Do Chesapeake’s Woes Equal a Buying Opportunity?

By Douglas Ehrman - August 21, 2012 | Tickers: APC, BP, CHK, COP, XOM | 0 Comments

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While many might argue that even considering a stock that has been punished as a result of poor debt management, the need to divest assets and general weakness in the price of the company’s primary product is unwise, Chesapeake Energy Corporation (NYSE: CHK) is not without a certain appeal. Not only has the stock bounced off of a 52-week low set in April, natural gas prices have climbed forty-five percent from the 10-year intraday low of $1.90 set in the same month. Additionally, the company recently reported its best quarter on record, and there is significant evidence that the company is getting its house in order. The question, therefore, that investors must both ask and answer is has the company’s recent performance matched the improvement in the stock’s position or is there remaining upside that creates a buying opportunity.

The Debt Picture & Earnings

Chesapeake needs to sell roughly $7 billion in assets by the end of 2012 to avoid a credit downgrade; the company’s debt is currently rated Ba2 by Moody’s with a negative outlook. In an August 7 teleconference company CEO, Aubrey McClendon, announced that the company expects to earn the needed cash through the sale of two Permian Basin asset packages by the end of the third quarter. He expects that total divestitures will reach $13 billion by year-end. The fact that Chesapeake has firm bids in hand seems to be calming the market, but many argue that the company still has not totally regained the trust of the public.

Also adding to Chesapeake’s push to emerge from the maelstrom was the best reported quarter in company history. The results must be viewed with caution, however, when one considers that it was asset sales that boosted net income by ninety-one percent to $972 million. Chesapeake, which is the second largest producer of natural gas in the world, second only to Exxon Mobil Corporation (NYSE: XOM), agreed to sell its pipeline interest in Chesapeake Midstream Partners LP for $4.08 billion. Without the sale of the asset to Global Infrastructure Partners, the quarterly results would have been dramatically different.  Profits from normal operations remain under pressure as a result of depressed gas prices. In this sense, diversified options like Exxon offer greater protection when natural gas stagnates. On the flip-side, when the expected appreciation in gas occurs, Chesapeake should experience a larger payoff.

Gas Prices

Since the April 19 low, gas prices have climbed back to the high $2 range; the commodity traded as high as $3.214 on July 30. Looking at current levels, the U.S. Energy Department’s weekly inventory report showed that supply grew by less than expected. There is still an excess of inventory in the market, which remains fifteen percent above the benchmark level and at the highest levels for this time of year in some time. Still as one looks ahead to the increase in usage associated with the winter months, the smaller-than-expected rise can be seen as mildly bullish for natural gas prices.

Conclusion

While Chesapeake’s current level makes its valuation, based on the company’s trailing twelve month price-to-earnings (P/E) ratio, more attractive than competitors like Anadarko Petroleum Corporation (NYSE: APC), BP PLC (NYSE: BP) and ConocoPhillips (NYSE: COP), Chesapeake’s missteps justify the lower multiple. Chesapeake is trading near a P/E of 6.4 relative to 7.9 for BP, 6.7 for Conoco and negative earnings for Anadarko. The other factor to consider here is that like Exxon, these competitors have the advantage of a more diversified product offering. One of the reasons for the higher multiples, therefore, is that investors are gaining exposure to oil prices, which have remained high. Additionally, with dividend yields of 4.5% and 4.6% for BP and Conoco respectively, it should not come as a surprise that investors are will to pay up for these stocks. With negative earnings and a dividend yield of 0.5%, the saving metric for Anadarko is that the company has an operating margin of 11% relative to 6% for BP and 9% for Conoco. Ultimately, however, the increased petroleum exposure makes a pure valuation comparison difficult.

Chesapeake's stock has risen nearly $6 from its 52-week low and yet, to the extent that the comparison holds, remains competitively priced against its more diversified competitors. If the encumbrances that have weighed on the stock can be eliminated, the stock should have significant upside heading into the cooler months. Overall, the stock should still be seen as a speculative play, given the volatility that is likely to surround the resolution of some of the issues mentioned, but the company appears to be on the right path. With this in mind, Chesapeake is one of the more attractive companies in the speculative space given its dominance in an important commodity. Ultimately, if natural gas prices remain stable, or rise as expected, the stock has additional upside and looks attractive at current levels.

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