Posted by Davy Bui on August 19th, 2008 in Enlightened-American Portfolio, Stock Research

A quick rundown on Q2 earnings and then I’ll focus on strategic matters. All results US$ unless otherwise noted:

• Cash flow from operations increased 30% to $2.8B for the 6 months ended 06/30/2008. That’s probably another record for the company but they’re going to need every penny and then some as they showed $6.3B cash outflows from investing activities, with $3B going to leasehold/property acquisitions, another $3B to actual drilling and $1.2B to other capital investment (probably things like building midstream assets, compressors, etc.) This figure includes gains of almost $1B from VPP transactions, sale/leaseback transactions and property divestitures. I’ve mentioned the financial hamster wheel in the past but this gives you some indication of the scale.
• The balance sheet shows no surprises: more liabilities piling up. Debt increased 19%, the current ratio stands at 0.44 with debt-to-equity @ 1.27, up 20 bp from just last quarter. Some of these numbers may be skewed by some of the derivatives liabilities they are carrying ($3.5B in current & $3.1B in non-current liabilities) because as I understand it, these are non-cash liabilities and will be backed by actual production. What is slightly more disturbing are the off-balance sheet obligations the company is exposed to, roughly $1.9B related to equipment leases, transportation & drilling contracts and loans/guarantees to related companies. These obligations come to an additional 7% of CHK’s $27.8B in carried liabilities.
• The company showed a huge loss due to mark-to-market accounting on hedges (backed not by cash but actual production). Not a big deal. Their diluted share count did exclude an additional 6% of shares outstanding if exercised.
• The company also announced a $404M verdict against them in West Virginia that they are currently appealing in the US Supreme Court. The filing indicates this verdict will not have an adverse effect on the company.

As usual, Zman does a great job of breaking down the quarter on his blog so I don’t want to waste pixels. He is more of a trader than I am, though and focuses on different items. I’ve outlined some of these items above.

Regular readers should get the sense by now that I focus more on numbers and less on “the story.” Any story worth hearing will usually be reflected in the numbers, whether they be reserves, cash flow, balance sheet, sales growth, etc. But being a numbers guy all the time is so boring and who doesn’t love smack talk every once in a while so I direct readers to a transcript of the XTO Energy Q2 08 earnings call.

When I first read it, it sounded to me like Bob Simpson, CEO of XTO, was calling out our dear old Aubrey as a “hype artist” in regards to the Haynesville (as well as their “past history”) but I couldn’t be sure as Simpson didn’t name names and I’m not well-steeped enough in the industry to know exactly who he was referring to. But I was worried because Simpson has been in the game for a long time and if Simpson was referring to Chesapeake, perhaps I am leaving myself open to disappointment with the Haynesville.

McClendon’s response in CHK’s earnings call (transcript here) cleared that matter up for me. The “hype artist” in question answers these allegations right off the bat and spends a considerable amount of time doing so (in detail). But my favorite quote on the call had to be McClendon’s response to some analyst’s call that gas would stay at $6.25/mcf due to massive oversupply: “That kind of analysis, I think, can only come at the dangerous intersection of Excel and Powerpoint. It can’t happen in reality.”

In the course of this call, McClendon and team also provide a great deal of color into other plays like the Fayetteville, Barnett and highly-hyped Marcellus Shale. He also goes into logistical details and limits which, like every other aspect of life, are grossly overlooked as people extrapolate knowledge from headlines. There are too many for me to summarize here so I highly recommend every retail investor with a stake or interest in the energy sector to read these transcripts, not just for the unusually public CEO spat but to glean real insights into how the industry runs and the limitations we have to deal with as a nation even as cynical politicians talk up energy independence.

As for our investment in CHK, the fact is we have already monetized some value in the Haynesville through the joint venture with Plains Exploration & Production (PXP) to the tune of $30,000 per acre once production costs are included. The data they provided on the wells completed to date in the Haynesville does nothing to dissuade me from confidence in management’s projections for this play. Other key points coming from the call regarding Haynesville:

• Much of CHK’s acreage in the play is held by production (HBP) as opposed to the finite lease terms in the Barnett which are forcing a drilling battle royale. So Chesapeake can control the timing of the drilling better in the new play.
• The gas is highly pressurized and so will not need to be compressed.
• Gas priced in the Haynesville is consistently over $1 higher than that in the Barnett.
• Infrastructure issues will limit the ramp-up of the Haynesville (and much more so in the Marcellus).

The other significant item to take away from this call was McClendon’s declaration of a new strategy for realizing value in the form of asset monetization via VPPs, JVs, etc. I almost think of it like a private equity group — buying assets on the cheap and sell all or part of it later at a premium. Obviously, Chesapeake has always had a large financial engineering aspect to it, with the constant balance sheet maneuvering and hedging. Why not add deal-making to it as well? The recent ability to execute deals such as the VPPs, the JV with PXP and the Woodford Shale divestiture to BP, even in this poor economic environment, gives me confidence in management’s ability to hit the financial targets they’ve set ($7.5B in asset monetizations in 2nd half 2008, $500M VPP in 2nd half 08, $1B - $2B VPPs in 2009).

An analyst on the call mentioned CHK had a core competency (or competitive advantage, if you will) in leasing land that others can’t duplicate and as such, the divestiture program is an interesting twist to the CHK story. I completely agree. They’ll need it as they estimate that 2008 and 2009 capex + costs will exceed projected cash flow and debt facilities. Things like their leasing team, their geological tech center, their in-house drilling and machine shops — i.e. things that don’t get priced into the stock until they hit the jackpot with something like the Haynesville — will give them a huge leg up as they implement this strategy. Keep in mind that CHK is the largest leaseholder in the Marcellus Shale (over 1M acres — let’s monetize some of that) and at YE 2007, roughly half their production still came from conventional plays in the Mid-Continent (i.e. not shale).

Oh and did I mention that they are now the largest producer of natural gas in the US?

Performance measurements:

• $7.5B in asset monetizations in 2nd half 2008 (VPP’s: $500M in for 2008 + $1B - $2B in 2009)
• 2008 production 851 - 861 bcfe
  • Barnett - 675 mmcfe/day by YE 2008
  • Fayetteville - 200 mmcfe/day by YE 2008
  • Haynesville - 75 mmcfe/day by YE 2008
• Hit reserves guidance @ 12-12.5 tcfe by YE 2008 & 13-14 tcfe by 2009 (they have already met 2008 target)
• Maintain 2:1 ratio on risked/unproved to proved reserves. Large decline may signal end of growth. This ratio is currently closer to 4:1.
• Operating costs (per mcfe):
  • G&A: $0.43 - 0.49
  • DD&A: $2.50 - $2.70
  • DD&A (non-oil/gas): $0.20 - $0.24
  • interest expense: $0.50 - $0.55