Chesapeake Energy (CHKA.Q) is an oil and gas company situated in the U.S. where it is the second largest producer of natural gas and eleventh largest producer of liquids (crude and natural gas liquids). As with many other energy companies, the decline in energy prices has negatively affected its share price. One of the crucial drivers for a stock is its dividend. So let's examine whether Chesapeake can sustain its payout under such a stressful time for energy companies.
The Basics
Dividend sustainability basically depends on two components, balance sheet strength and future cash flows. Chesapeake has $2.9 billion in cash, which is enough to cover pre-2018 debt principal payments worth $2.2 billion. This leaves around $700 million for dividends. Chesapeake pays $408 million annually to preferred and common shareholders. This means that if the company is unable to refinance its debt but can break even on cash flow, there is enough cash on hand to pay dividends for just under two years. Thankfully, the company has a credit facility that will allow it to refinance near term bonds. With $4 billion of capacity, the management can ensure that debt will be refinanced until at least 2019 and leave the $2.9 billion cash on hand to handle the day to day operations and pay some of it out to shareholders.
So the balance sheet provides somewhat of a safety net. What about the future cash flow? Historically, the company's operating cash flow has mostly been positive, but it only had one free cash flow positive year since 2005. Past operating cash flow has been used to increase reserves and drilling activities as well as purchasing more equipment to facilitate growth in the hope that future cash flows will exceed these initial investments. In fact, the dividends paid over the past couple of years can be attributed to funds from debt and equity financing. These are not sustainable sources of cash, and the company must generate regular free cash flow from operation for dividends to be sustainable.
Future Prospects
Chesapeake's free cash flow largely depends on the oil price and its capital expenditures. A higher oil will boost the company's operating cash flow and lower capital expenditure requirements will allow the saved cash to be used to pay dividends. While first quarter was not pretty, we should take the long term approach and evaluate whether the poor quarter would be the norm for Chesapeake. There may be a few factors in play that will increase Chesapeake's cash flow and allow it to make sustainable dividend payments.
With oil rebounding slightly after the first quarter, we can expect higher revenue and hence larger margins if oil continues this upward trajectory. However, you shouldn't just rely on rising commodity prices to justify an investment, after all, it is something that is outside management's control. A better measure of how the company will perform is how the management has managed costs in response to a trough in the commodity cycle.
Luckily for you as a shareholder, the management has dutifully monitored Chesapeake's costs and made the crucial decision to lower drilling activity and other capital spending in 2015. In March, the company revised its capital expenditure plan. Chesapeake will operate with a lower rig count (25 to 35 vs. 64 in 2014) and the capital budget has been reduced from $4-4.5 billion to $3.5-4 billion. While this decrease may limit short term gains if oil continues its recovery, the management has done a huge favor to dividend investors as the new plan will no doubt make dividend sustainability more robust.
Be Mindful of Macroeconomic Factors
Keep in mind that regardless of any cost cuts or balance sheet strength, the single biggest factor influencing long-term dividend sustainability is the commodity price. Currently many producers are slowing down drilling activities, decreasing supply in the short term. This is reflected in the recovery in oil price since mid-March. However, the recent rally is luring companies to expand again, which may start a race to the bottom for oil.
While Chesapeake's balance sheet and near term outlook suggest that dividends should be sustainable in the medium term, you must keep in mind of external factors such as oil price that will influence dividend sustainability.
With oil climbing higher and lower capital expenditure, I estimate that Chesapeake could generate over $200 million in free cash flow per quarter ($800 million annually). This is an ample amount for the current level of distribution so you shouldn't worry about a dividend cut in the near future.
