- Chesapeake posted results which might be in line with expectations, yet adjusted profits are not very strong.
- This observation follows the realisation that adjusted earnings are not sufficient to finance net capital investments, driven by artificially lowered depreciation charges.
- The lack of realistic earnings power and modest sales price of last week´s divestment makes that I continue to be cautious on Chesapeake, finding it too early to see appeal.
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Chesapeake Energy (NASDAQ:CHK) cannot seem to create sustained positive momentum for its investors, despite "adjusted" profits and delivering on a big divestment last week. I have reviewed the divestment over the past weekend already as the deal did little to provide real comfort to me, given that the deal involved the sale of about a fifth of current production, while cutting debt by a similar percentage amount.
This reason and the fact that adjusted earnings are both down sequentially and on an annual basis is bad enough as it is, as my concern is that net debt continues to creep up from normal operations as capital spending surpasses even the sum of adjusted earnings and depressed depreciation charges. This all still warrants a cautious view in my eyes amidst a lower production profile and soft current pricing.
The Earnings Release
After Chesapeake posted first quarter adjusted profits of $361 million, reported "adjusted" earnings fell to $139 million in Q2, being down from $205 million in the second quarter of last year. Reported GAAP losses totalled $40 million with this discrepancy largely related to impairment charges and hedge losses.
The big issue which I have is with the adjustments, as adjusted earnings come nowhere actual cash flows, due to the fact that past large impairment charges artificially lower depreciation charges. While this is good for the P&L, it means that Chesapeake has to continue to make net capital investments in order to maintain production.
Capital spending totalled $595 million this quarter (including capitalised interest). Including a $290 million combined depreciation and amortisation charge, net capital spending totalled $305 million, more than twice the reported adjusted earnings. These investments allow production to rise by 0.4% on an annual basis to 530,000 barrels of oil-equivalent per day, hardly a great improvement.
This is the main reason why net debt "refuses" to come down, standing at $9.7 billion by the end of the quarter. While the sale of the assets in Utica will cut this number by about 20%, Chesapeake still has a long way to go in order to reduce leverage and break-even costs and, finally, start to create real value for shareholders.
The problem behind the soft quarterly results has not been oil prices which have been rising, yet the declines in natural gas prices have been detrimental to reported earnings. The trends in both oil and gas prices in recent weeks provide little comfort to believe that the third quarter will show a meaningful improvement, as the seasonally stronger fourth quarter will probably boost natural gas prices and thereby quarterly earnings.
Updating The Thesis
Last week, I looked at Chesapeake after the company announced the $2 billion divestment of its assets in the Utica shale. I noted the relief which the transaction would bring to the balance sheet, cutting net debt by roughly a fifth and reducing the overall break-even costs as well. At the same time, the sale was painful for investors as well. After all, the assets produce 107,000 barrels of oil equivalent per day, and while the 9% oil shares in that number is modest, this still represents close to 12% to all of Chesapeake's oil production.
Furthermore, net debt has increased sequentially between Q1 and Q2 due to net capital spending and resulting negative free cash flows, making that net debt will only come in just below the $8 billion mark following the latest divestment. That means that a lack of operational progress means that it remains very hard for the company to really reduce leverage, and really reduce leverage ratios in relation to production.
This observation, the modest multiples received for the assets, and very poor adjusted earnings in Q2 (especially correcting for net capital investments) makes that I continue to be very cautious. This in part follows the initial positive reaction to the news about a deal, as the first reaction of investors to the divestment was all about the happiness to sell assets, and not necessarily sell assets at a good price.
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