After Chesapeake (CHK) indicated that CEO Aubrey McClendon has taken more than a billion dollars worth of loans to finance growth as collateral for yet more loans, the stock took an irrational dive. Investors like to criticize the company for its aggressive capital expenditures, but this has set the bar too low (see here for proof that the bears are dead wrong about Chesapeake). The secular trends in natural gas still remain incredibly strong and, moreover, Chesapeake's actions should be construed as a solid measure of confidence. But I'll get back to why Chesapeake is an easy "strong buy" in just a second…
In this article, I will walk you through my DCF model on Marathon Oil (MRO) and then triangulate the result with a review of the fundamentals compared to Chesapeake and Exxon (XOM). I find that Marathon and Chesapeake are both substantially undervalued.
First, let's begin with an assumption about the top line. Marathon finished FY2011 with $15.3 billion in revenue, which represented a 18.7% growth off of the preceding year. I model growth trending from 9.2% to 4% over the next half decade or so. This projection, in my view, errs on the conservative side. But, for the sake of proving a point, I am factoring it in as an input.
Moving on to the cost side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 40% of revenue vs. 5.8% for SG&A, 3.8% for R&D, and 20% for capex. Taxes are estimated at 37% of adjusted EBIT (i.e., excluding non-cash depreciation charges to keep this a pure operating model).
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $39.11, implying 33% upside. The market seems to be factoring in a WACC of 12.5%, which is much too conservative.
All of this falls within the context of strong momentum:
By any standard, the operating and financial results achieved in 2011 by Marathon Oil employees were outstanding. And we intend to continue that momentum and build upon our successes in 2012 and beyond…
2012 priority objectives: to deliver 5% growth in Upstream production available for sale over 2011, excluding Libya as well as dispositions; to spend within the announced capital and exploration expenditure budget of $4.8 billion, excluding acquisitions; to achieve Upstream reserve replacement of 150% or greater, excluding acquisitions and divestitures; to drill key exploration wells in the Gulf of Mexico, Kurdistan and Poland and, importantly, to achieve success; to continue to upgrade our portfolio through selective acquisitions in our core areas as well as dispositions of noncore assets; and enhance our overall cost competitiveness, both at the field level and above the field.
The stock trades at 12.3 times past earnings but only 6.6 times forward earnings. Chesapeake is even more attractive, trading at a respective 8.1 times and 6.3 times past and forward earnings. By contrast, Exxon trades at a respective 10.1 times and 9.5 times past and forward earnings. Yes, this Standard Oil heir is the world's leading energy company, but its current earnings power does not merit forward valuation that is roughly 50% higher than that of Chesapeake and Marathon.
Chesapeake bears lament the capital spending, but there is no immediate liquidity pressure. Nearly all of the 2012 budget is discretionary. And as Bank of America Merrill Lynch rightfully noted:
[W]ith ~$3-$4B of operating cash flow expected in 2012 even in the worst of gas price scenarios and some $10B-$12B of noncore asset monetization well under way… the scale of cash likely to be released in 2012 alone exceeds the entire market capitalization.
As natural gas prices improve, I expect that Marathon and Chesapeake will outperform Exxon. The world's largest energy company may be the safest, but this will cap risk-adjusted returns. Chesapeake and Marathon both have attractive leverage to positive secular trends, which creates opportunities for investors to exploit the day-to-day (or even week-to-week) irrational market swings and risk discounting.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
