Monday, June 27, 2011

Is Chesapeake Energy Stock Overvalued?

Chesapeake Energy (NYSE: CHK), the natural gas producer, may have exaggerated the value of its natural gas inventories. If so, its stock could be over-valued. If not, is it a bargain?

Chesapeake is an $8 billion (annual sales) producer of natural gas and oil and natural gas liquids in the United States. At the end of 2010, it owned 46,000 producing natural gas and oil wells that produced 3 billion cubic feet of natural gas equivalent (bcfe) per day. In so doing, it has grown revenues at 22% and its most recent net income of $726 million was up 128% from the year before.

Chesapeake is among the shale gas producers -- users of an extraction technique called hydrofracking that forces water into deep-underground rock formations to force natural gas to the surface -- whose supply estimates may be exaggerated. According to the New York Times, in April, a Chesapeake executive told an energy industry conference, “Shale gas supply is only going to increase.”

But Chesapeake engineers wrote emails contradicting the optimistic premise. According to the New York Times, the emails suggest that the magnitude of Chesapeake's shale reserves are significantly overestimated because they project decades of steady output when in fact production declines after the first year and the cost of retrieving the gas exceeds the profit from selling that supply.

According to a March 17, 2009 Chesapeake memo reviewed by the Times, "Our engineers here project these wells out to 20-30 years of production and in my mind that has yet to be proven as viable. In fact I’m quite skeptical of it myself when you see the % decline in the first year of production.” On March 16, 2009 that same geologist wrote, “In these shale gas plays no well is really economic right now. They are all losing a little money or only making a little bit of money.”

Moreover, major shale gas wells are producing at most 20% of the expected production. According to the Times, in three major shale formations — the Barnett in Texas, the Haynesville in East Texas and Louisiana and the Fayetteville, across Arkansas — "less than 20 percent of the area heralded by companies as productive is emerging as likely to be profitable under current market conditions."

If you believe Chesapeake's numbers, it produced weak first quarter financial performance -- but better than analysts expected. It reported a $205 million (loss of 32 cents/diluted share) in the quarter compared to a profit of $732 million or $1.14 cents per share in the 2010 first quarter. Its adjusted net income of 75 cents/share; however, was a nickel more than the mean analyst estimate.

Chesapeake's loss comes on top of a significant pile of debt. Specifically, it has $13.4 billion in long-term debt. But investors responded positively to the company's assertion that it wants to reduce its debt by 25% by the end of 2012.

And Chesapeake valued its reserves at a present value of $3.7 billion. When compared to its market capitalization of $18.4 billion, it appears that investors are valuing those reserves at 5 times their present value. While this appears very high, it would be even higher if it turns out that the estimate of its shale gas reserves -- that account for about 78% of its total reserves -- are way overstated as the Times suggests, then Chesapeake's market value could also be way too high.

All this production requires a significant amount of capital -- is Chesapeake generating a positive return to its capital providers? In a nutshell, no, but it's improving. After all, it’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales.

In 2010, Chesapeake’s EVA momentum grew 134%, based on 2009 revenue of $7.7 billion, and EVA was negative in both years but getting much less bad in 2010 from negative $11.3 billion in 2009 to negative $979 in 2010.

And the stock is very expensive — trading at a price-to-earnings-to-growth (PEG) ratio of 3.51 (where 1.0 is considered fairly valued). Chesapeake’s P/E is 26.7 on earnings expected to climb 7.6% to $3.16 a share in 2012.

With a chance that its reserves are over-stated, its EVA destruction, its high debt load, and its very high market valuation; it's hard to make a bullish case for this stock.


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