Chesapeake Energy: Now A Strong 'Buy' Candidate

Mar.28.12 | About: Chesapeake Energy (CHK)

Because of unusually warm March temperatures across the country curtailing natural gas requirements, the U.S. Energy Department's weekly inventory release showed an in-line build-up in natural gas supplies. This is on top of the already ballooned inventories. The over-abundance of natural gas has been the argument for some investors to turn away from Chesapeake Energy (NYSE:CHK) stock, or any of the other gas stocks, some of which supplies are currently above the 50% benchmark levels. This low demand/high output ratio tends to jolt investors, but one only needs to take a closer look at Chesapeake to see the potential of investing now.

One of the positives found when taking a closer look is Chesapeake's action to sell off some assets (selling about $2 billion in pipeline and infrastructure), while diversifying into other, more profitable arenas. As the largest oil and gas driller in the U.S., Oklahoma-based Chesapeake engages in the acquisition, development and production of onshore U.S. natural gas resources. The company now ranks as a leading U.S. natural gas producer, contributing about 3.5% of national total production. As of December 31, 2011, Chesapeake owned interests in close to 45,700 natural gas and oil wells that produced about 3.5 billion cubic feet of natural gas equivalent per day.

But, too much natural gas is the problem. Chesapeake has recently shut in 1 billion cubic feet per day of gross natural gas production. This represents approximately 1.5% of all natural gas production in the continental United States. In January 2012, Chesapeake announced an immediate reduction of 500 million cubic feet (MCF) per day of natural gas production, along with significant reductions in dry gas drilling for the year.

Other natural gas players have also announced drilling curtailments. Exploration and production outfits like Ultra Petroleum (UPL), Talisman Energy (NYSE:TLM) and Encana (NYSE:ECA) have all reduced their 2012 budget to minimize investments in drilling.

Chesapeake - the second-largest U.S. producer of natural gas behind Exxon Mobil (NYSE:XOM) - and rival explorer ConocoPhillips (NYSE:COP) is taking steps now to improve the bottom line instead of waiting for a revival of natural gas prices. Chesapeake's CEO, Aubrey McClendon, has stepped up plans to produce more oil and natural gas liquids while cutting dry-gas output. McClendon stated in a year-end presentation on Chesapeake's fourth-quarter and full-year 2011 earnings that some 60% of its revenue would come from oil and NGLs in 2012, up from roughly 50% anticipated by the company just a month earlier.

Focusing solely on dry natural gas drilling creates huge risk. Analysts believe that it only takes a small amount of liquids production to increase a company's standings. A recent Moody's report makes it clear how little oil and natural gas liquid a diversified producer needs to be selling as part of its product mix to support large-scale natural gas production.

Chesapeake forecasts an increase of more than 70%, (63,000 barrels a day), in liquids production in 2012 and is poised to deliver an average output of 250,000 barrels a day, becoming among the top five U.S. liquids producers by 2015. Chesapeake will spend $7.5 billion this year in drilling. Projections based on $100 per barrel of oil and $4/mmBtu natural gas, the company forecast un-hedged oil and gas revenue of $6.76 billion in 2012, and rising to $9.06 billion in 2013. Operating cash flow is expected to increase almost 60% over the same period assuming an increase of only $1 in natural gas prices.

The company is noted for growth by acquisitions. A recent New York Times article revealed that in early March, Chesapeake teamed up with Kohlberg Kravis Roberts (NYSE:KKR) to invest in mineral and royalty interests in important U.S. oil and gas basins. As per the deal, both parties are entitled to a combined $250 million of initial investment for royalty interests and mineral rights in the U.S. drilling fields. This gives them exposure to shale as well as other unconventional energy sources.

Additionally, according to a recent Reuters report, Chesapeake announced a joint venture for its acreage in the Mississippi Lime formation in Oklahoma, in the second quarter, comprising a large deal covering 2 million acres, a deal that is needed by Chesapeake to help close a funding gap.

I believe that Chesapeake's focus on shale gas should provide the momentum to monetize these assets more effectively and efficiently, thereby boosting returns. I like Chesapeake's plans to invest further in oil-related drilling over the next two years. In fact, looking ahead to 2014, Chesapeake projected that its liquids production will allow it to reach an equal balance between cash flow from operations and its planned drilling and completion capital expenditures.

Finally, Chesapeake looks like a solid bet despite being mainly a natural gas producer.

Chesapeake's revenue has risen for two straight quarters. In quarter three, revenue increased 54.1% to $3.98 billion from the year-earlier quarter. In the second quarter, the figure rose 64.9%. For the fiscal year, analysts are expecting earnings of $2.80 per share and revenue is expected to be $3.04 billion for the quarter, 53.9% higher than the year-earlier total of $1.98 billion. For the year, revenue is projected to come in at $11.97 billion.

After announcing the diversification, analysts have become more optimistic about the stock. As of this writing, Chesapeake stock was trading at $24.21 with a market cap of $15.4 billion. Trailing twelve-month P/E ratio is 10.44, and forward P/E ratio is 8.28. P/B, P/S, and P/CF ratios stand at 1.2, 1.6, and 3.1, respectively. Operating margin is 25.1% and net profit margin is 13.5%. The company has some debt issues. Debt/equity ratio is 0.9, but the actions Chesapeake is taking now to reduce debt will improve the ratio.

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