Description
**-FYI- my wife and I are expecting our first baby in the next day or two (actually she may be going into labor as I finish this up!), so I will likely be slow in responding to questions and posts, but I most certainly will as soon as I can pull myself away from my new daughter!
Background
This security was my original application to VIC 5 months ago but I have held off posting it out of uncertainty over the receptiveness for a commodity company that isn’t exactly an unknown quantity. But, considering the implied takeout value from APC’s purchase of KMG and WGC announced today, I felt compelled to put it forward. While at first glance Chesapeake Energy may seem to be an odd choice as a value selection (it’s a large cap commodity-based business in an industry that has appreciated substantially over the last three years), I would argue that this is the very reason that there is unrealized value available to the diligent and patient investor. The company has proved reserves of 8.2-8.4 Tcfe and unproved reserves of 11.6 Tcfe. 90% of the reserves are natural gas. Gas is a different animal than oil, it is not very transportable (barring LNG development a decade hence) thus the market is truly a domestic one. Meaning when prices spike there is little international arbitrage to provide extra supply as is the case with oil. Supply is largely constrained to North America and existing pipelines, and thus not very elastic. Due to the late-90’s build out of gas-fired power plants and home heating, demand for gas is very inelastic as well. While over the long term (10+ years) a barrel of crude oil and an mcf of natural gas will normalize somewhat close to their 5.9 to 1 energy equivalency ratio, currently they are severely disconnected. There are high levels of domestic gas storage due to the demand destruction from the post hurricane price spike in ’05 and the very mild winter. Also, oil is trading at an elevated level with somewhat of a Mid East security risk premium built in. Domestic natural gas isn’t subject to the same risk pricing premium. The current ratio of oil to gas is $70 to $6.20 or so, about 11.3 to 1. Backing out a $10 per barrel risk premium in oil (just a guess for illustration) you get a 9.7 to 1 real market price. Over the mid to long term this ratio will not hold as the btu content arbitrage will bring them back to about 6 to 1 by oil dropping or gas rising. I lean towards the latter. But the key to the CHK story is that gas does not have to go up for their to be substantial unrealized value in the name at today’s levels.
Chesapeake is very transparent on their corporate website and SEC filings as to strategy, positioning and operating history so I will mostly skip the background details other than a quick summary. The company pursues an aggressive reserve and production growth strategy of extensive drilling for organic growth (currently the most rigs of any company working in US) and acquisitions of strategic properties with an eye towards minimizing costs and maximizing local economies of scale. All of the company’s properties are safely onshore in the US so there is not event risk exposure to hurricanes or weather and very little to terrorism. These have combined for 10% + per year production growth in 10 of the last 12 years and are expected to continue doing 10-20% for the foreseeable future. The years that it missed this target were in the late-90’s when CHK blew up in pursuit of a high risk high reward drilling project just before energy markets crashed. Natural gas bottomed underneath $2/mcf and CHK’s stock price was crushed as the company was close to bankruptcy. I would characterize this as management’s ‘Damascus Road’ experience; they saw the light and subsequently got religion regarding operation of an economically sound business in a speculative commodity market.
Thesis
CHK’s underlying value is veiled by a complicated financial structure stemming from the acquisitions of properties paid for with a combination of convertible preferreds, senior secured debt, cash and stock. At the start of 2005 the company had less than 5 Tcfe in proved reserves, it has added 3.3 Tcfe through acquisitions and the drill bit in the last 18 months. These fairly consistent acquisitions and issuances of convertible securities as funding have capped the stock price with immediate dilution and placement pressure while the benefits of the deals will take longer to materialize. An illustration of the process might be helpful in understanding the strategy. CHK original focus was on the Mid-Continent region which at the time was infrastructure rich and producer poor, they followed a strategy of local concentration to take advantage of what economies of scale they could get by having equipment and access to pipelines all in close proximity. Recently management has expanded this strategy out of the MidCon into what they view as other attractive gas regions, usually acquiring a bulkhead and then adding on around it through the drill bit and through further acquisitions. Obviously to be an seen by targets as an attractive acquirer (at least more so than competitors) the company has to have the resources, knowledge and capabilities to acquire quickly and then integrate quickly. CHK maintains a large credit line to give them short term flexibility to make acquisitions quickly and painlessly without have to shop around for financing. After the deal is done management then can take their time in acquiring long term financing with fixed rate debt, convertible debt, or often convertible preferred stock.
