From myopic pessimism about low natural gas prices to irrational concerns over leverage and compensation, Chesapeake Energy (NYSE:CHK) is an attractive play on behavioral anomalies. The fundamentals of the company are strong, and management is equipped with deep industry knowledge. Despite what the media would have you believe, stock-based compensation is also not hindering value creation - just the opposite is true. Having worked in shareholder activist consulting and provided investor relations services to the sector, I say this with confidence. And I will explain herein, fundamentally, why compensation grows value.
In this article, I will run you through my DCF analysis on Chesapeake and then triangulate the result with an exit multiple calculation and a review of the fundamentals/technical indicators compared to Cabot Oil & Gas (NYSE:COG) and GMX Resources (GMXR). Given my belief in strong secular trends for natural gas, I also recommend investors consider opening long positions in smaller companies like Legend Oil and Gas (OTCPK:LOGL) and Pace Oil and Gas (PACEF.PK). These two have rightfully seen impressive momentum of late.
First, let's begin with an assumption about revenues. Chesapeake ended FY2011 with $11.6B in revenue, which represented a 24.2% gain off of the preceding year. Analysts model a 13.2% per annum growth rate over the next five years, and I view this sentiment as pessimistic. But for the sake of being cautious, I will accept the projection.
Moving onto the cost-side of the equation, there are several items to address: Operating expenses, taxes and capital expenditures. I model that cost of goods sold, COGS, will eat 53% of revenue over the next few years compared to 4.7% for SG&A and 0% for R&D. These estimates are roughly around historical three-year average levels. Capex is where forecasting, admittedly, gets trickier. This item represented 119.2%, 55.8% and 116.1% of revenue in 2009, 2010 and 2011, respectively. I expect the figure to trend, overall, from 80% to eventually 10% when the firm reaches maturity. Bear in mind that the much larger Exxon Mobil (NYSE:XOM) currently hovers between 6.5% and 10% even as the company makes supposedly audacious bets on gas.
We then need to subtract out net increases in working capital: We model accounts receivables as 18% of revenue; accounts payable as 35% of OPEX; and accrued expenses as 310% of SG&A.
Taking a perpetual growth rate of 2% and discounting backwoods by a WACC of 9% yields a fair value figure of $29.50, implying 21.2% upside. Stock-based compensation has been around $88M, and this doesn't even put a dent in the valuation. Not surprisingly, activist campaigns targeting corporate governance reform yield the lowest stock returns compared to other forms of activism. CEO Aubrey McClendon has created billions for his shareholders and is entitled to many millions for a job well done.
Management rightfully noted the importance of long-term outputs over short-term inputs:
"By 2014, we are confident the company will reach breakeven between its operating cash flow and capital expenditures, even if natural gas prices remain at depressed levels, which given the rapidly changing supply and demand fundamentals emerging in real time before us today, we think is very unlikely.
However, despite the obvious very good place where we are headed with our surging liquids production and despite the obvious very bad place we would be if we'd simply stayed within our cash flow and remain a 90% natural gas producer, I still read a surprisingly large amount of analyst commentary that remains singularly, and in my opinion, unimaginatively focused on how much CapEx we have spent. Our job as the management stewards of shareholders' capital is to create the highest amount per share of net asset value possible within our overall financial capabilities. That is why we focus on the outputs of our business, while it seems other people seem to obsess over the inputs to our business. But it is not the inputs that matter at the end of the day, it is the outputs. And our outputs are not only increasing in size, but also increasing in value on a per unit of production basis."
From a multiples perspective, Chesapeake is also cheap. It trades at only a respective 11.3x and 8.1x past and forward earnings versus 59.4x and 25.2x for Cabot. Assuming the multiple declines to 11x and a conservative 2013 EPS of $2.92, the rough intrinsic value of the Chesapeake is $32.12.
Consensus estimates for Cabot's EPS forecast are that it will grow by 23.9% to $0.83 in 2012 and then by 73.5% and 84.7% in the following two years. Assuming a multiple of 32.5x and a conservative 2013 EPS of $1.39, the rough intrinsic value of the stock is $45.18, implying 31.1% upside. GMX Resources has gained 38.4% for the year to date while trading at almost just one quarter of its 52-week high.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours.
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