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Summary

  • We're focusing on the potential of Chesapeake in this article.
  • The key takeaway for investors is that it offers growth at a very reasonable price.
  • As such, we think it could outperform this sub-industry peer moving forward.

In this article, we're taking a closer look at the prospects for Chesapeake Energy (NYSE:CHK) and comparing the stock to Hess (NYSE:HES). We think a comparison of the two companies is worthwhile because, although they are of very different sizes (Hess has a market cap of $31 billion, while Chesapeake's is just $17 billion), the two companies sit in the same GICS sector of energy, as well as the same GICS sub-industry of integrated oil and gas. We understand that many investors apportion their capital based on GICS sector and sub-industry classification, so we think a comparison of the two sub-industry peers could prove useful.

Profitability

Clearly, recent years have been highly challenging for Chesapeake. Indeed, the company's profitability ratios are not particularly impressive. For example, its return on equity last year was a disappointing 4.7%, while its return on assets figure was also fairly low at just 3.4%. Neither of these figures compare favorably to sub-industry peer Hess, which was able to post a much higher return on equity number of 10.7%, while its return on assets was only slightly higher than that of Chesapeake at 3.45%.

However, while Hess has a balance sheet that is only moderately geared, Chesapeake relies to a far greater degree on borrowings to form its capital structure. For example, Chesapeake's debt-to-equity ratio stands at 63.5%, while Hess has an equivalent ratio of just 25%. Although neither company appears to be over-leveraged, Chesapeake's return on equity number will have been helped by a higher proportion of borrowings, which makes Hess's profitability appear to be all the more impressive.

Growth potential

Of course, the future could be a whole lot different than the past for Chesapeake, since it is forecast to deliver exceptionally strong earnings growth over the next couple of years. For example, it is expected to increase EPS by 40.9% this year and by 22.3% in 2015. Both of these growth rates are far in excess of the market average and show that Chesapeake could be on the verge of turning a major corner. Clearly, if it does deliver on its potential, then its profitability will take a significant step forward.

In contrast, Hess is expected to increase its earnings by just 2.3% next year, which is a disappointment and shows that it may struggle to firm up market sentiment in the short term. This growth rate is not only far lower than that of Chesapeake, it's also less than that of the wider market, which could cause Hess's rating to come under some pressure over the short-to-medium term.

Valuation

We're surprised to see that Chesapeake trades on a forward P/E ratio that is considerably below that of Hess. Indeed, while Hess has a forward P/E of 18.7, Chesapeake's is just 12.1. To us, this seems rather low, since although the forward P/E takes into account the current year's growth forecasts, it does not take into account the previously mentioned 22.3% expected growth rate in Chesapeake's earnings for 2015. Indeed, on a relative basis, it seems that Chesapeake offers great value, since Hess is expected to increase its bottom line by just 2.3% next year, despite it having a forward P/E of 18.7. We'd rather buy a fast-growing company at a low price than a slower-growing company at a higher price, so Chesapeake seems, in our view, to offer by far the better value for money of the two companies right now.

This point is backed up by the EV/EBITDA ratio, which, in spite of Chesapeake's considerably higher debt levels, still comes out in its favor. While Chesapeake's EV/EBITDA ratio is just 5.6, Hess has a slightly higher ratio of 6. Sure, both ratios are very appealing at present, but Chesapeake again pips its sub-industry peer and seems to offer better value for money right now.

Conclusion

Although Hess is undoubtedly much more profitable at the moment, Chesapeake seems to have the greater potential of the two companies. For example, it is forecast to grow earnings by 40.9% in the current year and by 22.3% next year. Despite this, it trades on a forward P/E of just 12.1. For us, this is the key takeaway for investors: Chesapeake offers superb growth at a very reasonable price. On the other hand, Hess offers much lower growth prospects at a far higher valuation, and although it is more profitable right now, we think that it may struggle to keep up with Chesapeake in future. Therefore, we believe that Chesapeake could outperform its sub-industry peer moving forward as the market bids up the price of its shares in response to what we believe is a mispricing.

Source: Why Chesapeake Could Be A Better Buy Than This Sub-Industry Peer