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Matthew Sipos
Matthew Sipos
Articles (9) 

Value Idea Contest: Chesapeake Energy May Be a Good Pick to Go Long Energy Prices

Despite decent 2nd-quarter results, Chesapeake’s stock bounces off 20-year low

August 16, 2019 | About:

Company history and business

Chesapeake Energy (NYSE:CHK) is a beaten-down U.S.-based energy stock. The company was founded 30 years ago in 1989 and was once one of the largest natural gas producers.
Nowadays, it is in the middle of a restructuring process.

By the Feb. 1 acquisition of the oil-focused WildHorse Resource Development Corp., Chesapeake is shifting towards high-margin oil production.

This transaction cost $4 billion for Chesapeake. Nonetheless, the market values the shares at only $1.29 (market cap is $2.11 billion) at the time of writing. That is a 47% discount to the estimated value of WildHorse.

Historical share prices and revenues

Regarding the business outlook, oil and gas producers are in a price-competitive, highly cyclical game. Hence, they have no pricing power or brand recognition -- people used to buy gasoline on the basis price. Commodities markets are often characterized by bear and bull markets. Energy prices just entered bear market territory. The big question is: For how long? With no pricing power, producers usually burn money in bad times. I believe that such a bearish scenario is happening now, and some uncertainties like the trade war are causing panic sell-offs.

Source: Chesapeake Energy's second-quarter investor presentation

Chesapeake Energy's second-quarter results show mending fundamentals, and if the market environment supports this trend, share prices will advance, too.

Financials

Source: Chesapeake Energy's second-quarter investor presentation

On average, the management saved around $600,000 per well, have a cost-saving target of $250 to $280 for 2019, and delivered record oil production of 122,000 barrels of oil per day for this year.

For the first six months of 2019, net income was $77 million and operating cash flow was $853 million, while total capex for 2019 is projected somewhere between $ 510 million to $540 million.

Chesapeake has a weak balance sheet, though, which is also reflected by current valuations.

Source: Chesapeake Energy's second-quarter investor presentation

According to GuruFocus, interest coverage is around 2.11, while the price-earnings ratio is 2.26.

A tremendous amount of debt, around $10.16 billion, is four times the market cap. The good news is that Chesapeake recently exchanged senior notes due in 2020 and 2021, worth $884 million, into new senior notes maturing in 2026. Therefore, it seems that there is no real risk of bankruptcy until at least 2021.

Management

Robert D. Lawler has been the CEO of the company since 2013. He has comprehensive experience in the energy field by being on the board of large oil producers such as Anadarko Petroleum (APC) for 30 years.

Selling its gas-dominant Utica assets to acquire WildHorse Resources at this leverage ratio is quite adventurous. But it may boost production and shareholder return if energy prices rebound.

The management has skin in the game, luckily. Lawler and other board members (such as the chief financial officer and directors) bought 50,000 shares on May 24 this year, for an average price of $2 per share. The CEO himself owns 5,083,298 of the shares outstanding. I consider this a good sign.

Valuation

The average analyst price target for this equity is around $2.3 per share. Earlier this year, gurus like Mario Gabelli (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) bought into Chesapeake when the price averaged $2.5.

If energy prices keep close to their current levels, it is in a pessimistic scenario. If the oil and gas producer just survives, I think that a share is worth around $1.5 to $1.7 in this scenario. Currently, it is trading with a 15-30% margin of safety.

The optimistic scenario is an oil and gas bull market, in which Chesapeake can make huge profits and therefore spectacular returns for shareholders.

In this case, the stock can easily be a multibagger, and the $2.5 to $3 valuation range is maybe still well under its intrinsic value.

Risks

Indebtedness: Too much debt is never a good omen. Competitors, like Antero Resources and Range Resources, also bear a significant amount of debt on their balance sheets. Due to the commodity exposure, it is necessary to finance capital expenditures when the company does not make much money.

Commodity prices fluctuation: If oil and gas prices dip or energy prices stay low for the long term, the company is going to burn cash. The longer the prices are down, the higher is the likelihood of a panic sell-off.

The company has a track record of overspending on gas drilling -- in hindsight, this turned out not so well. Share prices at 20-year lows reflect this. A miscalculated acquisition could be catastrophic with this leverage level.

Black swan events may also occur, and investors should personally evaluate the risks associated with the company before building a position in it.

Outlook

The present second-quarter results do not appear that bad and in my view, investors are likely exaggerating due to the U.S.-China trade tensions.

There are emerging concerns about whether oil prices have shifted to a lower level or are just in a transitory lowering. I am bullish on commodities; if you think that green energy is going to eat into oil companies' profits, then avoid this idea.

I believe that Chesapeake Energy is a speculative way to bet on hydrocarbon prices with leverage. This is also the advantage of this investment; with precise evaluation, you might make better returns.

Still, buying a commodity ETF is a safer, but possibly less profitable, way to gain on this idea. And there are other oil and gas drillers with stronger financials and probably less upward potential. So this is really a high-risk, high-reward play.

Disclosure: No position.

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