Chesapeake Energy: The Price Is Far From Peak

May.14.14 | About: Chesapeake Energy (CHK)

Summary

Turnaround plan is on track as reflected by strong Q1 performance.

Free cash flow will experience notable growth in the coming years and funding requirement from asset sale and debt borrowing would be minimal.

The stock still trades at high discount to peers, making it a buy.

The share price of Chesapeake Energy (NYSE:CHK) has appreciated by 46% over the past 12 months, compared to a gain of just 16% for S&P 500 Index. In my view, future price upside is substantial as the company remains in early stage of a turnaround and the stock valuation continues to look cheap.

Chesapeake just reported Q1 2014 performance with both EBITDA and EPS beating consensus estimates largely driven by higher production and better price realization. Owing the strong performance, management raised their 2014 production growth guidance to 9%-12% (from 8%-10%). Annual operating cash flow guidance was also upgraded from $5.1B-$5.3B to $5.8B-$6.0B.

Based on the recent developments, I have performed a cash flow analysis to gauge the magnitude of Chesapeake's free cash flow growth potential over the coming 3 years (see chart below).

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My analysis started with consensus EBITDA estimates from 2014 to 2016. It is noted that the company's EBITDA to operating cash flow conversion ratio dropped to its 5-year low at 63% in 2012. The metric improved notably in 2013 to 84%. In my opinion, the conversion ratio should continue to rise over the coming years given that 1) Chesapeake has been making significant progress in improving economics through driving higher NGL production, gaining capital efficiency, and cutting operating costs and 2) the company has also managed to refinance $3B of debt in the current year, which should save approximately $100M interest expense per annum going forward. To be conservative, I assumed a flat 90% EBITDA to operating cash flow conversion rate over the forecast period from 2014 to 2016, and the resulted operating cash flow estimate of $5.3B for 2014 is much lower than management's revised guidance. In terms of capex, I assumed it to grow from $5.7B in 2014 to $6.5B in 2016, and the 2014 capex estimate is above management's guidance range from $5.2B to $5.6B. Based on these assumptions, free cash flow was projected to almost break even by 2016. Into 2014, Chesapeake has incurred $59M net issuance of debt and announced about $925M sale of assets. Without further funding (e.g. additional asset sale and/or debt borrowing), the company is able to fully cover its dividend commitments and can even increase common dividend payout in 2014. Based on my projections, the company will only to divest $600M and $500M assets in 2015 and 2016, respectively, to close funding gaps (i.e. breaking even in cash surplus) in those years. I believe this forecast is completely achievable because 1) I have used very conservative EBITDA to operating cash flow conversion ratios and 2) Chesapeake is expected to continue divesting assets such as its oilfield services business, which should garner ample proceeds (the oilfield services business would worth $2.2B at 1.0x EV/Revenue multiple). Assuming the EBITDA/operating cash flow conversion ratio increases from 95% in 2014 (note that even at 95%, my operating cash flow estimate of $5.6B is still below management's guidance of $5.8B-$6.0B) to 105% in 2016, cash surplus will increase from $495M in 2014 to $1.1B in 2016, meaning that the company can close the funding gaps even without any asset sale in 2015 and 2016 (see chart below).

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Despite the significant improvement potential ahead, Chesapeake's valuation remains cheap. Although its forward 2015 EV/EBITDA multiple of 5.7x is slightly below peer average at 5.9x, the stock's forward 2015 P/E multiple is at 20% discount to peer average. I view the P/E valuation gap to be very attractive as 1) Chesapeake's consensus long-term EPS growth estimate of 20.4% is considerably above peer average at just 9.1%; 2) the company's return on equity and return on capital metrics are mostly in line with par but these metric should increase over time owing to higher NGL volume as well as improved capital and operating efficiencies; and 3) Chesapeake has a slightly better-than-average dividend yield (see chart below).

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In addition, the stock also trades favorably to the overall market. Compared to S&P 500's forward 2015 P/E multiple of 14.8x, the stock trades at 12% despite the fact that the average consensus long-term EPS growth estimate for S&P 500 companies is just 8.5%. On a PEG basis, Chesapeake trades at 0.6x, less than half of S&P 500's 1.7x (see chart below).

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In conclusion, Chesapeake has demonstrated significant progress toward achieving positive free cash flow thanks to management's turnaround efforts, while valuation remains cheap. Even with conservative assumptions, the company can fund its capital programs (e.g. capex and dividends) with minimal proceeds from asset sales. Management will hold an analyst conference on Friday, May 16, 2014. It is expected that details on projects, operations, and potential sale will be discussed in the meeting. Given the positive development to date, I expect this event to be another positive catalyst for the share price. As such, investors are recommended to buy the shares ahead of the Friday meeting.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: I am long CHK. 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.