After billionaire Carl Icahn disclosed a more than 7% interest in Chesapeake (CHK), it appeared that the market would focus more on the fundamentals and less on emotion. Tuesday news speculating that billionaire CEO Aubrey McClendon sent emails seeking to keep land prices low in bidding contests raised concerns about antitrust violations and sent the stock down 8.4%. The supposed co-conspirator was Encana (ECA) - yet another whipping dog for the anti-fracking politicians. This speculation was particularly damaging in light of how the SEC is investigating McClendon's use of debt to invest along internal well development - an action that would ordinarily be viewed as evidence that the CEO is bullish on the plays.
At this point, Chesapeake trades at less than 2x operating cash flow. Natural gas has stared to rebound but it is still one-third of where it stood one year ago. From foreign policy concerns to economic efficiency priorities, natural gas has substantial positive secular trends that have not been properly reflected in Chesapeake's stock price.
In regard to capital expenditures, the market has failed to understand that Chesapeake doesn't have to spend all this money - $14.5B last year; $13.5B the year before - if it doesn't want to. Capex is ultimately an investment in the future and, if natural gas heads the direction where energy supplies indicate it is going, the upside is huge. By contrast, the downside has been properly factored in given the low multiple for the 2nd largest natural gas producer.
Chesapeake isn't the only scorned oil & gas firm. BP (BP) has become substantially undervalued since the Macondo incident. It is true that recent performance has been poor with a 9.1% miss in the first quarter and negative growth anticipated this year. But at 5x past earning and a 5.1% dividend yield under a strong brand name, the stock has little downside. A bearish $6 2013 EPS at a bearish 10x multiple puts the future stock value at $60. Discounting backwards by 10% puts the target price at $49.59, which offers more than a 30% margin of safety. The market seems to be factoring in an absurd ~15% weighted average cost of capital. Just like how Chesapeake has been beaten down by corporate governance concerns, BP has been beaten down by political concerns. Both of these issues have nothing to do with the fundamentals of these two leading energy firms that have built an impressive portfolio of assets.
And then we look at producers like Exxon Mobil (XOM) and Suncor Energy (SU) and see that they trade at north of 9x past earnings with much lower dividend yields and growth prospects. Yes, they are established firms that offer relative stability, but this safety limits the discount to intrinsic value. It is amazing the double standard that the market applies in viewing Exxon's growing leverage towards natural gas (ie. the XTO Energy acquisition in 2010) against Chesapeake's. Exxon continues to buy more shale leases across areas like Texas, Arkansas, and Louisiana, but Chesapeake is right on its tail.
Suncor similarly has made considerable investments in exploration and development yet has failed to garner the praise that Exxon has. And despite strong capex, the firm has actually cut net debt over the past few years. Oil sands production has grown 7.5% from 2010 to 2011. In fact, over the last year, the stock has fallen by 28% while Exxon has grown by 7.3%. During the same time period, the company has also done better against expectations. On average, Exxon has missed expectations over the last four quarters while Suncor has outperformed expectations. Thus, in terms of momentum, Suncor's growth prospects have failed to be fully factored into the stock price.
At the end of the day, Suncor and BP are reflective about what is happening at Chesapeake. The market is sticking with the Standard Oil heir despite growing signs that the still large players have positive fundamentals. As natural gas prices recover, I anticipate Chesapeake, in particular, to rally.
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.