1 Reason to Avoid Chesapeake Energy Corporation's Spinoff

There is a strong reason for Chesapeake investors to avoid the oilfield services unit that is being spun off into a standalone company.

Mar 27, 2014 at 9:22AM

Chesapeake Energy (NYSE:CHK) recently announced that it filed a registration statement on Form 10 with the U.S. Securities and Exchange Commission for the possible spinoff of its oilfield services division. The announcement comes after the company said last month that it is exploring strategic alternatives for the business. Chesapeake plans to distribute 100% of the spinoff's common stock to its shareholders. Once that happens, the key question for Chesapeake shareholders becomes whether they should continue holding shares in the spinoff. 

Spin off of oilfield services business
Chesapeake, which is looking to reduce its debt level, last month said that it is pursuing strategic alternatives for its oilfield services division, Chesapeake Oilfield Services (COS). Earlier this month, Chesapeake added that Chesapeake Oilfield Operating, which conducts the operations of COS, filed a registration statement on Form 10 with the SEC for a possible spinoff of the business.

Chesapeake Oilfield Operating will be converted into a corporation and renamed Seventy Seven Energy. The company expects that the spinoff will be tax free for shareholders. Chesapeake has not said when it plans to spin off the unit. Also, the number of spinoff shares that Chesapeake shareholders will get remains unclear. However, the company has said that 100% of Seventy Seven Energy's common stock would be distributed to its shareholders. But should investors keep their shares of the standalone oilfield services company?

Robust outlook for oilfield services business
Oilfield services stocks have had an excellent run over the past year; shares of Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB) have posted significant gains. In the past year, Halliburton shares have gained nearly 50%, while Schlumberger has seen its stock advance more than 28%. One reason for the strong performance has been the robust outlook for the oilfield services business.

According to Barclays, global spending on exploration and production is set to increase 6.1% in 2014 to a record $723 billion. The spending growth will be driven largely by the development of U.S. shale and Gulf of Mexico deepwater fields. Analyst research firm Cowen is slightly conservative in its E&P spending forecast. Still it expects an estimated 4% increase in spending to $687 billion. Similar to Barclays, Cowen forecasts a rebound in U.S. exploration and production spending; it is projecting an increase of 5.3% in 2014.

Given that Chesapeake's oilfield services division focuses on the United States, this is good news. But this is not the whole story. There is one major concern when it comes to Seventy Seven Energy.

Reliance on Chesapeake
Seventy Seven Energy, whenever it is spun off, will rely heavily on Chesapeake for its revenue. The unit reported revenue of around $2.2 billion in 2013; however, Chesapeake accounted for the majority of that revenue. The unit only generated around 10% of its total revenue from third-party exploration and production companies.

At least initially, Seventy Seven Energy as a standalone company will be relying heavily on one customer. And that customer happens to be a company that is cutting its capital spending. Last month, Chesapeake said that its capital expenditures for the year would fall around 20%. In such a scenario, one can expect a negative impact on Seventy Seven Energy's top line.

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Halliburton. 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.

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