It's been a long slumber. If the Chesapeake Energy (CHK) bears would bother looking at the multiples and stop hallucinating fictitious stories about CEO Aubrey McClendon perhaps they too would see the folly in their ways. My personal opinions about the CEO aside, I find Chesapeake to be exceptionally undervalued.
With the stock trading near the 52-week low on a beta of 1.3, strong secular trends in natural gas are, in my view, bound to send shares skyward. This $11.6B company trades just short of 2x FY2011 operating cash flow. Corresponding figures for Linn Energy (LINE) and BP are 15x and 5.9x, respectively. Despite this gap, according to NASDAQ, only Linn and BP are rated "strong buys".
Chesapeake is the second largest natural gas player and has leverage that enables it to yield higher risk-adjusted returns. If anything, investors should take the CEO's bets and personal loans as a good thing: he believes in his business. Consensus estimates for Cheaspeake's EPS forecast that it will decline by 60% to $1.12 in 2012 but then more than double and grow 48% in the following two years. To put that into perspective, consider that Chesapeake just needs to trade at 9x a conservative 2013 EPS estimate of $3.30 to skyrocket 70.8%. If the multiple depresses further to 7.2x, the stock would still appreciate 33%. All of this comes on top of a 2% dividend yield.
Perhaps the primary reason why the bears have been able to depress valuation is by misconstruing confidence with recklessness. Chesapeake's leverage is a function of the former, not the latter. After graduating Valedictorian of his high school class, McClendon went on to founding the origins of Chesapeake at age 23. Around 7 years later, Chesapeake Energy was capitalized with a $50K initial investment. By being aggressive in acquisitions, he was able to create a fortune for shareholders and himself. In his own words:
Chesapeake is the best in the industry at finding new unconventional plays, acquiring big leasehold positions in the heart of the plays, and then selling off a minority interest to a bigger company from elsewhere in the world that cannot do what we do but has access to capital that we do not have...
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.
Furthermore, capital expenditures is an input and not a negative output:
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.
In the process, Chesapeake will have realized positive free cash flow in a few years with cash flow north of $10B in 2015 and the company trading at several multiples higher than current levels.
The story is fairly similar at BP. This company only trades at a respective 5.4x and 6x past and forward earnings with a dividend yield of 4.7%. Consensus estimates for its EPS forecast that it will decline by 12% to $6.67 in 2012, grow by 2.1% in 2013, and then fall by 16.8% in 2014. Assuming a multiple of 9x and a conservative 2013 EPS of $6.78, the stock would hit $61.02 for 49% upside. The oil spill has very little, if anything, to do with the corporate fundamentals. And yet, investors keep equating the company with the fiasco. As the emotions dissipate, BP is well positioned to recover lost shareholder value over the years with nearly 20% more volatility than the broader market. Management remains friendly in returning free cash flow to shareholders and thus has showcased confidence over the fundamentals. It is about time that investors do the same.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.