Chesapeake Energy's Asset Sales May Be Inflection Point

Feb.22.11 | About: Chesapeake Energy (CHK)

Chesapeake Energy (NYSE:CHK) and BHP Billiton (NYSE:BHP) announced yesterday that BHP will acquire all of Chesapeake's Fayetteville assets for $4.75 billion in cash. The assets represent 487,000 acres of leasehold and producing properties, pumping 415 million cubic feet of natural gas equivalent daily, plus the 420 miles of midstream pipelines servicing the area. Chesapeake will use the money to pay down debt. This sale furthers Chesapeake's plan to increase production and cut debt by 25% in the next two years, and should make investors take another look at Chesapeake.

Chesapeake Energy is the second largest natural gas producer in the US, only trailing Exxon Mobil (NYSE:XOM), which acquired XTO energy last year. The company produced 2.6 bcf/day of natural gas in the last quarter of 2010, with about 1.7 bcf/day of that natural gas coming from shale plays. The company has been the most active player in the shale gas revolution, and led by its polarizing founder and CEO Aubry McClendon, has been gobbling up leaseholds in the US for the last 5 years in what the company calls a "land grab."

Most of this acreage was focused on natural gas up until 2010, when the company shifted towards acquiring leaseholds focusing on natural gas liquids (NGLs) and oil. The debt used to finance this land grab, questions as to how Chesapeake will come up with the billions and billions of dollars to develop the assets, and falling natural gas prices have kept the share price in check over the last two years. CHK shares have started to break out in 2011, and as investors begin to see CHK's management monetize assets and pay down debt, shares should have room to run further.

A big catalyst for the recent share price appreciation in CHK was the announcement in late December that activist investor Carl Icahn had purchased a 5.8% stake in the company, putting just under $1 billion into the company. That makes Mr. Icahn the largest shareholder in the company, holding more shares than any other entity.

Add to that the fact that management barley owns any shares, and the company seems vulnerable for activism. Mr. Icahn is well known in financial circles for buying into companies and then shaking things up, unlocking value for shareholders and making himself a fortune in the process. Though Mr. Icahn has been relatively quite on the position, he did mention in December that shareholders would benefit if the company were to delever. His silence since then is hard to read, but the speed at which CHK put the Fayetteville assets up for sale should not be seen as coincidental.

Mr. Icahn has a long history and impressive track record of removing managements that he disagrees with. CHK has 4 of 9 board of director seats up for election this year, making CHK vulnerable should Mr. Icahn decide to challenge the current board for control. The presence of Mr. Icahn into the situation will focus management more on increasing shareholder value, if for nothing else then for fear of losing their jobs, or the company, to Mr. Icahn.

As stated earlier, Chesapeake is the second largest producer of natural gas in the US. However, CHK's market cap of about $19.9 billion (based on a $30.45 share price as of this writing) means that every other company in the top 10 producers of natural gas in the US is larger than CHK in terms of market cap. Devon energy (NYSE:DVN) is twice as big, ConocoPhillips (NYSE:COP) is 5 times as big, and Chevron (NYSE:CVX) is 9 times as big. CHK's $11.5 billion in long term debt as reported in the most recent 10-Q is the biggest hindrance to an expanded market cap. Every dollar going to interest payments to bondholders is a dollar that shareholders do not see.

Paying off significant portions of this debt will not only lower interest payments and improve profitability, but will lead to a higher market cap as less of the enterprise value is eaten up by debt. The company reports its enterprise value at about $37 billion in its February investor presentation, meaning the market cap only represents about half the value of the company. As more debt gets paid down, expect a larger shift in that split, with more of the enterprise value reflected in the shares. Also, a smaller debt load should be rewarded with a higher multiple, adding to the upside for shareholders.

CHK's goal to increase production 25% does not mean it will be extracting 25% more natural gas from the ground. The company has been switching its focus towards liquids, namely oil and NGLs. These resources are priced much, much higher than natural gas. Price mix for natural gas is about $4 mcfe and about $15 mcfe for liquids, meaning that each extra mcfe of liquids will drop down to the bottom line more so than incremental gas increases. Production of liquids has gone from an average of 32,000 bbls/d in 2009 to 60,000 bbls/d at the end of 2010, with projections that production will reach 250,000 bbls/d by the end of 2015.

Given CHk's track record of finding new ways to squeeze more resources out of the ground, that goal of 250,000 bbls/day could be reached much quicker than CHK's current estimate. Expect the company to announce in the coming months it has unlocked new liquids reserves in one of its large leaseholds, as it hinted at in the February 2011 presentation. This should be a positive catalyst for the stock, and could kick off a round of analyst upgrades, depending on what the assets are, and what CHK expects to be able to extract.

Chesapeake Energy may be at a turning point in the company. The last 5 years have given the company vast holdings of land and resources, a large debt load, as well as technological expertise in the US Shale energy field. The company is no longer exploring the US for the next big find, but now has switched its focus into getting those resources out of the ground. Add to that the goal of paying down debt, through asset sales and Joint Ventures, and the company seems to be heading in the rich direction. Carl Icahn is involved to keep management focused, and political instability in OPEC nations like Libya could refocus the Federal Government on energy independence, as well as focus the large multinational oil companies on the US shale formations.

Both these events will provide a bid to natural gas, a bid to Chesapeake's assets, and most likely, a bid to CHK shares.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours.