Chesapeake Energy: Still a Lousy Balance Sheet for Company

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 |  Includes: CEO, CHK, SSN
by: Jason Merriam

In early March, fellow SA contributor Michael Filloon wrote a really nice piece on the hot Niobrara shale play. Filloon's article did a terrific job of connecting the dots to the major and minor players building stakes there.

It's becoming a crowded field and we would like to focus on Chesapeake Energy (NYSE:CHK) for this discussion, and in particular, CHK's highly leveraged balance sheet.

We owned CHK back in the old days when CEO Aubrey McClendon and Tom Ward set out to be wildcatters in the "horizontal" style of drilling. It was unconventional and these guys had chutzpah. But that was 20 years ago and several market cycles earlier.

And while CHK makes claim to be the second largest producer of natural gas and one of the largest if not the largest holder of inventory of leasehold and 3-D seismic properties in the U.S., the company's broken balance sheet does not flatter its glory.

Sure, McClendon's big block purchases of his company's stock at what some considered richly valued levels also helped keep investors with skin in the game. We owned a good chunk of shares back then and in 2003, CHK accounted for almost 35% of our realized trades that year.

No doubt about it, Mr. McClendon put his money where his mouth was and advocated for the industry, even riding on the coattails of T. Boone Pickens' foray into the alternative energy bandwagon.

But by 2007 and 2008, NG markets were loaded with speculators and price movements were way out of line to injection rates, drawdowns and seasonal supply.

Amidst all this hubub, CHK was issuing preferred shares, getting leveraged loans and selling junk debt to fuel the growth. And what Mr. Filloon so succinctly pointed out in regard to the activities in the Niobrara is what motivated us to take look at CHK's financials. Just as some things never change, being bigger isn't always better.

Mr. McClendon is a very gifted salesman, but the managerial skills he brought to the table were not what we would call the key to unlock shareholder value. If that had been the case, then after-tax returns on invested capital and free cash-flow returns on invested capital would give you something to hang your Stetson on.

Unfortunately, the balance sheet (still) tells a different story and it's not a warm and fuzzy one.

Cash flow: Q1 of 2010 saw CHK make a run for positive operating cash, only to head south in Q3 and 4.

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Another view of this can be seen in the widening spread and divergence between balance sheet cash flows and what our dual cash flow model considers "true" operating cash flow.

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Accruals: Exacerbating this inability to generate meaningful shareholder value is what appears to be a rapid return to accrual accounting, starting back in the third quarter of 2009.

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Margins have been challenged because costs are melting through the floor like acid and capital productivity has deteriorated significantly (above).

So to get back to a point made in Mr. Filloons article, CHK scooped up a chunk of Niobrara (from Samson (NYSEMKT:SSN)) then turned around and chipped out a deal with CNNOC (NYSE:CEO). And, as Filloon notes later, Samson sold the land and CHK will pay a royalty on top of that.

So, while CHK might be good at sniffing out hydrocarbons, they're doing it with other people's money. Perhaps that's what caught activist shareholder Carl Icahn's eye. One risk arbitrageur to another.

However, at $33 and change, Chesapeake looks by our reckoning to be almost 50% above our estimated fair-value price of $22.50 (adjusted for balance sheet changes).

Under any other circumstance, we would likely consider CHK to be a viable short candidate at these levels. However, natural gas, coal and other hydrocarbon resource plays will likely be primary beneficiaries to the foment of anti nuclear sentiment following the disaster in Japan for the near-term.

Earnings Quality: B-
OVERVALUED +49.12% +/-
AVOID

You can view the full report on CHK here.

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