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The investment case on Chesapeake Energy (NYSE: CHK ) seems pretty straightforward at first glance: The company is cheap based on production and based on its massive asset base. Unfortunately, it's just not that simple. While there are certainly many bulls attracted by the valuation and the assets, there are many detractors who have simply lost faith in the company.
First off, here's a peer comparison:
Price-to-Operating Cash Flow Ratio
|Anadarko Petroleum (NYSE: APC )||$40.1 billion||6.8||2.1||$13.9 billion|
|Chesapeake Energy||$16.9 billion||3.4||1.0||$11.8 billion|
|Devon Energy (NYSE: DVN )||$26.9 billion||4.9||1.3||$9.3 billion|
|EOG Resources (NYSE: EOG )||$27.7 billion||7.0||2.2||$5.2 billion|
|Noble Energy (NYSE: NBL )||$16.9 billion||7.4||2.2||$3.9 billion|
Source: S&P Capital IQ.
Based on the above table, Chesapeake appears cheap compared to its peers. It trades at a paltry 3.4 times its operating cash flow and at no premium to book value. The only peer above that comes within spitting distance to Chesapeake's multiples is Devon.
Along with its cheap valuation multiples, Chesapeake boasts a massive inventory of future drilling locations. Some of its major positions include 1.8 million net acres in the Marcellus shale, 2.4 million net acres in the Anadarko Basin, 460,000 net acres in the Eagle Ford shale, 830,000 net acres in the Permian Basin, and its newest development: 1.4 million net acres in the Utica shale. In total, Chesapeake has 14.9 million net acres of land to be developed.
So what's the problem?
So far, I've detailed a potentially undervalued energy company with an enormous drilling inventory for future capital expenditures. If only it were that simple. The main bearish argument can be summed up in one word: leverage. Management has shown that it's willing to take on debt to acquire attractive acreage positions.
Referring back to the above table, Chesapeake has the highest net debt position relative to its size. Chesapeake is quite aggressive in acquiring acreage positions whenever it sees attractive prices. Chesapeake's leading positions in 12 of the top 15 unconventional liquids-rich plays in the U.S. didn't happen by accident -- there's no written rule that says Chesapeake had to acquire such large positions in so many different areas.
Having great assets is good, but the combination of leverage and falling commodity prices is a terrible one. In 2008 and 2009, the company had to write down $13.9 billion in assets, causing earnings to go badly negative in 2009.
The comeback plan
In January of this year, the company announced its 25/25 plan, in which it promised to increase its two-year production by 25% and to reduce long-term debt by 25%. As part of this plan, the company promised to reduce leasehold spending and to monetize (i.e., sell) various assets.
The plan started off strong: In February 2011, the company sold 487,000 net acres in the Fayetteville shale to BHP Billiton (NYSE: BHP ) for $4.75 billion, not long after closing on its sale of a third of its Niobrara acreage to CNOOC (NYSE: CEO ) for $1.3 billion. Moves such as these flowed through the balance sheet: Long-term debt went from $12.7 billion at the end of 2010 to $10 billion at the end of the first quarter of 2011.
And back again?
However, investors are fretting about some recent comments made by CEO Aubrey McClendon at a recent conference, that there's "still acreage to be acquired." Also, the latest balance sheet from the third quarter showed an uptick in debt, from $10 billion to $11.8 billion. The fear is that the company will go back on its word and continue to acquire acreage while racking up debt, after it specifically promised to reduce leaseholds and debt.
It's understandable for investors to be jumpy, but the company's debt reduction and production increase plan calls for these deliverables by the end of 2012. In fact, the plan is now a 30/25 plan: Chesapeake now expects growth at 30% rather than just 25% during the allotted timeframe. Also, while debt may have crept up in the short term, the company still has more monetizations on the way, such as the expected December closing of its Utica shale joint venture for an estimated $2.1 billion in cash and drilling carries.
Foolish bottom line
This story is still unfolding. It's been an exciting one with a lot of moving parts, and has given fits to both bulls and bears alike. Now that the company has a lot of doubters, I expect management to play nice and go through on its plan to increase production while reducing its debt. If that happens, the share price would receive a welcome spike. As a shareholder, I can be counted among the hopeful.
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