February 08, 2011 - 6:16pm EST by
2011 2012
Price: 31.50 EPS $1.50 $2.85
Shares Out. (in M): 650 P/E 21.0x 11.0x
Market Cap (in $M): 21 P/FCF 0.0x 0.0x
Net Debt (in $M): 13 EBIT 0 0
TEV ($): 33 TEV/EBIT 0.0x 0.0x

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What can you say about a stock that is universally loathed. That doesn't have a single "buy" rating from any major Wall Street house that I'm aware of.  That is run by a guy  many believe is a gambler and a leverage junkie; who ran the stock up to $72 (I still have 100 shares in a tiny IRA that I purchased there.) before personal and firm leverage, financial and operating, caused a spectacular crash to $15, whereabouts the CEO himself got puked out of his personal position of millions of shares.

The stock is Chesapeake Energy (CHK). And, say what you will about Aubrey McClendon, but one thing I've learned about him is that he's at his worst, and gets into trouble, when things are good (and he can borrow money). He's at his best when things look bleak and he has to scramble to save the firm (again). 

A little background for newcomers. CHK was one of the first to recognize the potential of  the original shale gas plays. Aubrey moved aggressively acquiring leaseholds at ever increasing prices under the assumption that the recent sky-high NG prices would persist, at least to some degree. He borrowed to finance these acquisitions.

Then, NG crashed as shale gas plays became plentiful and as good old American ingenuity drove costs down and production up.

The stock tanked, Aubrey had his personal holdings sold out on a margin call, near the lows, and CHK was written off in revulsion by investors.

So, what does CHK then do? They see the huge valuation gap between oil (and also Natural Gas Liquids) and dry NG; and they also see how the same horizontal drilling that opened up shale gas was now going to open up shale oil plays, and Aubrey moved aggressively to acquire land positions in the nascent shale oil plays. Fairly quickly, the oil shale plays started to gain credibility as a highly profitable unconventional source of oil.

Now, CHK is saddled with a lot of debt and the need for capex in order to perform HBP (Held By Production) drilling on the original NG leases. But, it also has some of the best land positions in many of the new NG and oil plays; and a mid-teens stock price that few have any enthusiasm for. In fact, very few people are even aware of CHK's moves and still consider it a NG stock in a lousy NG tape. It won't be for long. (CHK expects that drilling capital for liquids will have gone from 10% of budget in 2009 to 70% in 2012.)

The solution?  Joint Ventures and the 25/25 Plan. The latter is a goal of reducing debt by 25% by year-end 2011 and reducing production growth, via JV's, to 25% from the anticipated 30-40%.  JV partners have been top-shelf firms, including  PXP, BP (OK, no BP jokes), STO, TOT and CNOOC.

A great deal of the information I have is from CHK's  February2011 Investor Presentation, which is a must-read for investors. (

This was an ingenious solution in several ways. By monetizing these assets for both cash and future drilling carries, CHK was able to simultaneously take in cash, lower future cash needs and dramatically revalue upwards their remaining holdings (Slide 20 of Inv Pres.). An excerpt from a Scotia report on the latest JV follows, and is illustrative:

Transaction details.

* Chesapeake sold 33.3% of its 800,000 net acres in the Denver-Julesburg (DJ) and Powder River Basins (see Exhibit 1) to CNOOC for a total of $1.267B ($570M in cash and $697M in drilling carries). Applying a present value factor to the drilling carries, which are expected to be incurred by year-end 2014, implies a total value of $1.159B.

* Assuming $70,000/boe/d for production implies ~$4,600/acre (undiscounted) or ~$4,200/acre (discounted).

* CNOOC will have the option to acquire a 33.3% share of any additional

acreage acquired by Chesapeake in the area and the option to participate in midstream infrastructure.

* The transaction more than recovered Chesapeake's total (100%) DJ and Powder River land cost of ~$800M and implies a value of ~$2.45B for its retained acreage (~533,280 net acres).

* Over the past five years, the company has invested ~$14.8B on land in the Barnett, Fayetteville, Haynesville/Bossier, Marcellus, Eagle Ford, and DJ/Powder River. Through its six JV transactions announced to date, the company has recovered ~$14.1B in cash and drilling carries.


So, where does this leave us with CHK? Referring again to the Feb2011 Investor Presentation:  CHK has only onshore US energy plays. Expects 100K bpd of liquids by yr-end 2011 (up to #13 in ranking in the US), 150K bpd by yr-end 2012 (up to #8), and 250K bpd by 2015...all the while expecting to be the #2 US NG producer. CHK believes it has a potential net unrisked resource of 142tcf of NG and 11B bbls of oil. The firm models (using $6NG and $90 oil, which is arguably optimistic.) combined 2011-2012 EBITDA of $10.8B, $10.2B of cash flow, and net income of $3.8B and projects for 2015 EBITDA of $10.2B, CF of $10B, and net income of $4.4B, while growing production, growing reserves and reducing debt.

On the negative side, there is some Aubrey Magic in the 2011 NG hedges. Buried in the footnote on hedging is a reference to "swap positions include the benefit of premiums received in connection with sold calls for a portion of future NG and oil production". It's unclear exactly what they did, but they apparently juiced near-term hedging prices by selling some portion of future production at some unknown price.

On the rather bizarre side is a reference to them being "#1 in an unnamed big liquids play" of greater than 1MM acres. Details to come in 1H11.

The latest JV has started to get the Street looking at CHK again. The sharp guys at Pickering were the first blue chip firm to recognize the transformation and recently upped their rating on the stock to a "buy". "Accelerated activity, plus further asset monetizations...set CHK up to be the most improved E&P story in 2012".  And then there's Carl Icahn, who has taken a large (and thus far very profitable) stake in CHK.  I believe he will keep Aubrey from doing anything rash and will ultimately catalyze the most possible value from CHK. With so many moving parts, it's impossible to come up with a definitive value for CHK. But, a sharp friend suggested one back of the envelope comparison: APC has liquids production of just under 200K bpd and a market cap of $40B, twice that of CHK; or an EV of $49B vs $33B for CHK.  And CHK is the #2 NG US NG producer. Bit of  an apples to oranges comparison, recognizing that both companies have very different assets, but a useful point nonetheless. I think that Pickering is just ahead of the pack in recognizing the transformation and value here. I believe that other firms will follow along as it becomes "safe" to do so, and the price is higher. In fact, I have been meaning to write this up for VIC for 6 weeks, but was waiting for the clarity that the membership often demands. The stock is now higher and I have very mixed feelings on my delaying posting it because I did not (and still do not, realistically) have the kind of hard numbers that many members need to be comfortable with an idea. I do think the stock has room to run in the interim as Wall Street discovers it; and will be a great long term value investment as long as energy does not sell off.

My personal speculation on how this plays out is that NG recovers a bit to the $6 level, making the NG side of the business active and attractive. I suspect that Aubrey will be chafing under the constraints of Icahn and will ultimately split the company into a NG-oriented firm and an oil-related firm. This will simultaneously unlock a lot of value, give Icahn his exit, and allow Aubrey to take the helm of one of the firms, most likely the NG firm.



Continued monetization of assets to crystallize value and deleverage, particularly possible asset drop downs to CHKM.
Icahn pushing for value creation and discipline.
Street recognition of value creation, shift to oil assets, shift to fiscal discipline via 25/25 program.
Possible split, ultimately, of NG and oil assets into two separate firms to unlock value of both, a la Encana.
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