For example, in the November 2003 acquisition of South Texas acreage from the private company, Laredo, CHK used $200 mill from the credit line for the purchase and later paid it down with issuances of preferred, in this case primarily a 5% Cumulative Convert. 1.5 mill shares were privately placed with a 225 k allotment for the underwriters. The funds paid for 108 bcfe of proved reserves and 88 bcfe unproved at an average cost of $1.41. The next 15 months production was immediately hedged at an average price of about $5.30. Factor in production and corporate expenses of roughly $1.50 per mcf- and the company locked in $2.39 per mcf at the deal’s closing. For the sake of this exercise assume that all of the convertible preferreds were exercised and that we would see dilution of about 10.5 million shares (in reality, some of these were bought back and some were already exercised). The ultimate value of the Laredo play is hard to pinpoint, there were at least 108 bcfe of legacy proved reserves we know of. In that area of Texas CHK has shown substantial growth in acreage and reserves in the last two years from 300 bcfe at the end of ’03 to 622 bcfe at the end of ’05. Some of this was from additional acreage but some portion of it was from the unproved reserves from Laredo. Let’s say that an additional 50 bcfe was proved for a total Laredo proved reserves of 158 bcfe effectively purchased with a convertible preferred with 10.5 million shares of dilution. Even at today’s stock price the $315 million of stock was a great exchange for 158 bcfe of natural gas bought at $1.40 per mcfe. Factoring in another $1.50 of processing costs that was then sold for anywhere between the initial hedge value of $5.30 to the levels of $8, $9 and $12 we saw in the last 12 months it’s not a stretch to assume that $700-900 million of intrinsic value was purchased with that block of shares. All that to say, although the seemingly perpetual dilution from convertibles issuances and continuous acquisitions puts pressure on CHK’s stock price, this example demonstrates how the reality of the intrinsic value being created and how much it outweighs the dilution and financing costs. The confusion engendered by the process works to the advantage of those of us diligent enough to cut through the mess.
Underscoring management’s long term view, all of the purchases make economic sense at almost any reasonable future commodity price deck. A recent purchase valued the assets at $1.73/mcf of proved reserves versus a current spot price of about $6.20 that has ranged from $6 to $14 over the last several months. And, operating mostly in the Mid-Continent region, CHK is afforded some of the lowest price differentials to NYMEX spot prices of any region with 5 year averages of roughly 35 cents. Differentials in some parts of the country can be a dollar or two off of NYMEX spot whereas CHK faces less of a location and infrastructure discount.
In addition management has demonstrated an understanding of how derivatives and hedging can be used to maximize stability and intrinsic value. The company is a serial derivatives user with the normal commodity swaps and hedges that other energy companies commonly use, but CHK also likes to play with other kinds of derivatives, using interest rate swaps, for example, to convert fixed rate debt to floating rate debt. My guess as to why management would execute such a swap is to alter their duration exposure, go short the low duration floating rate and long the fixed rate duration (swap floating for fixed) to better align there debt risk profile with the demand risk profile of their natural gas. Being long fixed and short floating provides a net positive duration where the assumed interest rates drops that would accompany a weak economy would actually benefit the company financially. Seems to be a smart move, hedging operating exposure with financial exposure using interest rate swaps; although I’ve never actually heard management express that as their intention so I may be giving them more credit than they deserve. From a commodity price hedging perspective the company is very aggressive about putting on hedges on any spikes in price, which have been common in the volatile gas markets. Currently their projected production hedged position is:
Natural Gas Crude Oil
Remain ‘06 88% @ $9.09 69% @ $61.85
2007 69% @ $9.86 56% @ $68.79
2008 55% @ $9.34 48% @ $69.50
2009 3% @ $7.57 2% @ $66.26
While these hedges do return a negative value when natural gas prices move above the hedged value, over the long term they will provide more predictable and consistent results in a highly volatile market. CHK likes to hedge immediate production of acquired properties to ensure the cash flow is available to pay down the debt/dilution taken on. The latest acquisition, purchased at $1.73/mcfe, has already been 100% hedged for ’07-08 gas production at an average of $9.50. The hedging program provides the company’s earnings with the lowest sensitivity to commodity price movements of any of its peers (I use APC, APA, EOG, DVN, XTO). The company has locked in the spread on the majority of proved reserves and is also partially hedging operating exposure on unproved reserves by building up a fleet of land rigs to buffer their leveraged to one of the chief worries of energy companies, development and production cost inflation. By the end of this year CHK will own 60 rigs capable of doing about 60% of their future drilling work. This moves emphasizes management’s eye towards operational efficiency. Indeed the company has the lowest G&A per mcf produced of any of the major independents and currently maintains a negative working capital ratio.
