Market Will Not Reward Chesapeake in Short-Term
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In its first earnings report since Carl Icahn came onstage and prompted a board overhaul in partnership with Southeastern Asset Management, Chesapeake (NYSE: CHK) reported second quarter net income of just $929 million against revenues of $3.4 billion, by including several gains that Chesapeake admits are not typically included by analysts. Excluding these line items, Chesapeake’s adjusted net income plummets to $3 million. At a glance, even using the adjusted net income this is a better report than many stockholders and analysts expected, but there are also several concerning disclosures in Chesapeake’s earnings report that indicate this company is still deeply troubled and not about to rebound without serious divestitures and changes to its operations.
Disclosures Undermine Positive Surface Numbers
One major disclosure made by Chesapeake is that the company wrote off 4.6 tcfe, or nearly a quarter of its total reserves as of year end 2011, as economically unviable to recover. The reserves removed came from Chesapeake’s proved undeveloped reserves, mostly in the Barnett and Haynesville shales. Chesapeake is able to report a 7% decline in total proved reserves due to reserves added in the first half totaling 4.2 tcfe, but that is still a substantial decline for a struggling company. Once Chesapeake releases its 10-Q the economic impact of these write-downs will become clearer, but a substantial loss in asset values will certainly accrue due to this move, further hampering Chesapeake’s attempts to get itself back on track.
Other firms, including Encana (NYSE: ECA), Range Resources (NYSE: RRC), and Devon Energy (NYSE: DVN) are performing well on the Haynesville, leading one to wonder why Chesapeake is not seeing improved results. Encana believes that it is possible to economically develop the Haynesville despite the formation’s low permeability, whereas Range Resources picks the Haynesville as one of the highest growth shales known.
Although the Marcellus Shale may be about to overtake the Haynesville as the most productive U.S. gas field, this is a misleading factoid since companies like Chesapeake and Comstock Resources (NYSE: CRK) are pulling out of Haynesville, reducing overall productivity despite the fact that there are trillions of cubic feet of natural gas still waiting for extraction in the shale. As noted by Louisiana Oil and Gas Association President Don Briggs, the Haynesville is “still the largest discovery in the United States.”
Another disclosure in Chesapeake’s earnings indicates that Chesapeake’s long term debt load is continuing its steady increase, now standing at just over $14 billion. The company is indicating that it wants to exit the year with a lower $10 billion long term debt load, primarily by paying off $4 billion in term loans with the proceeds from its planned $7 billion in asset sales in the third quarter. In other words, at least for the short-term over half of any cash outside of operations that Chesapeake can generate will go towards paying off its massive debt.
Positives Do Indicate Entries to Profit
There are positive indicators for Chesapeake, not least of which is the potential for improving margins. As Chesapeake was late to the gas to oil switchover, much of the cash the firm is hemorrhaging is flowing towards infrastructure development. Beginning in the third quarter, the company expects to see key infrastructure projects on some of its plays completed. On the Eagle Ford Shale, Chesapeake believes completion of new oil gathering pipelines and supporting infrastructure will lead to a $5 per barrel improvement in price realizations on production from the play.
The increase in Chesapeake’s oil production for the quarter was due in no small part to its Mississippi Lime play, where 40% of the company’s production was oil and production increased 56% over the first quarter. The Mississippi Lime is one of the most attractive plays Chesapeake owns on which it could make a deal, and the company confirmed that it plans to either seal a joint venture or a partial asset sale from its Mississippi Lime holdings with a transaction announcement to come “in the next few months.”
The potential Mississippi Lime transaction is in line with Chesapeake’s prediction of increased asset sales for 2012 over original estimates, with the company now providing guidance that at least $13 billion in asset sales should be completed this year. It appears that what many view as the most desirable asset in this bucket, the Permian Basin assets, will be sold piecemeal, most likely eroding the value that Chesapeake could realize through an all out sale. Chesapeake initially asked $5 billion for the assets. Now, the Permian assets are broken into three packages, one of which is under a Purchase and Sale Agreement with EnerVest Limited for producing assets in the Midland Basin area. Chesapeake accepted two bids that are still sealed for other packages in the Delaware Basin.
In the end, positive earnings per share for Chesapeake when many expected a loss does not erase the fact that some of Chesapeake’s fundamentals are shaky at best. Despite its completed and planned asset sales, it is barely holding on to profitability, and with a mounting debt load, further asset sales will only erode the underlying value on which Chesapeake obtained its first and second tier debt, possibly triggering acceleration. This is my biggest concern with Chesapeake and a factor that is helping push down its stock price, especially compared to its peers.
Comstock is currently trading around $16 with a price to book of 0.8 and a forward price to earnings of 10.7. Devon is currently trading around $57 with a price to book of 1.1 and a forward price to earnings of 8.4. Encana is currently trading around $22 with a price to book of 2.4 and a forward price to earnings of 75.6, more bullish numbers than it held as recently as mid-July when the firm was punished for announcing plans to spend its way out of the natural gas price glut by searching for oil. Range Resources is trading high, at $63 with a price to book of 4.2 and a forward price to earnings of 51.8. Comparatively, Chesapeake is a steal despite its many problems, trading around $20 with a price to book of 0.9 and a forward price to earnings of 8.7.
When dealing with Chesapeake, generalities no longer apply, but I still believe that the firm is a risky bet at best. Once the company’s 10-Q is released I think that shareholders will be able to look more deeply into Chesapeake’s earnings, and most of them will not like what they see. For the short-term, I do not think that Chesapeake will be gaining any ground on share price or value.
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