What happened

Shares of Chesapeake Energy Corporation (OTC:CHKA.Q) tumbled more than 12% by 11:15 a.m. EDT on Tuesday after the company agreed to acquire fellow oil and gas driller WildHorse Resource Development Corporation (NYSE: WRD) for nearly $4 billion in cash and stock. In addition, Chesapeake Energy reported third-quarter results.

So what

Staring with the positives, Chesapeake Energy posted solid third-quarter results. The company recorded $174 million, or $0.19 per share, of adjusted net income, which beat analysts' expectations by $0.04 per share. Fueling that stronger-than-expected result was production, which rose 5% year over year, driven by a 13% increase in higher-margin oil output thanks to strong drilling results from the Powder River Basin.

An oil pump next to a pond.

Image source: Getty Images.

However, the company overshadowed its strong quarter by agreeing to acquire WildHorse Resource Development for $3.977 billion, which includes the assumption of $930 million in debt. The transaction will do several things for Chesapeake Energy:

  • It will materially increase the company's oil production and enhance its oil mix. Chesapeake Energy sees its adjusted oil production doubling by 2020 while oil's share of its output will rise from 19% to 30%.
  • It will transform the company's portfolio by adding a new oil growth engine since more than 80% of WildHorse's 420,000 net acres in the Eagle Ford shale are undeveloped.
  • The combination will save the company $200 million to $280 million per year thanks to operational and capital efficiencies.
  • The deal will accelerate Chesapeake Energy's deleveraging by improving its net debt-to-EBITDA ratio to 3.6 next year and 2.8 by 2020, putting it closer to its target of 2.

Now what

While Chesapeake Energy delivered stronger-than-expected third-quarter results and announced a transformational transaction to acquire WildHorse Resource Development, the company is paying a high cost for that acquisition. Given the terms of the deal, current owners of WildHorse will own 45% of the combined company, which is a significant share considering that Chesapeake Energy --- a nearly $15 billion company by enterprise value -- is paying $4 billion for that company. In other words, the transaction significantly dilutes existing shareholders in exchange for a higher oil growth rate and faster deleveraging. While that transaction could pay off over the long term if oil prices continue improving, it could come back to burn the company if crude tumbles.