Chesapeake Energy (CHK) has been an aggressive developer during the shale gas boom, but low natural gas prices threaten to dismantle the empire Co-Founder and CEO Aubrey McClendon has built without much payoff for shareholders.
With debt exceeding $14 billion as of Q2, a $22 billion funding shortfall and weak cash flow due to the need for heavy investment and capital expenditures, the company has been forced to turn to asset sales in order to delever. These asset sales are hardly voluntary: credit rating agencies have signaled that ratings will be cut if $7 billion in assets are not sold this year.
The August sale of pipeline interests in Chesapeake Midstream Partners for nearly $4.1 billion, as well as the sale, in late October, of selected Permian Basis oilfield assets for $3.3 billion illustrates both the market for these assets and management's ability to close sales under a tight timeline.
Natural gas prices have risen considerably from a 10-year low, reached in April, of $1.90 per million British Thermal Units. The price climbed as high as $3.21 in July.
The company has been focused, necessarily, carefully managing its intricate capital structure for some time:
- In May 2011 the company spent nearly $2.1 billion in a tender offer for senior and contingent convertible notes of varying maturities.
- In March 2011, management spent $140 million to repurchase continent convertible notes due in 2038.
- In February 2011, $1 billion in principal amount of 6.125% Senior Notes due 2021 were issued, generating net proceeds of $977 million.
- In August 2010, an offering of $600 million of 6.875% Senior Notes due 2018 and $1.4 billion of 6.625% Senior Notes due 2020 was completed, generating net proceeds of $1.967 billion.
- Also in August 2010, tender offers of $245 million to purchase 7.00% Senior Notes due 2014, $567 million of 6.625% Senior Notes due 2016 and $582 million of 6.25% Senior Notes due 2018 were completed.
- In July 2010, $600 million of 6.375% Senior Notes due 2015 were redeemed.
- In June 2010, $364 million of 7.50% Senior Notes due 2013, $300 million of 7.50% Senior Notes due 2014 and $670 million of 6.875% Senior Notes due 2016 were redeemed.
Weakness is Relative
While Chesapeake may have overextended itself, this is a company with promise. LTM financials highlight the company's strengths:
- Market Capitalization of $13 billion
- Sales of $12.1 billion
- SG&A held to 6.2% of sales ($771 million)
- EBITDA of $5.9 billion
- Return on Equity of 13.9%
For anyone that believes this company might have a future, it is currently tantalizingly cheap (Price/Book of 0.9). If natural gas prices steer clear of the April lows, and McClendon and his management team are able to continue successfully offloading assets,
Chesapeake Energy could offer an attractive mid-term opportunity at its current price level, either through continued performance improvement, or an eventual sale of the company.
One well-tested means of improving the odds of an acquisition working is to buy companies when they are cheap. Chesapeake has a number of larger competitors that might be tempted at its current market cap.
Anadarko Petroleum (APC)
Anadarko is approximately the same size as Chesapeake, but it might be tempted to take advantage of its substantially higher market capitalization to acquire a struggling competitor.
- Market Capitalization of $33 billion
- Sales of $13.5 billion
- EBITDA of $8 billion
- Return on Equity of -5.75%
Energy majors such as ConocoPhillips (COP), BP (BP) and Exxon Mobil (XOM) could also be tempted to move opportunistically, though management at those companies could reason that cherry picking assets during the divestiture process, or waiting for the company to regain its footing before seeking to acquire it makes more sense. Of course, each has the ability to acquire Chesapeake if they so desire.
- Market Capitalization of $70 billion
- Sales of $186 billion
- EBITDA of $26.8 billion
- Return on Equity of 18.5%
- Market Capitalization of $132 billion
- Sales of $377 billion
- EBITDA of $36.1 billion
- Return on Equity of 15.9%
- Market Capitalization of $418 billion
- Sales of $435 billion
- EBITDA of $65.4 billion
- Return on Equity of 29.0%
Chesapeake Energy is down at the moment, but not out. A bullish case rests on the belief that we are unlikely to see a return to historic lows in natural gas prices, and that management can continue negotiate asset sales, thereby assuaging the fears of credit rating agencies. So long as the company maintains the confidence of creditors, and natural gas prices stay up, improvement will only be a matter of time.
In many ways the discount the market has placed on Chesapeake has overshot the fundamentals. Anadarko Petroleum is approximately the same size as Chesapeake, but is valued at a Price/Sales ratio of 2.6, vs. 1.0 for Chesapeake. Looking at book value, too, Chesapeake has a discount (0.9 vs. 1.6). Taking a conservative approach, I would expect that investors could look forward to Chesapeake closing at least half of the valuation gap with Anadarko. With book value per share of 22.37, a Price/Book 1.25 would imply a share price of nearly $28, a 40% gain.
The beauty of this situation for prospective investors is that the above scenario is only one of two paths to substantial gains. Should any of Chesapeake's competitors be tempted to acquire the company while the market is discounting it, investors could expect a healthy premium.
Buy Chesapeake, with two ways to win and minimal downside due the worst case scenario already being priced in. This is a very attractive proposition on a risk/reward basis.