The Price Is High For Chesapeake... Nothing New Here

| About: Chesapeake Energy (CHK)


Chesapeake's current valuation seems high when using a DCF analysis.

But the over value of the company isn't something new and happened even when oil was trading at $100.

As long as people believe the company won't go out of business, Chesapeake will remain overpriced.

The recent recovery in shares of Chesapeake Energy (NYSE:CHK), mostly due to the rise in oil prices, calls into question whether the company's current valuation is reasonable. After all, a company with such a heavy debt load that still faces a soft oil and natural gas market is expected to trade at a huge discount - at least compared to its peers that face lower costs, have economies of scale, and a much better balance sheet. Currently, CHK is trading at an EV/EBITDA of 6.9, which is still a bit higher than the industry's ratio of 5.6. But this higher valuation isn't something new. After all, CHK's valuation was high even in times when oil prices were around $100.

Is the price right? Was it in the past?

The company faces high debt burden, and with oil prices trading around $40 and natural gas well below $2, it seems that the company may not be around coming next year. And some analysts quote the company's high valuation - even at $4 per share, the stock seems overvalued - as one of the main issues they have with this stock (besides the growing chances of a bankruptcy). In a sense, they do make a point. The company is overvalued based on its current debt and assets.

By using a very simple DCF analysis (assuming: a discount rate of 10%; no change to its output over the next 5 years and afterwards maintain a steady growth of 2%; a realized price of oil of $40/NG at $2.2 - rising by $5/$0.2 per year until the terminal year where price will remain at $70 for oil and $3 for NG; capex of only $1.5 billion and to $1 billion by terminal year (I know, that's low); and a 10% ratio between operating cash flow and revenue, which is the same as it was back in 2015 (again a simplifying ratio but given the current state of the company seems reasonable)), I come with the following valuation of CHK, which unsurprisingly comes up to $363 million. And compared to its current market cap of $2.7 billion, the market puts a "premium" of $2.3 billion on the stock.

Source: Author's calculations

We can also examine the assumptions on oil prices, discount rate and growth rate in perpetuity. The first table shows the sensitivity analysis between oil (at terminal period) and the discount rate. Again for simplicity, I only looked at oil as it moves the total operating cash flow of the company.

Click to enlarge

Source: Author's calculations

As you can see, only if prices were to climb back up to $80 - and the company stays in business - the stock could be worth well above its current market cap (the breakeven point is at $82 for a discount rate of 10%).

And only if the growth rate is above 2% and oil prices higher than $80, CHK's DCF valuation makes its current market value a bargain.

Source: Author's calculations

But this isn't something new that oil investors and traders valued CHK much higher than its valuation.

Just consider a DCF analysis back in mid-2014 before the collapse of oil prices. Only then, one would assume oil prices at $100, natural gas at $3.5, and at least 5% growth in output over the next five years. Based on these assumptions, the stock was still trading at a much higher price with a premium of $6.5 billion.

Source: Author's calculations

So what's the point?

I'm not saying two wrongs make a right - so because CHK was overpriced when the oil prices were high, this mitigates the fact that CHK is overvalued now at the current state of the oil market - only that being overpriced isn't something new for CHK. And the main difference is that now there is a higher chance of the company going out of business as the weak balance sheet is much more prominent than it was back when oil was trading close to $100 a barrel. So the valuation is becoming more of an issue when the circumstances are much worse.

The high premium is likely related to traders gambling that oil and natural gas will bounce back and this trade will eventually pay off. That could partly explain the high volatility in the company's stock compared to other oil companies that are trading at higher values and aren't in such a bind as CHK is.

When it comes to bankruptcy, I still think that while the chance of this possibility continues to grow, it still doesn't seem likely in the near term - at least not from a cash flow perspective. This, of course, could change, if for example, oil and natural gas prices resume their descent or if the revolving credit facility is cancelled - which will reduce its available cash resource in case it's needed. The company could still sell off assets to cut its debt and build up more cash on hand if needed.

Some investors are still optimistic about CHK - an optimism that doesn't seem to be backed by the current valuation of the company. But this circumstance isn't something new when it comes to Chesapeake (and many other stocks for that matter). And perhaps, traders still think the company is beaten too harshly due to its weak balance sheet and the talk over a possible bankruptcy. Thus, as long as the oil and gas producer doesn't go belly up - and for now it doesn't seem likely in the near term - the stock is still likely to take its pace from the direction of oil and natural gas prices and experience big swings. For more please see: Is Chesapeake on the right path?

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.