Chesapeake Energy: There Is More Where That Came From

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About: Chesapeake Energy Corporation (CHK)
by: Long Player
Summary

This management will continue to outperform.

The latest stock price action provides a buying opportunity.

The oil production from the acquisition was not present for a full quarter.

Cash flow from operations temporarily dipped below the annual rate of $2 billion.

The rapid liquids production growth should lead to a rapid profitability increase.

The stock of Chesapeake Energy (CHK) has taken a pause from the recent rally. The exciting merger has now been completed. Plus there are rumors that a major shareholder wants to exit (along with the stock overhang). But this management has brought this company back from the walking dead. The company was headed towards a certain corporate reorganization until this management found a way out of that with the latest merger. That puts this management in a very rarefied talent circle. Shareholders can count on a lot more accomplishments in the future based upon past results. In short, there are a lot more accomplishments on the way as this management works to restore this company to its former glory days.

Stock Price Action

This stock price took a dive in December that may mark the low point for the foreseeable future.

Source: Seeking Alpha Website May 9, 2019

The stock did take a step back when earnings were announced and the corresponding conference call followed. But that step back was nothing like the pessimism of the merged company prospects back in December.

If a major shareholder does indeed exit, then this company has the trading liquidity to withstand such a move. That would give readers time to read the latest 10-K and company pronouncements to decide if this stock fits their investment goals. Even major shareholders do not have infinite amounts of shares. So for potential buy and hold investors, this could be a decent entry point to further gains.

Cutoff Effect On Finances

The merger makes a mess of the financial statements for about 3 to 6 months. Despite the best attempts of accountants, the increase in shares outstanding combined with the merger related charges often make the financial statements completely incomprehensible to all but the most advanced and experienced investors.

Source: Chesapeake Energy First Quarter 2019, Earnings Press Release

Shown above is the production upon which the earnings are based. Note that the Brazos Valley (the acquired acreage) only receives credit for about two-thirds of the quarter. On the other hand, the divested Utica Shale assets were present for the full quarter in the previous year. The Brazos Valley production will show steady growth just by receiving a full quarter's credit next quarter. This is important because the Brazos Valley production is largely oil. Oil is far more profitable than natural gas production (from the Utica Shale assets sold).

Therefore the cash flow potential will become far more apparent next quarter. Management has already reported considerable well cost progress and increasing well production on the acquired properties. Chesapeake Energy is large enough that the progress made could take a quarter or two to really affect the bottom line. Still, for a merger as large as this one, management appears to be making significant progress quickly.

Part of this has to be due to the long Chesapeake Eagle Ford operating history. These properties are close to ones that Chesapeake was already operating. Therefore the chances of success are greatly improved.

Note also that the company continues to move rigs from the gassier properties to the more liquids rich properties. The Powder River Basin picked up an additional rig. Combine that with the sale of the Utica Shale properties and the acquisition of the Eagle Ford oil rich properties to conclude that this company has made a big change in strategy towards liquids.

That strategy change should increase corporate profitability considerably going forward even if oil prices correct from their current levels. Gas pricing has simply become too weak to make decent money at current price levels. The continual shift of rigs towards the liquids based acreage proves that conclusion.

Finances

Basically the company swapped the Utica Shale gas leases for the Eagle Ford oil leases. The market may have been overly concerned with some perceived drops in the financial statements. But any setbacks are likely to be temporary.

Long term debt appears to have remained at about the same level once this swap was completed. Production may have declined, but the all important oil production increased. Plus management has a goal to increase that oil production a lot this fiscal year.

Cash flow took a dive in the first quarter compared to last year. But that may have been due more to cutoffs magnifying the oil price decline in the fourth quarter. The recent oil price rally combined with the full quarter inclusion of the new Brazos Valley acreage should materially increase cash flow.

Overall, the first quarter cash flow dropped below a $2 billion annual rate. But most of the rigs are now drilling on acreage that will produce mostly oil and liquids. Depending upon operational results, Chesapeake Energy could easily exit with cash flow running at a $4 billion annual rate. Management still forecasts a sizable increase in liquids production. The continuing cost improvement campaign will also aid cash flow increases.

The largest expense drop was the nearly $1 BOE drop in gathering, processing and transportation expenses. That drop in expenses was led by natural gas liquids which (on a BOE basis) dropped from the $8 range to the $5 range. Much of this BOE improvement was attributed to the sale of the Utica Shale leases. There was also some contract adjustments noted during the quarter. Slowly but surely, some of these inherited and outrageous costs are becoming far more reasonable.

The debt levels remain close to $10 billion. So there is some pressure for the company to increase cash flow considerably. Management appears to have a reasonable strategy for that accomplishment. It would not be unusual, though, for another material sale and potential acquisition to speed the process along. This management has shown considerable discipline in waiting for "the sale price" and making accretive acquisition. Therefore any announcements in this area are likely to be over the long run and not a quick short term fix.

Summary

One show of faith in the company's financial progress is the switch from full cost accounting to successful efforts accounting. Note, though, that both accounting treatments can be abused to mislead shareholders about company prospects. The successful efforts method also has the benefit of dispensing with the cost ceiling calculation. This company has had many write-downs due to excessively high book values. So the change could hide still more excessively high book values.

Offsetting that should be a move towards more conservative depreciation rates. Over time, that move should result in conservative asset valuations. In theory, the successful efforts method of accounting is supposed to be more conservative. Time will tell if that is the case with this company.

Management basically reiterated earlier guidance but did take the time to note the changes that would accompany the changes in accounting methods. Mr. Market will need some time to digest the merger and the accounting changes.

The overall increase in liquids production should provide positive earnings comparisons in the future simply because the targeted liquids are more profitable than the gas production. As the merger expenses fade, the positive comparisons should find favor with the market.

There is a risk of a severe sustained oil price decline that could derail the merger benefits and the current guidance. However, that scenario appears unlikely at the current time. Instead it is far more likely that the stock will continue to appreciate from current levels as the continuing good news unfolds. The finances make this investment speculative. But management now has a clear path to investment grade. In short "there is more where that came from!"

Disclosure: I am/we are long CHK. 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.

Additional disclosure: Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.