Chesapeake: Getting Rid of Bad Baggage

This company's had some management problems, but we still like it: Its profits are higher than expected, despite all, and its net income is up 2 cents per share this year, compared to losses of 11 cents last year.

Let's look at the management meltdown first, and then we'll get to the good stuff.

On 29 March, an uncomfortable conflict of interest issue saw Chesapeake Energy Corp. (NYSE:CHK) move to replace its CEO Aubrey McClendon. Stock prices were down and investors were revolting. McClendon actually co-founded the company, but investors didn't like his track record, and he had already lost his post as chairman in 2012, so it was only a matter of time before he was replaced as CEO. Shareholders weren't fond of McClendon's management missteps and the company's stagnating performance. But what made things worse was shareholder suspicions that McClendon was using his personal stakes in thousands of company-owned wells which allowed him to get over $800 million in private loans. While this was a clear conflict of interest and McClendon was cleared of "intentional" wrongdoing, the damage was done and shareholders wanted him out. McClendon's right-hand man, COO Steven Dixon has replaced him temporarily.

But there's more… On 6 May, Chesapeake accepted the resignation of another top guy, board director Louis A. Simpson (no reason given, and he's only been there 2 years). His spot will be filled by Thomas L. Ryan, president and CEO of Service Corp. International (NYSE:SCI). Ryan will face a shareholder election on 14 June.

The purge was a necessary idea that is renewing confidence in Chesapeake in a big way.

Gas prices are rallying, and demand improving, swinging Chesapeake into high profits - 5 cents higher per share than any analyst predicted.

Here are some highlights over the past 7 days:

•    Net income is at $58 million: 2 cents a share (compared to losses of $28 million-11 cents per share-in the same quarter last year
•    Per share profits (excluding non-cash hedging losses and severance expenses) were 5 cents higher than predicted
•    Q1 2013 profits were $15 million, compared to a net loss of $71 million Q1 2012
•    Chesapeake rose 1.1 percent to $19.54 yesterday in New York trading.
•    The company's production expenses have fallen 18% over the same quarter last year, thanks to more efficient drilling (specifically multi well pad drilling)
•    Chesapeake's average natural gas price rose to $4.46/thousand cubic feet equivalent (mcfe)-up from $4.02 last year

So, Chesapeake has been born again, and with gas futures trading up this quarter, demand is up and the company is enjoying some golden times.

•    Gas futures were trading up 39% in New York this quarter
•    Gas prices reached a 20-month high of $4.43 on 18 April
•    The glut is easing a bit

Now let's look at the company's assets, which are predominately (and unfortunately) gas-for now. We will admit the company is tight on cash, having spent most of it buying up new fields and leaving little left over to actually drill. But we think this will turn around this year, especially under new management. If Chesapeake can raise the $7 billion it is targeting this year by selling off some of its assets to reduce debt and spend more on drilling, it will be sitting pretty. 

It was McClendon who went on the asset binge, gobbling up US shale basins. But the massive debt he amassed did no favors to Chesapeake. In 2008 we saw the worst of this start to hit when gas prices collapsed and the company was left with tons of assets that they couldn't develop.

But what we're really eyeing here is Chesapeake's oil potential. It's doing well with crude production from its shale basins (most notably Eagle Ford, Texas). Production is up and expenses are down here, and the new management is intent on focusing on these strong points. To wit: there is going to be a lot more drilling on Chesapeake's prime assets, increased output targets and more profitable crude thanks to lower expenses. 

This is what it has to deal with this year:

•    $13.4 billion in long-term debt
•    $3.5 billion funding gap

So far, Chesapeake has signed or nearly sealed $2 billion in asset sales this year. On 2 April, Chesapeake sold 158,000 acres and 176 wells to Gastar (GST) for $75.2 million. On 16 April, it sold over 57,000 acres and 11 producing wells in Woodbine/Eagle Ford to Energy Exploration Partners (not sure how much for yet). On 29 April, it sold 160,000 Marcellus acres to Southwestern Energy (SWN) for $93 million.

Chesapeake Energy's February JV transaction for some of its Mississippian assets (to Sinopec) was disappointing: It only got $2,400/acre but had estimated this acreage worth at many times that. Again, this is on McClendon. It was overvalued. China's Sinopec got half interest in 850,000 acres of Chesapeake's Mississippi Lime play leasehold for $1.03 billion cash. The cash will be paid when the deal closes in Q2. 

We are confident that Chesapeake will focus more on its oil production, because this is the more profitable of its assets. After all, its oil production rose 56% this year, while gas production rose 9%.

The company will also focus more on liquid-rich plays as it divests some of its dry gas assets. It's also going to slow down spending on dry gas drilling this year, earmarking only 14% of its budget for this. That's a 2% reduction over its dry gas development budget for last year. That's not much, but in 2009 it was spending 90% of its budget on this.   

But let's not hang McClendon out to dry entirely. He was a bit of pioneer after all, especially in US shale basins. That said, he made a bad gamble, and got too greedy.

Bottom Line: We are going to go against the grain on this one. We think Chesapeake's rough times are coming to an end. We like the new management, and the new strategic focus. One thing though: Chesapeake should change its slogan, "America's Champion of Natural Gas".  It doesn't reflect what the new focus WILL and SHOULD be: less gas, more liquids.