Will Chesapeake Start to Heat up Again?

The sharp rise in shares of Chesapeake Energy (NYSE: CHK  ) has curbed down in the past several months. Although the company's third-quarter earnings results were strong, this wasn't enough to impress investors. How did this performance compare to that of competitors ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) ? Will the company continue to grow in the fourth quarter? Let's analyze these issues.  

Third quarter results and fourth quarter outlook
One of the main driving forces behind the company's sharp rise in revenues is the 119% spike in marketing and gathering operations. Alas, this business segment has only a profit margin of 0.7%  so it doesn't have much of positive effect on Chesapeake's bottom line. Conversely, the oil and natural gas operation has a gross profit margin of 82%, so the 15.5% rise in revenues in this segment is something worth noting. The company's gain in this segment's revenues was mostly related to higher oil and natural gas prices and stronger oil and NGL production.   

In the third quarter, the market price of natural gas rose by 23% (year over year). The company's realized price increased by nearly 15%. Nonetheless, Chesapeake's natural gas revenues grew by only 3.7%: The sharp rise in natural gas price was partly offset by the 10% drop in NG production. Looking forward, the positive effect of natural gas on Chesapeake's revenues in the fourth quarter is likely to be less dramatic. Currently, the quarterly average price of natural gas is only 2% higher than in the parallel quarter in 2012. 

Although the price of oil rose by 15% during the quarter, the company's realized price of oil increased by only 1.4%. This was also the case for Exxon and Chevron. Exxon's realized oil price grew by 5.6%; Chevron's by 7%. Moreover, these companies' revenues remained near-stagnant in the third quarter: Chevron's revenues inched up by 0.2%; Exxon's revenues slipped by 2.4%. Chevron's modest rise in revenues was due to adverse impact from currency changes, declines in asset sales, and little progress in downstream revenues. For Exxon, the sharp drop in downstream sales was among the main reasons for the decline in sales. Thus, in terms of growth in sales, Chesapeake has outperformed its competitors. 

Moreover, the rise in oil and natural gas prices has also reflected in the increase in Chesapeake's profitability when combined with a dramatic cost-cutting initiative.   .  

The chart below shows the changes in Chesapeake's operating profit (excluding goodwill charges) and normalized prices of oil and natural gas to the third quarter of 2012. The company's profitability grew slightly to 9% in the third quarter of 2013.

Source: Google Finance, and Energy Information Administration 

As you can see, in the fourth quarter of 2013 (to-date) the prices of natural gas and oil were higher than the prices in the same quarter in 2012. If oil and natural gas prices don't dramatically fall in the coming weeks, this could suggest prices will have a positive impact on the company's revenues and profit margins in the fourth quarter. For the fourth quarter, nearly 80% of its natural gas production and 91% of its oil production are hedged. So part of the company's production is hedged in case of a dramatic price decline. Specially, based on the company's current projection for its production in the fourth quarter and the current prices levels, the company's revenues from natural gas, oil, and NGL operations could rise by 4%-5% compared to the fourth quarter in 2012 – nearly half the growth rate recorded in the third quarter.  

Bear in mind, however, natural gas operations account for less than 34% of Chesapeake's oil and gas revenues – last year this percentage was 38%. The drop in natural gas's share of total revenues is related to the company's decision to sell some of its natural gas operations in the past year. Therefore, the changes in the price natural gas on total revenues will have a diminished effect compared to previous years. 

Despite the relatively positive earnings results, the main issue for Chesapeake remains rebuilding trust with its investors following last year's cash flow problems. The company's free cash flow reached nearly $-1.7 billion in the past nine months. Last year during the same time frame, this number was -$8.3 billion. The dramatic improvement is mostly related to the drop in capital expenditure and higher cash flow from operations. Besides higher cash flow from operations and asset sales, the company partly financed its negative free cash flow from its joint ventures. 

Next year, the company plans to fund its capital expenditure by increasing its cash flow operations

Gaining confidence
During the past year, the company has slowly been gaining back the confidence of the markets: Chesapeake's credit default swap (five years, in U.S. dollars) has declined during 2013 from 589 basis points at the beginning of the year to nearly 270 bp at the end of October. The current price of 270 means the annual premium is $270 thousand in case the company defaults $10 million of its debt within the next five years.

The sharp drop in the CDS is an indication that Chesapeake is regaining the confidence of both bondholders and shareholders. The company seems to have sold enough of its assets to finance its capital expenditure for the near future, repaying some of its loans and paying dividends. The last sale was made back in July when Chesapeake sold assets in the Northern Eagle Ford Shale and Haynesville Shale for nearly $1 billion.

If the company is slowly regaining the confidence of its investors, is the stock price still fair?  

Chesapeake's valuation remains stable
Despite Chesapeake's improvement, its valuation remains lower than its competitors. In the table below are the calculated enterprise value and EV-to-EBITDA ratios of Chesapeake, Chevron, and Exxon.  

Source: Google Finance, Damodaran, and wikinvest

As you can see, Chesapeake's EV-to-EBITDA ratio is still higher than the industry average but remains lower than the ratio of Exxon or Chevron. This suggests, at face value, that Chesapeake's stock price remains well priced and still has room to grow. 

The bottom line
I think Chesapeake has done well in the past year to get out of the cash flow problems it faced a year back. The company still has room to improve its financial situation and grow its operations, mainly in the oil market. 

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