Posted by Davy on June 1st, 2008 in Enlightened-American Portfolio, Stock Research
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An overview of Q1 2008 results (US$):

• Operating cash flow (OCF) up 53.3% to $1.5B. OCF per share was up 60.5% to $3.04. Both figures have to be some sort of record for them. Despite the huge cash flow, CHK spent $3B in capex, on their way to a projected $6.8B 2008 capex spend.
• Management said it best, “It’s also been a, it’s been a kind of corporate finance challenge to be able to pay for all this stuff [drilling].” In a recurring theme with these Chesapeake updates, the current ratio slid to 0.46 from 0.51 at YE 2007 and debt increased 12% to $12.3B (107% of equity). During the quarter, they sold off non-core assets in the Rockies & Woodford Shale for $243M. Shortly after the quarter, they raised $1B in an equity offering, completed a $623M VPP transaction and issued $2B in senior notes and convertibles. Obviously, the never-ending finance hamster wheel still dominates the balance sheet at Chesapeake.
• On the income statement, Chesapeake registered a loss of $0.29 per share. The sole culprit were the company’s unrealized losses on its hedges. This can be seen by comparing its operating income to OCF. The company’s adjusted income (excluding the loss-making hedges) were at record levels as well.

For several quarters now, CEO Aubrey McClendon vigorously combated perceptions that CHK was a serial diluter but as of Q1 2008, he’s thrown in the towel. From the company’s 10Q:

“We had previously planned to fund our 2008 and 2009 capital expenditures through cash flow from operations, borrowings under our revolving credit facility and from asset monetizations. Our previously announced asset monetizations remain on track, and on May 1, 2008, we announced a new planned transaction to sell leasehold for anticipated proceeds of over $1.2 billion in mid-2008. Considering the increasing number of opportunities available, however, we expect to fund some or all of our additional capital expenditures through public capital market transactions.”

The issue was never whether CHK were serial diluters (yes) but whether they were irresponsible in doing so. The company’s subsequent announcement of the intended sale of their Woodford Shale assets combined with their aggressive approach to the Haynesville and other new plays demonstrate management’s excitement over the potential buried in these new areas.

Back in Q3 2006, the company had proclaimed that it was moving from “resource inventory capture” to “resource inventory conversion.” And while they haven’t quite given up the ghost on being free cash flow positive in the near future (2009, 2010), it’s obvious that we are back in “resource inventory capture” mode — i.e. beg, borrow and capital-raise every penny we can get our hands on to exploit these new plays. The finite term on leaseholds require fast response to effectively exploit the land without having to rollover leases at expensive rates.  Also, competitors are bidding up land prices once word gets out so early movers reap big rewards.  As such, investors in the stock should be prepared for anything — capital raises, increased debt, asset divestitures, leasehold sales, etc. — as the company pursues these new opportunities.

Are the new assets worth it? If management lives up to its prior track record, the answer is an unqualified yes and then some. McClendon, one of the most respected CEOs in the industry, has gone on record stating that this (Haynesville) could be the biggest thing to ever happen to the company and eventually expects returns from Haynesville to exceed those of its Barnett Shale position. He also presents an interesting case that Chesapeake is being grossly undervalued by the market, basing it on the SEC’s PV-10 valuation and then adding in midstream assets, 37 tcfe unproved reserves and ignoring millions more less-glamorous acreage that the company feels is valuable nonetheless.  According to this math, the company is worth at least $61B ($99 per share net of debt) compared to an enterprise value of $39.5B around the time of the conference call.   Readers can see my rough valuation of Chesapeake from a previous post.

At this point, McClendon and his team have earned the benefit of the doubt.  They’ve nearly doubled our money in a little over a year and their track record is superb.  Even a major correction in natural gas prices wouldn’t be devastating as they’ve hedged the majority of their production through 2009.  As such, I remain confident that Chesepeake’s management will continue to successfully navigate its corporate finance challenge.