With Chesapeake Energy (CHK) down substantially of late, investors would be wise to remember that value investing works on a long-term basis. The success of Chesapeake depends on the rise of natural gas and liquids, not on the latest liquidity constraints. While the firm has a higher amount of risk given its aggressiveness in production, it is more skewed towards reward and, accordingly, rated a "buy" on the Street. In comparison to producers, like Linn Energy (LINE), the company has room for multiples expansions. Based on my multiples analysis and DCF model, I find that Chesapeake will generate higher returns than Linn.
From a multiples perspective, Chesapeake is by far the cheaper of the two. It trades at only a respective 11.5x and 9.2x past and forward earnings while its competitor trades at a respective 19.5x and 15.9x past and forward earnings. In addition, Chesapeake has more flexibility in cutting costs due to its scale and comparatively low gross margin level of 50.8%. With that said, Linn offers a dividend yield that is more than 600 basis points higher at 7.7% and is rated a "strong buy" on the Street.
Furthermore, the company noted strong production growth and strategy in the third quarter:
"LINN continued its active drilling program in the Granite Wash, where it drilled nine operated wells during the third quarter. LINN now has 29 operated horizontal wells producing and nine additional operated wells drilling, completing or awaiting completion. In addition, the Company owns working interest in 25 non-operated horizontal producing wells with three additional non-operated wells in progress. The Company's net production from the horizontal Granite Wash program during the third quarter averaged approximately 64 MMcfe/d, up from 51 MMcfe/d during the second quarter 2011.
LINN will continue to optimize its Granite Wash horizontal program by systematically drilling and completing multiple wells in a section at the same time. This technique minimizes the impact of offset completion activity on producing wells. LINN believes this method will enable the Company to capitalize on operating efficiencies and reduce both drilling and completion costs".
Analysts are also bullish about the $530M purchase of Plain E&P's Mid-Continent assets, which provides access to 80 mmcfe/d worth of liquids rich production and proven reserves of 254 Bcfe. The properties scale 20K acres in Granite Wash and 75K more acres outside of the region. Around $200M worth of equity will need to be issued at the second half of 2012, so volatility could be abnormally high until then as investors assess the value. Management recently guided above expectations due to the success of its capital program and aggressive actions at Granite Wash. It now expects to yield a 43% y-o-y growth in production to 520 Mmcfe/d. 2012 capital expenditures are now targeted at $880M with a focus on liquids - more than half of which will come from Granite Wash.
Consensus estimates for Linn's EPS forecast that it will grow by 17.5% to $1.81 in 2011 and then by 22.7% and 18.9% more in the following two years. Assuming a multiple of 19.5x and a conservative 2012 EPS of $2.17, the rough intrinsic value of the stock is $42.32, implying 17.7% upside. Modeling a CAGR of 19.7% for EPS over the next three years and then discounting backwards at a WACC of 9% yields a smaller figure at $33.17. Thus, while Linn may be favored on Wall Street, appreciation may be constrained.
In my view, investors have irrationally discounted Chesapeake's value due to recent developments. The company plans on reducing its LT debt by 25%, but the market has been overly focused on tactics used in the past. Over the last two years, the company reduced net LT debt by $2.2, but perpetual preferred shares (practically, equivalent to debt) made of more than half of the production. At the time, this helped finances the cash shortfall and address projects at Granite Wash Royalty Trust and Utica. With China's latest offshore oil firm acquiring a one-third interest in the Eagle Ford projects, however, Chesapeake has demonstrated more attractive ways to improve liquidity. Production between 2012-2015 will focus almost entirely on liquids growth with very little in gas.
Consensus estimates for Chesapeake's EPS forecast that it will decline by 4.4% to $2.82 in 2011, decline by 16.7% in 2012, and then grow by 51.9% in 2013. Assuming a multiple of 14x and a conservative 2012 EPS of $2.27, the rough intrinsic value of the stock is $31.78, implying substantial upside. If the multiple plummets to 9x and 2012 EPS turns out to be 10.2% below consensus, the stock would fall by 11.3%. Clearly, the former case is much more believable and, hence, Chesapeake should be rated a "strong buy".