Investors To Chesapeake: Show Us The Money

Nov. 7.11 | About: Chesapeake Energy (CHK)

Chesapeake Energy (NYSE:CHK) released third quarter earnings last week and announced the pending close of yet another joint venture (JV) with an undisclosed partner in part of the Utica Shale play. The markets initially celebrated CHK's announcements but soured on the stock after digesting the conference call.

Long-term investors know that quarterly earnings are not the key driver surrounding an investment in CHK. As I have detailed in the past with Chesapeake, the company boasts an excellent operations team and track record. Q3 results were no exception:

  • Net income came in at $879M ($1.23 per share) with EBITDA and operating cash flow at $1.4B.
  • Perhaps more impressively, though not unexpected, Chesapeake increased production by 9%. This production boost was weighted toward higher-value liquids, consistent with management's announced strategy.
  • Chesapeake also added 5% to proved reserves, net of divestitures, year-to-date.

Readers can review the specifics of Chesapeake's earnings report at the company's website but Chesapeake's operational excellence is not in dispute. Rather, investors remain skeptical that Aubrey McClendon and his team can manage the company's financial matters in a more conservative manner. While this issue can not be settled in the span of one earnings call, several points raised during the past week continue to justify such skepticism.

CEO Aubrey McClendon is well-known for his bold proclamations and enthusiastic advocacy for his company. But the market is clearly tiring of McClendon's shtick, or more precisely, the lack of results to back it. The latest, greatest game-changer comes in the form of the Utica Shale, of which McClendon states:

[Utica] plays have become, by far, the more frenzied new leasehold play in the industry since the Haynesville in 2008. And as I've stated publicly in the past few months, the Utica is the biggest thing to hit Ohio since the plow...

McClendon asserts that the Utica will "be proven up in time as the nation's most profitable play." So why are investors skeptical?

Perhaps it would be instructive to look at one of Chesapeake's previous latest greatest game-changers, the Haynesville. At the time, McClendon stated it could be the biggest thing to ever happen to the company and the market (myself included), believed him -- CHK peaked at over $66 per share. At the time, I thought a 15% dilution was a modest price to be paid for the massive resources and profits promised by the Haynesville. A few months later, I pointed out Bob Simpson's surprising jab at Chesapeake, referring to McClendon as a "hype artist" regarding the Haynesville. McClendon delivered a spirited response which included taunting an analyst who called gas staying at $6.25/mcf due to massive oversupply with yet another bold proclamation: "That kind of analysis, I think, can only come at the dangerous intersection of Excel and Powerpoint. It can’t happen in reality."

In hindsight, it is clear McClendon lost both rounds. Bob Simpson ran his company responsibly and conservatively. When the time came, he realized real value for shareholders by selling XTO to Exxon-Mobil (NYSE:XOM). As for that analyst call, gas prices have dropped far below McClendon's previously impossible $6.25 level. In fact, Chesapeake's strategy toward its gas shale plays may be a significant contributor to the poor state of U.S. gas prices.

In last week's earnings call, McClendon boasted

Chesapeake single-handedly has generated almost half of the entire industry's growth in natural gas production ...

Said in the simplest way that I can, natural gas markets during the past 5 years were basically changed single-handedly by the efforts of 1 company [CHK].

I had to scratch my head -- here the CEO was claiming credit for crashing the gas market and devaluing his company's most important resource. Despite the shift to more liquids production, over 80% of Chesapeake's reserves are gas ... gas that's worth much less than 5 years ago due "single-handedly by the efforts of 1 company." Much of Chesapeake's production growth in the past few years was irrational, driven by various agreements that forced the company to keep drilling even when it no longer made economic sense, thus depressing the market even more.

The CEO then goes on to say, "And now I'm telling you, during the next 5 years, it will be very different from now. And the future's curve is currently pricing natural gas, we believe, incorrectly ..." But investors have seen this rodeo before and we're not buying the hype.

During the recent earnings call, McClendon, as he is wont to do, repeatedly pointed out Chesapeake's overlooked value, but investors are wary and The Utica JV does little to ease investors' discomfort. If this latest play will become the nation's most profitable play, why is the company limiting its exposure to future profits (what it calls de-risking)? If funds are needed to develop the play, why not divest one of the other assets completely, as they did with the Fayetteville Shale and focus on the best assets? Instead, the company complicates its balance sheet even more and obligates itself to drilling a certain number of Utica wells through 2016, again exposing investors to the possibility of uneconomic exploration should energy prices fall. The market will punish Chesapeake as long as the company needs outside capital to fund development. Management's response was to dream up yet another financial vehicle to make our heads spin in the form of a subsidiary issuing preferred equity in the Utica. Sigh.

To top it off, the company unsurprisingly and quietly pushed out estimates for positive free cash flow from 2012 to possibly 2013. So it goes.

For years, we've heard management conjecture about CHK stock price possibly doubling or tripling but in the five years I've been long Chesapeake, the only things that have doubled are debt and share count. At this point, I prefer alternative stocks to open new long energy positions but continue to hold Chesapeake preferred D shares since the assured dividend and attractive asset base provide some backstop and I retain lottery-ticket potential should management ever deliver real, not conjectured, value to shareholders.

Disclosure: I am long CHK.