Chesapeake Energy (NYSE:CHK) had a well-earned reputation as the riverboat gambler of the natural gas world. If there was a hint of meaningful natural gas in an area, you could usually count on Chesapeake to be among the those bringing out the biggest checkbook to gobble up acreage. The end result of that policy was a large reserve base, but also a stretched-out balance sheet and weak profitability as natural gas prices plunged.
Now the company starts a new period. A new CEO brings at least the hope of better capital allocation, while an aggressive divestiture program should help fill the funding gap. While I think Chesapeake's economic returns are going to be impacted for some time to come by the aggressiveness of past days, I do believe the shares may offer decent value today if you believe in the future of natural gas usage in the U.S.
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Slimming Down To Get Through
Chesapeake started the year with an estimated funding gap of around $4 billion and announced intentions to use JVs, asset sales, and other transactions to generate around $4 billion to $7 billion in capital. Through roughly mid-year, the company is making decent progress though not always on terms that the Street has liked.
Investors weren't too happy with a JV announced with Sinopec (NYSE:SNP) for about 850,000 net acres in the Mississippi Lime area of northern Oklahoma. Although the deal generated about $1 billion in cash, the per-acre valuation of $2,400 was well below prior transactions in the region and most analysts' estimated value.
Other deals have gotten a better reception. Chesapeake sold about 99,000 net acres in non-core areas of the Marcellus and Utica to EQT (NYSE:EQT) for $113 million. Most recently, Chesapeake sold acreage in the Eagle Ford and Haynesville to EXCO (NYSE:XCO) for $1 billion, divided up as $680 million for the Eagle Ford (55,000 net acres) and $320 million for the Haynesville (almost 10,000 net acres). All told, Chesapeake is now closing in on $4 billion in disposals for the year, with management sounding relatively optimistic about the potential for further deals.
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Will New Management Make Better Decisions And Get Better Results?
Chesapeake's management was often a controversial subject, for reasons that go well beyond the scope of this piece. Suffice it to say, now-former CEO Aubrey McClendon was an aggressive CEO who appeared more than willing to make sure that his personal financial interests were well cared for by his involvement with the company.
Now there's a new person in charge, with former Anadarko (NYSE:APC) executive Robert Lawler taking on the job of CEO. Given Anadarko's reputation as a good allocator of capital, I don't think its unreasonable for Chesapeake shareholders to now be expecting a more disciplined, returns-focused approach from the company going forward.
This is a dangerously simplistic way to view things, but consider the fact that Chesapeake's reserve base puts it in between Apache (NYSE:APA) and Anadarko, but it's market cap is about 40% of Apache's and 30% of Anadarko's. Likewise, the company's unit profitability is quite poor – on par with other gas-heavy companies like Southwestern (NYSE:SWN), but quite weak compared to Anadarko, Apache, and others like EOG (NYSE:EOG).
As time goes on, I think Chesapeake will benefit from a greater focus on liquids. Over recent years, the percentage of Chesapeake's reserves made up by natural gas has declined from over 90%, down into the 80%'s, and now down to about 70%. At the same time, the company has curtailed its drilling activity in areas like the Marcellus – cutting its rig count by more than half and seeing companies like EQT and Range Resources (NYSE:RRC) take the lead in terms of the number of rigs. This should ultimately translate into better unit profitability and better returns on investment – factors which, though often underappreciated by investors, do actually seem to drive long-term stock performance.
The Bottom Line
It's going to take a while for Chesapeake to restructure itself and clean up from past mistakes. Were natural gas to jump back into the mid-to-high $4's, that would certainly be a great help. Failing that, though, I still believe there's a case to make for owning Chesapeake shares. Even with Chesapeake's stretched balance sheet, I don't think a 5.5x EBITDA multiple is unreasonable, and that would suggest a fair value around $25, while a NAV analysis points to a valuation range of $23 to $26. Though I'm still inclined to believe that Southwestern, Apache, and Anadarko are generally better companies, I wouldn't sleep on the prospect that Chesapeake shares could benefit from a one-two punch of improving operations and improving sentiment around the company.