Chesapeake is Not a Strong Long Term Investment

By chesapeake-is-not-a-strong-long-term-investment - October 24, 2012 | Tickers: APC, BP, CHK, DVN, XOM | 0 Comments

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Chesapeake Energy Corp (NYSE: CHK) is a hot item in the news lately. With corporate governance issues, asset sales, a cash crunch, and a cheap valuation the stock has all of the ingredients of a news worthy company. They helped to create a huge natural gas glut and now the fruits of their labor has forced them to write down reserves and sell assets. Based on recent earnings Chesapeake is cheap with a PE ratio of 6.46. Although Chesapeake may be a good investment in the short term as their valuation returns to industry norms, I believe that investors looking for exposure to natural gas can find more sustainable investments in other firms.

(Data from Chesapeake)

The Majors 

It is rather awkward to compare Chesapeake to the majors as the company is an upstream operation and not a large diversified firm with upstream, downstream, and midstream segments. Regardless, ExxonMobil  (NYSE: XOM) is a major natural gas producer in the U.S. and in 2Q 2012 it was the only firm with a greater daily production than Chesapeake. Exxon has made major investments in shale gas and sees it as a major growth sector. With petroleum resources becoming increasingly difficult to find and the increased dominance of national oil companies, shale gas provides a profitable growth sector where Exxon can invest its profits and expertise. As the above figures show Exxon's reserve to production ratio (RP ratio) was already higher than Chesapeake's before Chesapeake's recent asset sales. Exxon's current PE ratio of 9.48 and price to book value of 2.5 are much higher than Chesapeake's, but comparing the two companies is some what difficult as CHK is an inherently more risky firm and thus should trade at a cheaper valuation. XOM's reasonable PE of 9.48 and high RP ratio of 19 show that the firm is not dreadfully expensive at current prices and has a significant amount of assets which it can drill in the coming decades. 

BP p.l.c. (NYSE: BP) was the 5th largest producer of U.S. natural gas in 2Q 2012 and is similar to Exxonmobil. BP has the highest RP ratio of any of any of the firms but its production of 1833 mmcf/day of natural gas is a little more than half that of Chesapeake. The firm still faces some overhang from the Deepwater Horizon disaster and trades at a very low PE ratio of 5.14 which is below Chesapeake's 6.46. A firm's return on invested capital shows how effectively management is able to use its resources and BP's ROIC of 11.47% is significantly higher than Chesapeake's ROIC of 7.3%. Compared to other majors BP is cheap. Their price to book value ratio of 1.159 is much less than XOM's 2.5.

XOM Free Cash Flow Yield data by YCharts

XOM Return on Invested Capital data by YCharts

Smaller Firms with Midstream and Upstream Operations

Anadarko Petroleum (NYSE: APC) and Devon Energy (NYSE: DVN) come in as the third and fourth largest producers of natural gas based on daily U.S. production. Devon has shale operations throughout various parts of North America though the majority are found in Texas and Oklahoma. They have major midstream operations and these revenues help to decrease the volatility from their upstream investments. Still, they're not an oil major and the recent fall of their ROIC to 8.54% is very close to CHK's 7.30%. Devon's RP ratio of 13 is not close to that of BP or Exxon. Anadarko is not in a better position as their RP ratio of 9 is the lowest of group and suggests that investors ought to pay close attention to their ability to acquire and grow new assets. They are more diversified than other small firms with operations in the Gulf of Mexico, Mozambique, and New Zealand. Their ROIC has been depressed over the past year and is currently the lowest of these firms at -3.88%. At the same time their price to book value ratio of 1.570 is second only to Exxonmobil. 

Conclusion

For long term investors I believe that Chesapeake is not a great investment. The firm currently trades at a discount due their uncertain cash position over the past year. They have been able to sell assets and find bridge financing which coupled with the recent increase in the price of natural gas paints a positive picture. Their short term prospects should not obscure the fact that the company had questionable management and was driven into a place where asset sales were necessary. An energy firm which does not plan for volatility in energy prices should be treated with a grain of salt. It is expected that the value of the stock will continue to increase in the short term, but I believe long term investors should not ignore larger firms like Exxon which offer a higher return on invested capital, a strong free cash flow yield, more diversified operations, and a relatively healthy PE ratio of 9.48. Chesapeake may offer a good short term play but longer term investors shouldn't forget the majors. 

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