Investors in Chesapeake (NYSE:CHK) were not very happy with the company's second quarter results. While operational growth has been impressive the company was hurt by much lower natural gas price realizations in particular.
The consequent earnings miss dominates the news flow for the short term, while other long term achievement such as the debt reduction towards $10 billion and production growth are quite impressive. As such, I remain cautiously optimistic in this. long-term turnaround story.
Second Quarter Results
Chesapeake posted second quarter revenues of $5.15 billion, a 10.2% improvement from last year. Analysts believed that sales would come in roughly flat at $4.67 billion.
Despite the solid growth in the headline results, net earnings were down by roughly two-thirds to just $145 million. This is as topline sales growth was aided by the marketing, gathering and compression businesses which is not profitable while lucrative natural gas and oil revenues were down sharply.
Diluted earnings fell by a similar percentage as the company held the outstanding share base roughly flat over the past quarter, with earnings falling to $0.22 per share.
Adjusting for certain items including gains and losses recorded on divestments and the repurchase of debt, Chesapeake posted earnings of $0.36 per share. This was a bit lower compared to consensus estimates for earnings of $0.44 per share.
Looking Into The Numbers
Topline sales were aided by a nearly 54% jump in revenues related to marketing, gathering and compression services which came in at $3.17 billion. At the same time costs which are directly attributable to this business rose to the same level resulting in an break-even result which compares to a modest $29 million profit a year ago. Note that this result comes before the allocation of other corporate costs.
Net sales of natural gas, oil and NGL came in at $1.70 billion, down by nearly 30% compared to last year. Asset sales, but notably lower realized prices hurt the topline. Adjusted for asset sales, production rose by 13% to 695,000 barrels of oil-equivalents. While many energy companies focus on oil over gas these days, the production of just 113,400 barrels of crude remains relatively low.
Sales of the smaller oilfield services business came in at $281 million, a 32.5% increase compared to last year. Note that this business is no longer part of Chesapeake going forwards after the recent spin-off.
All of this resulted in income from operations of $610 million, a number cut nearly in half compared to last year. While the company managed to cut interest expenses significantly, other losses on investments hurt the bottom line. A $195 million loss recorded on the purchase of debt has been costly as well.
Now add to that a relatively high effective tax rate, minority interests and preferred stock dividends, and all you have left over for common shareholders is just $145 million.
After struggling with its debt load for years, Chesapeake finally made some progress in reducing its net debt load. The combination of severe cuts in capital expenditure budgets and asset sales combined with operational cost cuts is paying off.
Capital expenditure for the first six months of this year totaled $2.2 billion, while it totaled $1.8 billion in the second quarter of last year alone. Asset sales have been helpful as well as Chesapeake received $675 million in proceeds from the sale of non-core assets throughout the quarter. Another $700 million in proceeds from other sales are anticipated to arrive in the second half of the year.
All of this has resulted in cash and equivalents balances which increased towards $1.5 billion. Total debt came in at $11.5 billion which results in a net debt position which is slightly above the $10 billion mark.
With some 664 million shares outstanding, and shares trading at $26 per share, Chesapeake's equity is valued at little over $17 billion. The company has now posted trailing revenues which approach $20 billion while it reported net earnings of about $650 million. As is typically the case, GAAP earnings are impacted by a range of items given the asset divestiture strategy and the refinancing costs of debt.
This values equity in the business at around 0.85 times sales and roughly 26 times GAAP earnings.
Chesapeake has once been the darling of the energy sector, notably before the financial crisis. Following this period, shares have lagged as the company was saddled with debt while it focused, and continues to rely on the production of natural gas which results in much lower yields compared to oil.
Shares have vastly underperformed versus the wider market and especially domestic oil exploration companies. Yet the company is making real efforts to streamline the business while it actually manages to report growth while doing so.
For the year, Chesapeake anticipates to spend between $5 and $5.4 billion in capital expenditures, allowing the firm to increase the production outlook by 10,000 barrels of oil-equivalent per day.
Other strategic targets have been met as well, including the spin-off of the oilfield service unit, Seventy Seven Energy (NYSE:SSE) which was completed at the end of June. The spin-off allowed the company to remove $1.1 billion in debt on its balance sheet.
CEO Doug Lawler is upbeat about the growth in production, forecasting an exit rate of 730,000 barrels of oil-equivalent per day for the year. This compares to 695,000 barrels of oil-equivalent production for the past quarter.
Another positive development has been the repurchase of the preferred shares of CHK Utical LLC. The company spend $1.26 billion to repurchase the preferred share, thereby foregoing $75 million in annual cash dividends to be paid to outside investors.
Adjusted for asset sales, Chesapeake reported a 13% increase in production to nearly seven hundred thousand barrels of oil-equivalent for the quarter.
The company is making real progress in streamlining costs and boosting profitability of the business, yet the lower prices of natural gas and relatively poor hedging results had a real impact on the operational profitability of the business. In terms of barrels of oil-equivalent proceeds excluding hedging came in at $30.32, while realizes prices including hedging amounted to just $26.97.
As such there are still incremental drivers going forwards, as the company has hedged a considerable portion of estimated production going forwards. This insulates the company to some extent to price swings in the short to medium term.
As such I can easily envision, Chesapeake posting earnings of over a billion going forwards which could make the valuation quite a bit more appealing going forward. Also note that growth could actually re-accelerate given the rapid decrease in both absolute and relative leverage, given that asset sales can slow down or stop going forwards as leverage is more contained.
I remain cautiously optimistic, hoping that lower gas and oil prices could provide shares to re-test their lows of around $24 of earlier this year.
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