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Three main factors have been the determinants of our recommendation on Chesapeake Energy Corp. (NYSE:CHK). Due to these factors, of which the first is the huge funding gap, second being the resultant dependence on asset sales to fund the gap, and lastly the significant decline in gas prices, we flag CHK as a high risk company.

However, we do not rule out the fact that the company may witness a turnaround if natural gas prices could reverse by next year (as per the general expectations in the market), and the company pulls off its intent of liquidating its assets in 2012 and 2013 to meet its funding gap.

We recommend investors to short sell the Natural gas ETF (NYSEARCA:UNG) against any long positions in CHK. In case natural gas prices rebound CHK will outperform UNG. UNG will serve as a hedge if natural gas prices keep sliding lower.

Industry Overview

The Independent Oil and Gas Exploration and Production Industry is primarily involved in the exploration of new oil and gas reservoirs, and the production of oil and gas from existing and new reservoirs.

The performance of the industry is directly linked to the prices of oil and gas in the local and international markets, as oil and gas prices will derive the level of activity.

Introduction

CHK is an oil and natural gas producing company, and is the most active driller of new wells in the U.S. Its operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the U.S. The company has vertically integrated its business and owns substantial midstream, compression and oilfield services assets.

Shift from Natural Gas to Oil and Liquids

Since 1988 till 2008, the company focused on the discovery and production of unconventional natural gas, and made significant discoveries on that front. However, 2009 onwards, the company switched its focus to liquid production. The company has seen its liquid production grow 275% from 30,000bbls in 4Q2009 to 114,000bbls in 1Q2012.

For 1Q2012, the company produced a total of 333bcfe, which consisted of 271bcf of natural gas (81% on a natural gas equivalent basis) and 10.3mmbbls of oil and natural gas liquids (19% on a natural gas equivalent basis).

Nevertheless, more than 50% of the revenue for the company in 2012 is expected to be generated through the production of oil and liquids. This increased contribution in revenue is not only due to the increased production of oil and liquids, but also due to the severe drop in natural gas prices.

Aggressive CAPEX and funding gap

The CAPEX for 2012 is expected to be around $14.7 billion, and the funding gap will increase to $11 billion as per the estimates of Credit Suisse analysts and company disclosures. To fund this gap, the company has declared that it will sell assets worth $11.5 billion by the end of 2012. The company has also announced plans to sell its pipeline and related assets to Global Infrastructure Partners for more than $4 billion, and it intends to sell additional assets worth more than $ 7 billion to meet its funding gap. The company will have an additional shortfall of $5 billion in 2013, and it intends to fill this shortfall with sale of additional assets.

The funding gap is being created primarily due to the aggressive shift towards liquid production and to continue its aggressive growth model, and has been aggravated due to the decline in natural gas prices over the last year.

Another reason for CHK's high CAPEX could also be the huge decline in production from unconventional wells after the first year of production, and to continue its growth path the company requires continuous CAPEX in new wells. The CAPEX is expected to be 85% and 90% towards liquids in 2012 and 2013 respectively.

Catalyst

A reversal in natural gas prices could be a potential trigger for this stock, since 80% of its production is comprised of gas at the moment.

Recent developments

Litigation

The company has been at the center of lawsuits from shareholders since April, after it was revealed that CEO Aubrey McClendon enjoyed perks and compensation, and certain business strategies were pursued to his own benefit at the detriment of the company.

Acquisition of 7.6% stake by Carl Icahn and change in board

Multibillionaire Carl Icahn, declared by the end of May that he had acquired a 7.6% stake in CHK, and called for a change in the board representation. He demanded that the board should have two representatives from his side and two from Southeastern Asset Management, the largest shareholder.

CHK announced today that it had reconstituted its board, and Southeastern Asset Management had three board representatives while Carl Icahn had one representative on the board. Archie Dunham (Ex-Chairman ConocoPhillips) has been appointed as the independent non-executive chairman of the board.

Job cuts

CHK recently announced that it was going to eliminate about 70 jobs for its operations in North Texas as one of its measures to reduce it funding gap.

Due diligence being performed by Sinopec Corp

It was reported yesterday that the head of Sinopec Corp. was performing due diligence on CHKS's assets and is contemplating a multibillion dollar bid for its assets.

Competitors

CHKS's major competitors include ConocoPhillips (NYSE:COP) and Anadarko Petroleum Corp (NYSE:APC). ConocoPhillips is trading at a P/E and P/B ratio of 8x and 1.1x, and offers a dividend yield of 4.8%, which is the highest in the industry. Its EPS is expected to witness a decline of 30% in 2012.

Anadarko Petroleum Corp. is trading at a P/E and P/B ratio of 12.5x and 1.6x, and offers a low dividend yield of 0.5%. Its EPS has witnessed a growth of 369% in 2012.

Recommendation

Trading at a P/E and P/B ratio of 11.x and .90x and offering a dividend yield of 1.90%, we flag CHK as a high risk investment given the huge funding gap, significant dependence on asset sales to fund the gap, and the significant decline in gas prices over the last one year.

We recommend investors to short sell the Natural gas ETF against any long positions in CHK.

 

CHK

COP

APC

P/E

11.01

8.1

12.55

P/B

0.9

1.1

1.58

P/S

1.0

0.3

2.28

Dividend Yield

1.9%

4.8%

0.50%

2012 EPS growth expected

-80%

-30.0%

369%

3 month performance

-25%

-4.0%

-20%

YTD performance

-21%

-1.6%

-19%

52 Week Performance

-36%

-1.0%

-13%

Source: Is Chesapeake Energy A Turnaround Story?