading around $28 per share. Note that shares started the year around $17 per share.

Despite asset sales, Chesapeake has grown revenues in recent years on the back of increased production and a modest recovery in prices. Between 2009 and 2012, Chesapeake has increased its annual revenues by a cumulative 60% to $12.3 billion. The company reported multi-billion losses in 2009 on impairment charges but has returned to profitability at the moment.

Investment Thesis

Chesapeake continues to make progress, with shares trading with year to date gains of around 70%. These gains are mostly driven by continued asset sales to deleverage, the final ousting of McClendon, and the fact that very prominent investor Carl Icahn continues to invest in the company. Actually he increased his stake to about 10%.

These actions combined with layoffs and increased liquids production support the profitability of the company. Reductions in leverage combined with growing core operations will furthermore support the relative leverage ratios which are coming down. This is despite the many debates about real proceeds of asses sales and the lack of debt reduction in recent times. Proceeds from this strategy are "masked' by the continued high capital expenditure requirements of the core assets.

Back in Many, I last took a look at Chesapeake's prospects. At the time, shares were merely trading at $19 per share. Shares have witnessed a nearly 50% rally ever since. I concluded that operating performance continues to improve, while debt remains a worry given the lack of smooth assets sales. Even back then, Chesapeake was able to report adjusted earnings of around $1 billion on an annualized basis. This is despite relative modest natural gas prices and a future expected pick-up in oil production.

The long term risk-reward was good at the time, as stabilization and asset sales had averted the scenario of a liquidity crisis or even bankruptcy. Yet the divestiture strategy is painful to watch for shareholders, being dilutive to long term earnings while often resulting in short tem renewed impairments.

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

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.