Chesapeake Energy: Glass Half Empty? Or Almost Full?

| About: Chesapeake Energy (CHK)
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Chesapeake Energy Corp. (NYSE:CHK) is an oil and natural gas E&P company. Some years ago, it bet the farm on natural gas; and it is now the second largest natural gas producer in the continental US behind Exxon Mobil (NYSE:XOM). Then the bottom fell out of natural gas prices; and CHK has struggled to convert to a more liquids and natural gas company. It has been largely successful at that. About 25% of its production for 2013 was liquids. In Q4 2013 about 26% of production was liquids, although this was down from 27% in Q3 2013.

The bad news in the Q4 2013 earnings report was that CHK missed badly at $0.27 per common share versus a consensus estimate of $0.41 per common share. Revenue rose by 28% to $4.54B. The FY2013 EPS result was also short at $1.50 per share versus an expectation of $1.65 per share, although the $1.50 per share was far better than the year ago's $0.61 per share. For FY2013 revenues were $17.51B (+42%) versus the FY2012 revenues of $12.32B. Revenues beat estimates slightly, yet CHK still missed badly. Without adjustments to EPS, CHK had a loss of -$0.24 per common share. This sounds terrible; but the adjustments were legitimate; and many of them such as the $154 million restructuring charge (due to the 10% layoff) are not likely to recur. This should mean that CHK is in good position going forward. It should mean that future earnings will not be so greatly impacted by one-time charges.

Another problem was that average daily production for FY2013 was 669,600 boe per day. Yet the average daily production for Q4 2013 was only 665,000 boe per day. This was an increase of 2% from Q4 2012; but it was a decrease of -1% from Q3 2013. Most investors don't like to see negative growth.

Again CHK had good explanations for the sequential decrease in production from Q3 2013 to Q4 2013. The decrease was primarily due to planned reductions in well connections during Q4 2013 as the company had already completed most of its well inventory reduction initiatives in Q2 and Q3 2013. Severe weather also impacted CHK's production in October and December. There were also significant asset sales. Adjusted for 2013's $4.4B in asset sales, total production in Q4 2013 increased approximately 10% year over year. This is good growth for a company the size of CHK; and that growth was even after the significant negative problems in Q4 listed above.

Even after the $4.4B in asset sales in FY2013, CHK still has great assets. Many people thought the claimed net acres of leasehold would go down significantly after the roughly $12B in asset sales in 2012. However, the 2012 Annual report listed CHK's total onshore US leaseholds as 15 million net acres. It listed liquid-rich plays with established production on them already at approximately 6.4 million net acres. The 2013 Annual Report is not available yet; but I would not expect the amount of leasehold to be drastically changed. Virtually certainly it should be well above 10 million net acres. This is a wealth of development opportunities; and it should mean CHK has a terrifically bright future.

CHK's main problem in the past has been controlling costs. It has had to sell off properties continually in order to pay for its development activities. Aubrey McClendon was a master at managing this. He typically managed to get into new fields very early at low prices for leaseholds. CHK would then do some work to develop and prove the leaseholds. At that point CHK would sell off 25%-33% of a field to a competitor. The competitor would end up paying for the entire cost of the CHK's lease holdings in the field plus some of the initial costs of CHK's development. Still CHK had to do a lot of development in order to hold on to these fields (make the leaseholds held by production). The chart below shows just how much in the red CHK was running over its operating cash flow during many of those years.

As readers can see, CHK cut its Capex expenses by -49% during FY2013; and it intends to cut Capex by more than -20% in FY2014. This should leave CHK with operating cash flow approximately equaling Capex for FY2014. This achievement has been a long time coming; and it is in itself a big milestone for CHK. CHK plans to do approximately the same amount of development for the lower cost.

Does that mean CHK will stop selling assets? From its executive speak, it does not sound like it. CHK management says it has effectively already sold about $1B in assets in 2014. CHK says it may sell its Chesapeake Oil Services business (or spin it off). COS had revenues of approximately $2.2B in FY2013. Plus it has a significant amount of capital equipment. In a sale it might bring $2.5B - $3.5B; but that is just an educated guess on my part.