Adding heft to management’s actions is that co-founders Aubrey McClendon (Chair, CEO) and Tom Ward (former COO) have historically always owned enormous amounts of equity in the company, 23-24 million shares apiece as of the last reported numbers. There has been some concern with the recent resignation of Ward from the company. Anytime a major officer leaves a company of course it is cause for a closer examination. But in this case my impression is that it is truly a simple divergence of interest, McClendon and Ward had worked together as partners for 15 years, primarily as scrappy entrepreneurs. They got their start as wildcatters, and it seems that Ward still has that small operation, get your hands dirty, type of affinity, and was simply not as happy in the multi-billion dollar corporation that Chesapeake had become. The resignation seemed very amenable with no ill-will. However, there is a concern over the potential overhang from his holdings possibly being sold. Ward had until May 15th to exercise all outstanding options, so he’s done with that by now. He is staying on as a consultant until August but then all ties with the company will be cut. His 24 million or so shares of CHK could be a risk factor. However, it is noteworthy that CHK’s average daily volume is over 20 million shares, so even a stake of that size could be liquidated with minimum impact. McClendon’s stake will remain, indeed he added to it with a purchase of 100,000 shares in mid-June. He is clearly aligned with minority owner’s long term interests, not merely in what he says but in where his treasure primarily is. I have met McClendon on occasion and had the oppurtunity to speak to him about the company. Although this is purely subjective and anecdotal I have always gotten the feeling that he is the kind of manager/fellow shareholder you want running your business.
Despite all of this CHK trades at a valuation discount to peers, to its reserves, and to its cash flow generation potential. The acquisitive nature and accounting dilution of Chesapeake’s purchases have served as a veil on the intrinsic value and as an inhibitor to the stock price realizing the value of the underlying organic and acquired assets.
Valuation
Due to the complicated structure and the new acquisitions and reserve growth, trailing price and EV multiples aren’t as useful as doing valuations on the current assets in the ground or projecting the potential cash flows.
Take Out- Private Market- Using reserve multiples paid on recent deals both by CHK for acquisitions and other acquirers. Also I am using fully diluted shares outstanding and net liabilities greater than just net debt outstanding (for deferred tax costs, etc.)
• COP Purchase of BR on a proved reserve basis- $35.6 B EV on about 12 Tcfe= $2.94 of EV per proved mcf.
o $2.94 x 8.3 Tcfe = $24.4 B less $7.0 net liabilities = $18.7 /441 = $42.20 per share. (Note- CHK’s assets are arguably more val. than BR. as they are all domestic and 90% gas vs. BR at 66% domestic and 70% gas, also their unproved reserves potential is higher).
• CHK Purchase of Columbia Nat’l Resources- $2.20/proved mcf, $1.26/unproved mcf.
o Apply to CHK’s reserves= $18.3 B Proved + $13.9 Unproved=EV of $32.2 B. Less $7 B net liabilities= $25.2 / fully diluted shares of 441 = $57.14 per share.
• APC Purchase of KMG- Paid $16.4 B + $1.6 in assumed debt. The per mcf price of KMG is pretty speculative as a large piece of the value APC is projecting comes from the unproved reserves, so its hard to assign how much of the $18 B price should go to proved versus unproved, but the estimate I am using is $2.75 per proved and $1.40 per unproved mcfe.
o Apply to CHK’s reserves= $22.8 B proved + $11.2 Unproved= EV of $40 B less $7 B in net liabilities= $33.0 B / 441 in total diluted shares out = $74.80 per share.
Anadarko’s deal for KMG and WGC and COP’s recent agreement to purchase BR is evidence of the potential appetite of majors for high quality reserves. CHK would make an attractive acquisition target for a domestic or international company looking to gain focused exposure to the onshore US natural gas market. Potential acquirers could include CVX or RD, both of whom will need to show some high value reserve growth in the near future. Also there are international companies that could be suitors. However, I don’t anticipate CHK being taken out as the premium that McClendon would likely demand for giving up his company could be too great. COP was criticized for ‘overpaying’ for BR (although the naysayers were largely using commodity price decks from a bygone hydrocarbon era and COP will likely be vindicated in the long run) and the CHK premium would likely be higher than that deal’s $2.94 per proved mcfe. But, if CHK is taken out at $3.50 + per mcfe so much the better for us.
