Posted by Davy Bui on April 5th, 2008 in Enlightened-American Portfolio
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I’ll skip over the financial results from YE 2007. Any interested reader can search for the breakdown easily enough or get the press release from the company website. CHK pretty much hit all the performance targets I laid out in my last update (refresh your memory here) and I’d rather move on to the exciting bit of news.

After reviewing Chesapeake’s recent Haynesville play announcement along with the 2007 results, I am inclined to raise the intrinsic value due to several factors:

• Raising the base range of natural gas prices from $5 - $7 to $6 - $10.
• the new prospects recently announced which the company has fingered at 10 tcfe and 1B BOE in additional reserves

That last point is NOT A TYPO! An addtional 10 tcfe in nat gas reserves combined with an extra billion barrels of oil reserves (with oil priced at ~11:1 price-to-btu ratio, nearly double the traditional 6:1 ratio) would more than double the company’s current reserves and obviously, do nice things to NAV.

This is all very good news but it wouldn’t be life without disappointments and Aubrey McClendon was understandably mum on many of the details of these new plays. So in the interest of prudence, I discounted about half of the announced additions, raising the company’s reserves for valuation to 18 tcfe and 500MMBOE, .

• Intrinsic Value: $75 - ??? (the numbers here are literally crazy, even based on my discounted reserve totals)
• Accumulation Range: $40 or better

The company approaches valuing their assets differently than my method above but basically they get a range of $73.50 - $107 per share based on a range of $8 - $10 nat gas price. Their method excludes the recently announced plays while my method gives them no credit for their risked unproved reserves such as the Fayetteville, Marcellus, the Lower Huron, etc..

Of course, this being Chesapeake Energy, no update would be complete without…wait for it…an equity offering. The company announced a share offering during the last week of March and the latest investor presentation shows an expected fully diluted share count of 558M, up from 487M at YE 2007, for a 15% dilution (not including effects from senior convertible notes). Regardless of my previous focus on avoiding shareholder dilution, 15% dilution in return for more than doubling reserves is fair, to put it mildly. Keep in mind, McClendon and his team, usually sandbaggers extraordinaire, asserted with “complete confidence” that they controlled 7.5 tcfe over 200k acres in the Haynesville play but they are targeting 500k acres for a possible 20 tcfe. With their track record, I would expect them to exceed their announced totals in the Haynesville as well as the other announced plays. In my original report, I mentioned their drilling and seismic data as a boon to operations and that combined with their new Reservoir Technology Center should continue to provide impressive results going forward.

The impetus behind raising new capital is to drill these new plays as well as ramp up production in the Barnett and other areas. Management complained of other E&P companies bidding up leaseholds in some areas like the Barnett and Marcellus — their solution is to drill as fast as possible so as to avoid renewing leaseholds at mark-up prices. The financing portion of all this drilling appears to be getting a little trickier as the company’s previously planned capital raising efforts — selling off mature production (VPP) or assets, monetizing their midstream assets, sales-leaseback transactions — are already accounted for in the previous budget. Luckily, costs are projected to flatten this year.

Currently, the company is projecting up to $6.8B in capex. Last year, they generated $4.9B OCF. They’ve hedged 70% of 2008 production at an avg $8.69 mcf vs. last year’s nat gas equiv. realized price of $8.47 and are projecting a 20% increase in production this year. So assuming prices realized roughly equal last year’s, we get a rough $5.9B OCF based on production increase. The share offering will gross them around ~$1B, the 2nd VPP offering is projected @ ~$600M and the midstream partnership should see ~$700M to Chesapeake with $300M staying in the new entity. Combined with the increased OCF (~$8B total), that should provide the funding necessary to power CHK’s aggressive drilling program.

Frankly, it’d be nice to see the company develop a little slack in this area. Their current ratio was already sitting at 0.51 at YE 2007 (excluding off-balance sheet obligations which would lower it to 0.45). But these are only my rough back-of-the-envelope estimates and this is the aspect that worries me most about my investment. With the credit markets in flux, it is also hard not to worry about liquidity problems as the company runs with only $1M cash on hand. I’ll be keeping a close watch and look forward to the Q1 conference call.