Chesapeake: Too Little, Too Late?

| About: Chesapeake Energy (CHK)
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The environment is changing far more at Chesapeake Energy Corp (NYSE:CHK) than perhaps anything happening in the volatile energy industry.

Big Changes

The big change is at the top. Co-founder Aubrey K. McClendon, who had served as CEO since the company's founding in 1989, was reportedly forced out, though the official company statement said he is retiring on April 1.

The other major change affecting Chesapeake are activist investors Carl Icahn and Mason Hawkins growing their ownership positions in the company to 8.9% and 13.5%, respectively. They now control a substantial portion of Chesapeake's Board of Directors and have brought in new board members, with the hope of better governance. These two investors have a tremendous track record of creating value.

Recent Performance

For impatient investors, these changes couldn't come too soon, as the company has been struggling for years. The company suffered a $6 billion loss in 2008, and reported flat earnings in 2011. Although Chesapeake Energy reported a quarterly profit of $0.58 a share a year ago, the consensus estimate calls for earnings per share of just $0.14 when the company reports fourth-quarter and year-end earnings on February 21.

In addition to lower earnings, a large debt load caused its interest expenses to double between 2010 and 2011. In its latest full year, the company reported negative returns on its assets and investments.

The stock price is down nearly half in the last five years, currently trading around $20 a share. Meanwhile, in this same time frame, Chevron (NYSE:CVX) is up over 30%, while Shell (RDS.A) and ExxonMobil (NYSE:XOM) are both close to flat.

The company's financial woes combined with the change in management lead many to speculate of a possible sale in the near future. However, those predictions are tempered when one considers the complex structure from which Chesapeake operates. Its legal and operating structure comprises seven joint ventures, 10 volumetric production payments to fulfill, $3 billion in preferred equity, and $2.4 billion in non-controlling assets.

Based in Oklahoma City, Chesapeake is the second-largest producer of natural gas, a top 15 producer of oil and natural gas liquids and the most active driller of new wells in the U.S.

Chesapeake isn't without its strengths. For one, it has consistently increased its revenue, which is projected to be $2.86 billion for the quarter, 4.9% above the year-earlier total of $2.73 billion. For the year, revenue is expected to come in at $11.44 billion. A year-over-year drop in revenue in the third quarter ended a streak of revenue growth that had lasted three quarters. Revenue fell 25.3% in the third quarter and rose 2.1% in the second quarter, 50.1% in the first quarter and 38.1% in the fourth quarter of the last fiscal year.

A second strength is the fact that it grew its fuel production by 190% from the third quarter of 2010 to the same period last year.


Some are also hopeful that the company is serious about focusing more on oil production and less on natural gas, given that oil sells for much higher margins. The company produced 143,000 barrels of oil per day during the third quarter of 2012, ahead of its goal of 135,000. It has grown its liquid energy production from 8% of its 2008 production to a projected 25% in 2013. Liquid fuel now accounts for more than 50% of its realized revenue.

The company says this redirection will reduce capital expenses by 35% going forward, and that it can be funded almost entirely by operating cash flow.

Natural gas still represents about 80% of its Chesapeake's overall production. Natural gas prices fell from $4.12 per MMBtu in 2011 to $2.83 in 2012. The fall came as Chesapeake spent heavily on expansion. Its capital expenditures totaled more than $6 billion last year, exceeding its cash flow from operations. It went from a cash position of $1.75 billion in 2009 to $351 million at the end of 2011.

The U.S. Energy Information Administration expects the price to rebound to $3.86 this year and just about $4 in 2014, still less than 2011 levels. Chesapeake has stated that a $0.10/Mcf increase in NYMEX natural gas prices would increase its EBITDA by $100 million and shareholder value by $1.00 per fully diluted share.

The company is carrying about $16.5 billion in debt, which it hopes to trim to $9.5 billion by the end of the year, mostly through continued asset sales. The company has divested $30 billion in assets since 2008, about a third of those in 2012 alone. With McClendon's exit, some watchers expect the company to divest another $19 billion in assets in 2013.

While the purging of assets helps pay off debt, it likely will have a negative impact on future earnings unless the company can increase production from other sources.

Yet despite its financial issues, the company continues to pay dividends. Chesapeake's current dividend yield is 1.7% based on a recent closing price of $20.40; meanwhile, Exxon yields about 2.5%, Shell yields over 5%, and Chevron yields around 3%.

Don't Jump The Gun

The company appears to be trading at a discount to Net Asset Value and Equity Book Value. The transition from gas to liquids, reduction of debt, and a stabilizing natural gas market will help close that gap in the near future.

Factoring in the recent overhaul of management, the opportunity that comes with savvy new investors, the challenges of paying down years of debt, its over-reliance on low-priced natural gas, and a strategy of trying to diversify more into oil production, it's no surprise that most analysts think investors should stand pat on Chesapeake Energy. Currently, 17 of 27 analysts rate the stock as a hold. With Chevron, Exxon, and Shell all having an average rating above hold, they all seem to be better choices and this point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.