Comparable Multiples
Reserves TTM Price/
Cap (b) Tcfe * Net EV EV/mcfe Cash Flow
CHK $11.6 8.3 $17.6 $2.12 3.8
APA $21.0 12.7 $22.8 $1.80 4.2
APC $21.0 14.5 $23.5 $1.62 4.9
DVN $24.5 12.7 $29.0 $2.28 4.2
EOG $15.7 6.2 $15.8 $2.55 6.5
XTO $14.9 7.6 $18.0 $2.37 6.4
*- most recent proved reserve #’s I have but might not be exact for some of the comps
**- EBITDAX= EBITDA plus CapEx
The value per mcfe of proved reserves puts CHK in the middle of the pack, however this does not take into account their huge unproved reserves or their superior location onshore North America and operational efficiency advantages. On a cash flow basis the entire group is interesting. Granted the majority of this cash flow is reinvested into the business at this point, extracting oil and gas is certainly capital intensive, but below are some discounted cash flow estimates assuming capex was limited to strictly maintenance capex with no more for growth (i.e. from a control/take-out perspective).
Present Value of Future Cash Flows
These projections primarily depend on realized sales price (i.e. future commodity price + hedges) and operating cost inflation. I have run out some present values for average realized prices over the next decade taking into account the extensive hedging currently on the books. Other relevant assumptions are: operating cost inflation 200 bps above price inflation, a 10% discount rate, 441 mill in fully diluted shares, capex limited to production and development of current proved and unproved reserves with no growth capex, and finally a terminal multiple of 10 x’s earnings 10 years out.
• At $6.00 per mcfe avg. price= $23.2 B EV-debt / 441 in fully diluted shares = $40.00
• At $7 = $29.6 = $53.50
• At $8 =$43.0 = $84.00
It is interesting to note the huge operating leverage the company has. If natural gas is truly supply constrained and averages $8 + over the next 10 years while we wait for LNG plants and nuclear facilities to ease the strain, CHK is worth $80 to $100 in today’s dollars. However, if natural gas were to return to $4 per mcf CHK might only we worth $20-25 today. This downside leverage is what makes CHK a more risky holding than a traditional value investment; the fundamentals of the natural gas market certainly seem to support a price significantly higher than $4 per share. However, if something were to come out of left field and surprise the majority of people (as the market is wont to do) CHK has some downside risk. However I think the potential upside to $60 + outweighs the risk of seeing $20 per share in the vast majority of reasonable commodity price scenarios.
Valuation Summary
Using take out values, comparable multiples and PV’s of FCF, CHK triangulates to an intrinsic value range of $45-60 per diluted share, 50-100% upside from current levels. It’s important to note that this range is simply a value on the assets currently owned and does not reflect the potential incremental value of future deals and reserve increases by the drill bit. CHK has a great track record of adding value there. Intrinsic could easily end up being $60+ but this requires more speculative forecasting and projections than I am comfortable with. However it is equally important to realize that the intrinsic value, especially once the current hedges run off, is wholly dependent on the price of natural gas.
Catalyst
Catalysts/Risks
Over the short term, the most likely catalyst for CHK getting closer to realizing its intrinsic value is a continuance of M&A in the area. If Majors and Internationals begin anteing up for domestic assets a light will be shined on the value of CHK’s assets. APC’s recent actions may be a continuation of the trend COP kicked off. COP’s purchase of BR might be the lowest price paid if the M&A market really heats up. Historically these guys tend to follow each other around and deals beget deals, which would be good for CHK stock. Also any external shock that impacts natural gas or crude prices tends to have a direct impact. Event risk from hurricanes and terrorism is actually a positive catalyst for CHK’s stock price as the correlation of gas prices with systematic shocks is generally positive. For those with an EMH bent this reason alone may make CHK an intelligent hedge in a diversified portfolio. Over the long term the catalyst is more subtle, a market realization of the quality of CHK’s underlying domestic assets and high quality management. As the expectations on future gas prices solidifies and the market gets comfortable that $3-4 gas is probably not in the cards, CHK’s long term values will rise to reflect the acceptance of this price deck.
That is the risk as well though, at the bottom CHK is in a commodity business that historically has boomed and busted with regularity. No matter how good their hedging or management, if by some unforeseen eventuality natural gas prices plummet the value of the company’s assets will plummet as well. The fundamental weakness is a franchise value predicated on an external factor- which is much riskier than an entirely internally competitive advantage. Were the US to pursue an aggressive plan of building nuclear facilities the future demand for gas as power would decrease. Additionally, an increased focus on building LNG receiving terminals would allow foreign supplies into the US and remove a significant barrier to entry. Also we will likely see more dilution from convertible issuances to pay down the bank lines for the latest deal and to pay for future deals. There is also the possible overhang from Ward’s shares. However, I believe the margin of safety to intrinsic is such that these risks are adequately priced in. The ride could be a wild one, but as a somewhat noteworthy value investor has said, I would “prefer a lumpy 15% to a smooth 10%.”