Why Chesapeake Continues To Sink
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In a volatile commodities market, I weigh my thinking about the market towards fundamentals. Transparent balance sheets that reflect true valuation, asset sales that shore up cash, and smart acquisitions help a company resist commodity price fluctuations that are beyond the control of chief executives and the board. Chesapeake Energy (NYSE: CHK) has been remiss in upholding these basic principles. Chesapeake's management has recently treated financial engineering and executive privilege not as auxiliary tools but as fundamental parts of the company's plan. Only in the past few days has this begun to change, but not before major external pressure.
For these reasons and those below, I advocate a hold position on Chesapeake shares, and caution should be exercised in initiating new positions. There are better options for those interested in the E&P market that both have an exceptional upside and are managed in a more transparent and growth-inducing manner. The earnings report confirmed for May 1 will provide further guidance.
Valuation and Risk
It is not particularly easy to place a 12-month target on Chesapeake shares. Most on the Street place a target anywhere from $20 to $32. There are more reasons for accepting the pessimistic target over the optimistic one. Aside from these reasons, documented below, Chesapeake is not undervalued as much as other more favorable companies. Moreover, Chesapeake's actual value is obscured by its unclear financial practices and non-standard reporting methods. The ownership structure of Chesapeake is complex, with many joint ventures and affiliates with public ownership.
Though risky due to the political instability in Africa, Kosmos Energy (NYSE: KOS) is presently at a bottom as it emerges from a developmental phase. A target of around $20 for Kosmos is a conservative estimate on the Street, amounting to over a 65% upside from the present price of about $12. Kosmos is engaged in exploration and production in West Africa and more recently South America. Kosmos holds a 25.8% stake in Jubilee, a lucrative oil field off the coast of Ghana. I see Kosmos as an excellent opportunity for aggressive investors. Another interesting prospect is Hess (NYSE: HES), which is emerging from a $46 52-week low. With a target price of over $80, Hess has been recently upgraded to buy from hold by The Street Ratings amidst increased profit margins. Hess missed the earnings per share target by 3 cents in Q1, and saw a total revenue decline of 7.3% year over year. Looking at the previous quarter, the company's net income jumped from -$131 million to $545 million in Q1. Hess looks ready to outperform its peers in the next 12 to 24 months.
CEO Woes
Aubrey McClendon, the Chesapeake CEO, has engaged in a number of less-than-transparent financial practices lately that might be putting his interests at odds with the company's interests. According to a recent Reuters report, McClendon accepted past loans from Frederick Whittemore in the 1990s, a former board member of Chesapeake, without disclosing the associated transactions as a potential conflict of interest. These loans potentially used company assets as collateral, leading many to question whether this was in investor interest or not. Presently, Newman Ferrara LLP is opening an investigation to determine whether this breached their duty to investors.
There are other issues with McClendon's investment approach. According the company's controversial Founders Well Participation Program, McClendon could claim 2.5% interest in wells drilled by Chesapeake. This made Chesapeake the only E&P with this practice, though it has been practiced in the past. Further, through a recent active move, the Chesapeake board ended this practice altogether. In my estimation, given the potential investigation that could result from this news, the board still has a long way to go in reestablishing investor trust and confidence. Reconsidering management personnel is only one step, as it seems that there is a recent ethic at Chesapeake to conceal debts.
Hidden Debt
Chesapeake's debt to capital ratio is around 37%, but things might be more gloomy than this value would suggest. Though a peer like Anadarko Petroleum might have 45% debt/capital, Anadarko has the advantage of keeping a more transparent balance sheet than Chesapeake. Chesapeake's cash flow per share is unimpressive at $4.86, and it is presently strapped for cash. Apache Energy, for instance, maintains a cash flow per share of $21.89, while Devon Energy remains around $10.
Chesapeake makes regular use of preferred stock, which essentially acts as a debt. Additionally, Chesapeake continues to maintain many long-dated commodity futures on gas and oil, royalty trusts, and IPOs of partial interests. In an effort to raise funds, Chesapeake has resorted to various financial instruments that, though well veiled, are ultimately loans that use future oil production as payment. These volumetric production payments (VPPs) are not always very competitively priced, but they do infuse Chesapeake with capital. A major issue is that Chesapeake has considered this instrument to be a form of asset sales. In reality, however, these amount to off-balance sheet debts to be paid later.
This is not the only problem with Chesapeake's finances. S&P recently lowered Chesapeake's debt issue rating to BB from BB+, placing them on CreditWatch with negative implications. Chesapeake's capital expenditures massively outpace cash flow by somewhere between $6 and $8 billion. In the end, Chesapeake's true value is not necessarily reflected in its share price, leading to needless risk. At this point, initiating positions in Chesapeake would amount to voodoo investing. The solvency of Chesapeake's finances rests in how well management executes the intended 25% debt reduction.
The Saving Grace: Liquids in, Gas out
Management hopes to derive this debt reduction from increased output at its Fayetteville assets and Niobrara joint venture. Aside from this, fortunately, Chesapeake has an excellent and diverse portfolio of oil and gas holdings. Over the next year, Chesapeake will be decreasing gas production by 6% while increasing liquids production 78% to account for sluggish gas prices (around $2/MMbtu, compared to the $3.50+/MMbtu projected for 2013). Currently operating 5 rigs at the Utica Shale Joint Venture, Chesapeake intends to increase this to 20 by the end of 2012.
But there is a silver lining to Chesapeake's liquid holdings. Whereas Apache, for instance, has exceptional plays on the current price of Brent-WTI spread crude, Chesapeake has about 35% of its liquids volume in natural gas liquids. This trades at over a $20 discount to WTI prices, presently around $93.
While gas prices are low, the projected increase of gas prices to "real" levels-around $4.50-by 2015 means that Chesapeake is well positioned to make a run in the gas market. Chesapeake is second only to Exxon Mobil in respect to total demonstrated gas reserves in North America. Additionally, Chesapeake is well hedged on gas, though near-term natural gas hedges are not in place.
Conclusion
Chesapeake has an excellent set of holdings that will ensure long-term profitability. However, short-term issues regarding cash flow, management, and present gas price structure lead me to caution against initiating new positions in Chesapeake.
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