Even the speculation of the prospective sale (or spin off) in the earnings report caused ripples for Chesapeake Oilfield Operating LLC (COO). Moody's placed Chesapeake Oilfield Operating LLC's Ba2 Corporate Family Rating and its Ba3 senior unsecured notes rating under review for a downgrade. Apparently Chesapeake Oilfield Operating LLC has been benefiting from its association with CHK, which Moody's rates Ba2 stable. For those who don't know, Ba2 is the second highest junk bond rating. Ba1 is the highest junk bond rating; and Baa3 is the lowest investment grade rating obtainable from Moody's. I am unsure at this time how much impact Moody's actions will have on CHK's plans for COO.

As for other asset sales, CHK will likely keep trying to sell off some of its "non-core" assets. The reality of CHK's situation is that it needs to develop its huge amount of properties much faster than it possibly can given its goal of a safe fiscal policy (in pursuit of an investment grade credit rating). CHK's probable strategy will be to continue to sell off assets to avoid having to pay lease renewal fees on leases not held by production (or to avoid losing leases outright to expiration). If CHK continues to sell assets, it will be able to more quickly pay down more of its debt, which amounted to $12.886B as of December 31, 2014. It may also be able to replace the acreage assets it sells with newer, cheaper net acre leases in new fields. Since CHK owns some prime leases, it should be able to have success following this strategy.

CHK has been making positive progress toward an investment grade rating, although its actual debt level increased in 2013. In fact it rose from $12.157B on December 31, 2012 to $12.886B on December 31, 2013. However, progress was still made. CHK's net debt to adjusted EBITDA ratio fell from 3.3x to 2.4x year over year. CHK's net debt to proved reserves fell from $4.71/boe to $4.50/boe. When you consider that natural gas production decreased by -3% in FY2013, the last figure is even more impressive. The boe's that caused the improvement in the debt to proved reserves ratio were all oil and NGLs boe's, which are currently much more valuable than natural gas boe's.

Average daily oil production increased 32% year over year; and average daily NGLs production increased 19% year over year. CHK estimates the following metrics for 2014E (see table below).

Readers of CHK's release were also put off by the relatively low amount of overall production growth in FY2014, especially in the first half of 2014. However, the chart below explains this well. The first half is needed just to recoup the asset sales of 2013.

The chart above more clearly shows that actual FY2014 production growth is expected to be 8% to 10% if you factor in the 2013 asset sales. This is a much better outlook than the simple 2% to 4% increase in production predicted for FY2014. Rationalizations always sound better; but this one makes a lot of sense to me. Plus CHK may beat production growth estimates.

CHK has many cost saving initiatives. It is doing more Pad drilling, which saves on both drilling and fracking costs. It is decreasing its spud to spud cycle times. It is cutting the average cost of a well. It is increasing its total gross processing capacity for NGLs in the Utica. All these things should add up to greater future success. Even on the disappointing earnings information, CHK is a buy.

The two year chart of CHK provides some technical direction for this trade.

The slow stochastic sub chart shows that CHK is near overbought levels. The main chart shows that CHK has been in a sideways consolidation pattern for about six months. One might think that the earnings information would make CHK's stock price go downward. However, the earnings information (Webcast) also contained very positive information about natural gas prices obtained in the first two months of Q1 2014. This might tend to send CHK's price upward, especially since it obtained some more higher priced hedges for the rest of 2014. With this in mind, CHK is a buy.

Further the higher natural gas prices could prove sticky with the currently very low amount of natural gas in US storage (about -40.3% below last year at this time). This should brighten the outlook both for 2014 and 2015 for CHK, especially since CHK is the #2 natural gas producer in continental US. CHK has a CAPS rating of four stars (a buy). It pays a significant dividend of 1.3%. This should rise significantly as CHK pays down its debt. It should rise as CHK improves its credit rating.

Over time, CHK should be a good performer in almost any portfolio. It has a PE of 18.84 and an FPE of 11.59. It has an analysts' average next five years EPS growth per annum estimate of 53.29%. Very few stocks can claim anything close to that. CHK is a long term own for almost any portfolio.

NOTE: Some of the above fundamental financial information is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.