Bruce Berkowitz Likes This Large Natural Gas Player

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Bruce Berkowitz, one of the most famous investment managers in the world, has managed to deliver a decent annualized return of 12.10% since the inception of his fund in 1999. His fund, The Fairholme Fund, has beaten the S&P 500’s annualized gain of only 2.61% during the same period.

In the first six months of 2013, the Fairholme Fund gained 15.08%, with ten concentrated positions. In the second quarter of 2013, Bruce Berkowitz had initiated a long position in Chesapeake Energy (NYSE: CHK). He owns nearly 3.2 million shares of the company, accounting for 1.1% of his total portfolio. Should we follow Bruce Berkowitz into Chesapeake? Let’s take a look.

The turnaround of the large natural gas player

Chesapeake is the second-largest natural gas player in the U.S., with around 19.6 trillion cubic feet equivalent of proved reserves in around 15 million net acres of leasehold in total. The company ranks second, only behind ExxonMobil (NYSE: XOM), the leader in natural gas in the country, having nearly 74 trillion cubic feet equivalent in its proved reserves.

Chesapeake has been an activist target of billionaire Carl Icahn and Mason Hawkins. Both of them are bullish on Chesapeake because of its oil/gas assets. Icahn commented that the company owns some of the greatest oil/gas assets in the world. However, the market does not realize them because of “enormous risk associated with an ever changing business strategy, enormous capital funding gap, poor governance and unchecked risk taking.

Chesapeake has been unlocking its hidden potential by divesting non-core assets so that it can focus on the profitable “core of the core” drilling area. The company sold up to $12 billion of non-core assets last year, and targets another $5 billion-$7 billion more in asset divestment this year. Year-to-date, the company has successfully completed a $3.7 billion divestment.

Recently, the company reduced its capital spending. The leasehold capex budget was down 80% year-over-year. The financials have also improved. In the first quarter 2013, its adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) came in at $2.6 billion, a year-over-year growth of 56%, while the company has managed to reduce its borrowing cost by issuing $2.3 billion in bonds at a blended rate of 5.1%.

Looking forward, Chesapeake would be more focused and disciplined in capital allocation. For the full year 2013, total capex is estimated to be around $7.23 billion, 46% lower than 2012, along with the shift to higher return liquids-rich areas. The company expects to generate more than $1 billion in adjusted net income, a year-over year growth of 136%, while adjusted EBITDA experienced a 31% growth, from $3.75 billion in 2012 to $4.91 billion in 2013. The market values the company at only 5.8 times its trailing EBITDA.

How about ConocoPhillips and ExxonMobil?

Chesapeake is valued lower than ExxonMobil but higher than ConocoPhillips (NYSE: COP). At $92 per share, ExxonMobil is worth $408.9 billion on the market. It is valued at 6.93 times its trailing EBITDA. Recently, ExxonMobil experienced a significant decline in second-quarter earnings. Its net earnings dropped 57%, from $15.9 billion last year to $6.86 billion this year, while the EPS decreased 55% to $1.55. The recent drop in earnings was due to the falling crude oil prices and production levels, as well as lower refining margins.

Investors would have expected cash return from both dividends and share buybacks from the company. However, investors should become more cautious as ExxonMobil reduced its share repurchase to $3 billion in the third quarter this year. Of course, over the long run, ExxonMobil could still be considered a good stock due to its large proved reserve base and the potential for more reserves. Its Kearl oil sands, with 4.6 billion BOE (barrels of oil equivalent) in proved reserves, was the first oil sands operation without an upgrader. ExxonMobil thinks that Kearl’s reserves “will meet energy needs for the next 40 years.

ConocoPhillips is the cheapest among the three. The market values ConocoPhillips at 3.7 times its trailing EBITDA. ConocoPhillips is also one of the largest global oil/gas players, with around 8.6 billion BOE in its proved reserves. The company has re-positioned itself to focus on the core exploration and production business by divesting its lower margin downstream business. The company expects to generate as much as $8.5 billion in cash by selling its offshore operations in Kazakhstan, Algeria, and Nigeria.

In the period of 2013-2017, its capital expenditure is estimated to be around $16 billion. Around 45% of the total capex would be used on development programs to mitigate base decline, while the major projects would consume 30% of the total capex for production growth.

ConocoPhillips is the right choice for income investors with the highest dividend yield of 4.10%. ExxonMobil ranks second with a 2.70% dividend yield, while Chesapeake yields only 1.80%.

My Foolish take

What I like about Chesapeake is its ongoing business restructure, to divest as much as $5 billion-$7 billion in assets this year and to focus on the “core of the core” drilling area. The divestment would help strengthen its balance sheet, deliver higher profitability and cash flow, and unlock potential shareholder value. As mentioned above, ConocoPhillips is also a good pick for income investors, due to its juiciest dividend yield, low valuation, and potential asset divestment. 

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Anh HOANG owns shares of Chesapeake Energy. The Motley Fool has the following options: long January 2014 $30 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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