Why Chesapeake Energy Still Isn’t Worth Buying

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

Chesapeake Energy (NYSE: CHK) continues to execute its 25/25 plan, which includes setting a 2-year production target of 25% and debt reduction of 25%. We believe the energy company still has near-term pressures that will lead to uncertainty for the stock. Earlier this year, famed corporate raider Carl Icahn took a large stake in an effort to realign asset utilization and help the company reposition its debt (check out Carl Icahn's big bets).

Chesapeake's high debt levels, a result of aggressive CapEx, have strained the company's operations. Concerns of late have been related to Chesapeake’s ability to fund CapEx, but more so being able to meet debt obligations. 3Q balance sheet debt came in at $16 billion, which was a debt to capital ratio of nearly 50%.

Boding well for Chesapeake is its transition toward a more liquid-rich portfolio, expected to increase its liquid mix to 25% in 2013, from 19% in 3Q 2012. Although this is a positive, we still see earnings pressure as these changes occur.

As can be expected, then, Chesapeake has been looking to reduce its debt and CapEx, including cutting its gas rigs to nine, compared to 75 in 2011. Drilling CapEx is still expected to come in upwards of $8.5 billion in 2012, well above current cash flow. This shortfall led Chesapeake to take a $4 billion loan, while targeting asset sales of $14 billion by the end of this year.

From a valuation standpoint, Chesapeake trades well below most of its peers, and rightfully so. The energy company's cost structure has forced its EBITDA margin to industry lows at 7%, and as a result, its P/E is a lowly 13x. This valuation does not make the energy company a solid investment, though, given its industry-low long-term expected EPS growth rate of only 6%.

Are there better investments in this space?

Plains Exploration & Production (NYSE: PXP) is up 25% year to date, pushing the stock's P/E up to an industry-high of 34x, primarily due to a buyout offer from Freeport. This appreciation has upped Plains' sales valuation to among the industry's most expensive, at a P/S of 2.7x.

Even with its high valuation, Plains may still be a solid investment given its 5-year expected EPS growth rate of 30% and EBITDA margin of 67%. Steven Cohen and SAC Capital were heavily invested in this stock last quarter (check out all of Steven Cohen's top bets).

Schlumberger (NYSE: SLB), meanwhile, is one of the bigger energy exploration companies with close to a $100 billion market cap. Schlumberger trades in its industry's mid-range at 17x earnings and 2.2x sales. Despite its mediocre valuation, Schlumberger has much better growth prospects; the sell-side expects an EPS CAGR of 18% over the next five years. Billionaire Ken Fisher, founder of Fisher Asset Management and long-time Forbes columnist, is the top fund owner of Schlumberger with over 8 million shares (see Ken Fisher's full portfolio).

Prime competitor EOG Resources (NYSE: EOG) is much richer than Schlumberger on a valuation basis at 28x earnings, with a slightly better growth forecast (22% 5-year EPS CAGR). Major positives for EOG include its industry-high 50% EBITDA margin and a low debt ratio of 20%.

Last but certainly not least, Marathon Oil (NYSE: MRO) pays the most robust dividend of the stocks listed here with a 2.2% yield and a 25% payout. Marathon trades even cheaper than Chesapeake on a forward earnings basis at 10x, and almost as low at 1.4x sales. Although this energy company appears cheap, it is for a reason. A 2011 spin-off of refining operations has hurt Marathon Oil's ability to generate strong earnings appreciation. The Street expects it to flirt with 5-6% EPS growth over the next few years, annually speaking.

Chesapeake, our stock of focus, still has near term pressures and unsavory debt and cash flow issues that make it a sub-par investment. We believe that the Plains run-up puts the company in overvaluation territory, and EOG does not have the growth to support its valuation. We do like Schlumberger, though, as the top 'growth at a reasonable price' energy play, and Marathon investors can use the stock as an income boost but shouldn't expect any high-flying fundamentals.

This article is written by Marshall Hargrave and edited by Jake Mann. They don't own shares in any of the stocks mentioned in this article. The Motley Fool has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, long JAN 2014 $30.00 calls on Chesapeake Energy, and short JAN 2014 $15.00 puts 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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