Chesapeake Energy (CHK, Financial) has gotten knocked around in recent months. Most recently, it joined the selloff of energy stocks in the wake of concerns that oversupply is bound to drop oil prices.
But there are many unique elements in Chesapeake that make it worth an investor’s time to get to grips with this company. In particular, investors should understand the consequences of Chesapeake’s recent merger with WildHorse Resource Development. The combined entity has a lot going on that could prove enticing to a serious value investor.
In today’s research note, we take a look at Chesapeake and its merger with WildHorse. This battered petroleum and natural gas exploration and production concern is getting ready for its next act. WildHorse should help make it a good one.
Back from the brink
Chesapeake has taken a beating in recent years, after suffering a crushing blow during the last big drop in oil prices. An unsustainable debt load drove the company to the brink. But Chesapeake has been working hard to transform itself, and it is now a radically different company with sustainable financials and the capacity to move forward without the baggage of the last mini-oil crisis. On the Oct. 30 conference call, CEO Doug Lawler highlighted the strides the company has taken to move beyond its troubled financial past:
“We have decreased our total debt and leverage by more than $12 billion, eliminated legacy commitments and (midstream) obligations by more than $10 billion, significantly reduced complexity, delivered industry-leading capital efficiency, and eliminated more than $1 billion in annual cash costs, all while preserving a world-class portfolio of unconventional assets in an extremely challenging commodity price environment.”
With a clean bill of health at last, Cheasapeake is ready to start thinking about serious growth. It has a host of cash-generating assets already, but the addition of WildHorse to the fold could prove a game-changer if executed correctly.
Jumping a wild horse
When the deal with WildHorse was announced, it was clear immediately that Chesapeake was pouncing on the opportunity created by the general pullback of oil and gas stocks. With its own share price also depressed, and its enterprise value composed almost entirely of debt, Chesapeake was able to use its little remaining equity as leverage. Ultimately, the deal saw Chesapeake’s equity representing about 55% of the combined entity, with WildHorse shareholders receiving the remaining 45%.
That deal might be hard to stomach at first glance for the deep value investors who saw an undervalued gem in Chesapeake before the merger. The effective dilution certainly dented the near-term prospects for any long-term investors with extant long positions.
But that dilution is just part of the story. Digging deeper, we find a coherent justification for the move.
Betting on Eagle Ford
WildHorse made for a particularly attractive acquisition thanks principally to its excellent oil-rich acreage in the Eagle Ford shale formation. WildHorse has been able to post impressive margins with Eagle Ford. Indeed, an August presentation highlighted these superior margins to those of several Permian oil producers.
On an acreage basis, WildHorse was the third largest player in Eagle Ford. With these assets added to its own, Chesapeake is now the largest producer in Eagle Ford, in addition to holding some of the highest-value acreage. This represents a huge opportunity for Chesapeake to become a dominant player in the second most important shale formation in the U.S., after the Permian basin.
If Chesapeake can leverage its new position of power in Eagle Ford, it should be able to reduce costs and boost margins across the board. Chesapeake has a team steeped in operational excellence, and that ought to bring considerable benefits to the combined entity. Indeed, if things go well, it should remove the sting of dilution entirely and reinvigorate the prospect of growth for Chesapeake shareholders. And, if the acquisition price is taken on a per-acre basis, it could be argued that Chesapeake got WildHorse’s assets for below-market prices. Not bad!
Setting a new course
The post-merger Chesapeake promises to be a different kind of energy company, one that should prove considerably better balanced and stable. That balance will come in part from changing production mix: The company is targeting oil and liquids production to reach 30% of total production by 2020, up from 19% before the merger.
At the same time, Chesapeake will be focusing its resources with care, targeting high-value asset development and production first and foremost. CEO Lawler spelled this out during the Oct. 30 conference call:
“Expect that over 80% of our drilling and completion activity will be focused on our high-margin oil assets in the Eagle Ford and PRB, while we continue to generate free cash flow from our Marcellus and Haynesville positions.”
Chesapeake is on track, but execution will be critical. And a true collapse in gas prices could also throw a spanner in the works, since Chesapeake is not yet the diversified producer it is set to become in a few short years.
Verdict
Chesapeake took a major step when it moved on WildHorse. It has taken a long time to shake off the dead weight and escape the financial stresses that crushed it in the past, but Chesapeake has done the hard work to make itself lean and fit. The company is ready to take bold moves, and this is one that appears likely to pay off.
After completing the sale of a few assets, the new Chesapeake should have about $8 billion in net debt. The company is guiding for its ratio of net debt to adjusted Ebitda to fall to 2.8 by 2020.
Given Chesapeake’s growth trajectory, and comparing it to companies that it ought to resemble in a couple years, we can consider an appropriate price target. If things hold up for Chesapeake and the next phase of its development plan is carried off with the same aplomb as the first, then the stock price might well double in a relatively short span.
Disclosure: No positions.
