Is the Market Too Pessimistic Over Chesapeake Energy's Spinoff?

The spinoff of the oilfield services business looks like the right move for Chesapeake Energy -- but the market seems to disagree.

May 30, 2014 at 8:20AM

Back in February, Chesapeake Energy (NYSE:CHK) announced that it was pursuing strategic alternatives for its oilfield services division. Finally, the company decided what it was going to do with this division. Chesapeake Energy recently stated that it was going to spin off its oilfield services business.

The market didn't like the news, and Chesapeake Energy shares have been under pressure since the day of the announcement. However, it looks like market participants are overly pessimistic about the spinoff.

Major step in leverage reduction
In earlier years, Chesapeake Energy amassed significant debt, which stood at $12.7 billion at the end of the first quarter. The company was betting on rising natural gas prices, but this bet didn't work as planned. As a result, Chesapeake Energy was left with a complex asset structure that couldn't produce the results that shareholders expected to see from the company.

Chesapeake Energy was already active on the asset sale front last year, but it was clear that asset divestments were not over given the amount of leverage that the company carried on its balance sheet. Thus, the spinoff of the oilfield services business is another logical step toward the simplification of Chesapeake Energy's asset structure and leverage reduction.

Chesapeake Energy stated that $1.1 billion of debt will be eliminated from its balance sheet as a result of this transaction. In addition, Chesapeake expects to receive $400 million in dividends from its oilfield services business to pay off inter-company debt. Besides the oilfield services spinoff, Chesapeake announced non-core asset sales totaling $600 million.

Together, these transactions are expected to reduce the company's net leverage by nearly $3 billion. In exchange, the company sacrifices 2% of its production and $250 million of operating cash flow. This doesn't seem like a major price to pay for a $3 billion debt reduction. The amount of sacrificed cash flow is small, and the company still expects that its operating cash flow will exceed its capital spending this year. This will be helped by the fact that $250 million of reduced cash flow will be offset by $200 million in lowered capital spending and a $70 million reduction in interest expenses and dividend payments.

Slower production growth is priced in
Following these asset sales, Chesapeake Energy expects to achieve adjusted production growth of 9%-12% this year. Sure, this growth target is more modest than the expected production growth of peers like Cabot Oil & Gas (NYSE:COG) or Range Resources (NYSE:RRC). However, the market already accounts for this difference, as Chesapeake Energy trades at just 12 times its future earnings. In comparison, Cabot Oil & Gas trades at a 24 forward P/E, while Range Resources trades at a 35 forward P/E.

Despite the planned leverage reduction, the problem of debt remains for Chesapeake Energy. The company will still carry a substantial amount of borrowings on its balance sheet. Thus, one can expect more activity on the asset sale front this year or in 2015.

Bottom line
Chesapeake Energy continues to transform its business. The company is surely moving the right way with its debt-reduction program. Importantly, this does not come at the expense of growth. Sure, there is a lot of work still to be done on this front, but Chesapeake Energy looks ready to follow the chosen path.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Range Resources. 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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