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Chesapeake Energy – Where to From Here?

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By: Micheal Kaufman
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Last year, Chesapeake Energy (CHK) emerged as a leaner and fitter entity: the company enhanced the production of more profitable liquids instead of natural gas, reshuffled its management, cut its excessively large workforce, and revived much of the investor confidence it had previously lost. The market responded enthusiastically to the management’s initiatives, and the stock returned a hefty 60% in 2013.

But now, the more cautious investors are questioning whether the stock’s strong performance in 2013 was just a one-off thing, or if it marks a sustainable upswing for the company.

Revenues for Chesapeake, the second-largest producer of natural gas in the US, grew at an annually compounded rate of 12.46% from 2009 to 2012. Its yearly revenues at the end of that period totaled $12.32 billion. But gas prices, an important determinant of Chesapeake’s performance, had been declining over the period, dropping nearly 23.1% from 2009 to 2012. Therefore, to support sustained growth in the topline, Chesapeake had to increase natural gas production nearly 7.7% every year from 2009 onwards. But is that strategy sustainable, and how far will the company’s stock go from here?

Segmentation

Chesapeake Energy has three divisions, namely: Oil and Natural Gas, Gathering and Compression, and Oilfield Services.

The Oil and Natural Gas segment’s contribution to the company’s topline has fallen over the years, largely due to a shift in the management’s focus towards the Gathering and Compression segment. The Gathering and Compression segment adds value to the natural gas and oil produced by Chesapeake, and then sells it to various intermediary markets, end markets and pipeline operators. Revenues from the Gathering and Compression segment now account for 28% of the company’s topline, compared to 14% four years ago.

Domestic Exposure

All of Chesapeake’s reserves are located in the US, which has so far insulated the company’s profits from fluctuations in foreign exchange rates, and its operations from other geopolitical risks.

The company segments its natural gas and oil operations by four regions, namely: Southern, Northern, Eastern and Western.

The Northern division operates 942 wells, most of which are situated in the Anadarko Basin in Northwestern Oklahoma. The Western division operates 718 wells, while the Eastern and Southern segments operate 578 and 363 wells, respectively.

Production Shift

The company has been tweaking its product portfolio by shifting its focus from natural gas, whose prices have been declining, to increase the exploration and production of crude oil and natural gas liquids (NGL). The company targets production of 250,000 barrels per day (bbl/d) of net liquids in 2015.

Net liquid production reached 166,400 bbl/d in the first three quarters of FY13 alone, and it looks like the company is well on its way to reach its goal.

The Oil and Natural Gas segment contributed 51% of the company’s total revenues in fiscal 2012 (FY12). According to data from the third quarter (3Q) of FY13, Chesapeake’s production mix is heavily skewed towards natural gas, which accounts for 82.2% of its total production, while oil and NGL account for 17.8%.

Cash flow

Chesapeake has expanded its asset base by investing heavily in the acquisition of natural gas and oil reserves, and the company booked capital expenditures of at least $12 billion every year from FY10 to FY12. However, the management now seems to be satisfied with the well-diversified asset base the company has acquired, and plans to cut capital expenditures. During the three quarters of FY13, the company booked only $5.92 billion under the capital expenditures head.

Because of its high capital expenditures, Chesapeake’s free cash flows have been negative over the last four years. In other words, its capital expenditures have been higher than the cash it generated from operations. The company is aware of the problems this can pose, and has been consistently trying to limit outflows. By curtailing capital expenditures in the first three quarters of FY13, the management brought free cash outflows down from an-all time high of $11.9 billion to $2.3 billion.

Dividends

Chesapeake stock yields 1.37% of its price in dividends. Dividends paid to investors have increased at an average annual rate of 5.27% over the last three years.

Assets

As of 3QFY13, Chesapeake’s Oil and Natural Gas segment controls 84% of the company’s total assets, which are worth nearly $37 billion. All other segments combined hold the remaining 16%. The company’s asset base has grown at a compound annual rate of 3.98% over the past three years.

Sell Side Expectations

Earnings Review

Chesapeake posted revenues of $5.06 billion for 3QFY13, which exceeded analyst expectations by a margin of 27%. Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) totaled $1.3 billion, up 29% year-over-year, while adjusted net income in 3QFY13 totaled $282 million, translating into per share earnings of $0.43.

The company guided EBITDA of $1.325 billion for 4QFY13.

Sales of assets in the Mississippi Lime, Eagle Ford, Haynesville and Permian Basin regions resulted in a 2.65% decline in natural gas production over the preceding quarter (QoQ). Natural gas output declined to 2,970 million cubic feet per day (MMcf/d); on the plus side, crude oil production was up 4% QoQ to 119,600 bbl/d.

MBOE = Million barrels of oil equivalent

Chesapeake Energy is currently trading at a one-year forward price-to-earnings (P/E) multiple that is lower than that of Anadarko Petroleum and Exxon Mobil. This indicates that investors do not see as much growth in the company as compared to its peers. Chesapeake is also trading at a discount to the S&P 500 index (SPX).

Chesapeake’s stock price is up 47.4% in the last twelve months, outperforming the Energy Select Sector SPDR ETF (XLE) by 28.30 percentage points (ppts). Its stock price performance has also beat the SPDR S&P Oil & Gas Exploration & Production ETF’s (XOP) returns over the same period by 27.9 ppts.

Debt

The company had long-term debt commitments totaling $12.74 billion in 3QFY13, with no portion of the debt due to mature in 2014. In addition to being free of long-term debt repayments for the year, the company is not liable for any short-term loans either.

Conclusion

Chesapeake had been walking a tightrope till the new CEO, Robert D. Lawler, took over in June 2013, but has seen its stock rise 32% since then. The company initiated a massive layoff scheme under Lawler, cutting nearly 10% of the total workforce, and emerged leaner and more efficient as a result.

The company’s P/E multiple is currently lower than the market average, which makes the stock an attractive buy. However, the boom in crude oil and natural gas production can be a double-edged sword, as Chesapeake’s revenues and earnings depend heavily on the prices of these commodities.

We believe that the company will increase production of natural gas from the top shale plays, but if the entire industry follows suit, this could drive natural gas prices down and result in margin contraction for the company. Given that scenario, we will rate the stock as a hold for now.

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