Jason Zweig writes about natural gas this weekend, arguing that value investors should be interested. The price of the commodity is 80% less than it was 4 years ago. Drilling technology has allowed companies to access much more of the stuff than ever before (which increases supply and makes it unattractive), but we also may start using more. Gas is cleaner burning than coal, which is primarily what utilities use now. Boone Pickens, of course, hopes vechicles will eventually move over to gas from crude oil-based fuels. Capitalism, eventually, should recognize the cheap price of the commodity, and begin to use it instead of expensive oil. (So far, of course, it hasn’t.)
As Zweig reminds us, Jeremy Grantham has written recently that “everyone who has a brain should be thinking of how to make money on this in the longer term.”
Zweig cites analysts advocating Range Resources, EnCana, and Chesapeake. This last one has been in the news lately for the shady dealings of its CEO Aubrey McClendon, who owns interests in the firm’s wells, and has borrowed prodigiously now and in the past – even from an ex-board member, as has just been revealed – to maintain those interests.
This is what Zweig says about Chesapeake:
A tattered stock in a battered industry, Chesapeake recently traded at three-quarters of book value and less than four times cash flow, according to Standard & Poor’s. The company has extensive holdings in gas-rich shale, analysts say. Chesapeake has lots of debt and not much cash. It’s an extra-risky bet that natural gas will rebound sooner rather than later.
We thought we’d do a 10-minute test on Chesapeake’s most recent annual report to see how it looks. Chesapeake is the nation’s second-largest natural gas producer.
First, the balance sheet shows nearly $42 billion in total assets (nearly $70 billion if one adds back depreciation). The firm has almost no cash; all the assets are in wells and property. Against these assets, the firm has $24 billion in liabilities ($11 billion in long-term debt or $17 billion in total long-term liabilities). It also has $3 billion in preferred stock outstanding. On the surface, that seems like a fair amount of debt.
The income statement shows that the firm has produced just under $3 billion in operating income for the past two years and a loss of $9 billion in 2009. It seems odd that the firm’s interest payments have been only $44 billion, $19 billion, and $113 billion for the past 3 years. Given all the debt the firm is carrying, that seems like an improbably low interest payment. How can a company with $11 billion in debt pay signifiantly less than $100 million in interest on the debt? There are, howevever, heftier “losses on purchases or exchanges of debt” — $176 billion, $129 billion, and $40 billion, but still not enough to make complete sense.
In any case, the company turned in stated profits of $2.32 and $2.51 per diluted share for 2011 and 2010. In 2009, the company posted a loss of $9.57 per share.
Chesapeake is paying more than 10% of its stated earnings as a dividend — $0.30 per share in 2010 and $0.3375 in 2011. Althought that’s not a large dividend payout, it’s interesting that a company viewed to be having such troubles increased its dividend in 2011. Either it isn’t having trouble, or it’s trying to hide the fact that it is.
Things get really interesting on the cash flow statement, where the firm adds back between $1.6 billion and $1.9 billion in depreciation, amortization, and depletion to net income over the past three years. The firm also adds back a $1.1 billion defered income tax expense for the past two years, though it subtraced a $3.5 billion benefit in 2009. The firm also added back a whopping $11 billion property impairment charge in 2009. Derivatives trading added between $500 million and $800 million for the past 3 years.
Overall, the firm reported operating cash flow of $5.9 billion, $5.1 billion, and $4.4 billion for the past 3 years.
The capital expenditures of Chesapeake constitute perhaps the most interesting part of the firm’s financial statements. Over the past three years, in total, the firm has made capital expenditures well in excess of its operating cash flow. Capital expenditures were $5.8 billion, $8.5 billion, and $5.4 billion for the past three years, respectively. (Only in 2011 did the firm achieve slightly more in operating cash flow than its capex charge.) The cash flow statement shows both acquisitions and dispositions of property which shouldn’t be considered part of maintenance capex, but the largest line item each of the past three years is for “drilling and completion costs on uproved and unproved properties.” This charge alone was more than operating cash flow for the past two years.
So, in addition to its seemingly impossibly low interest payments on its debt, it appears that Chesapeake isn’t making money or generating positive cash flow despite what its income statement indicates. The firm appears Free Cash Flow negative.
To complicate matters, the firm is also IPOing its oilfield services division.
This is an awfully difficult situation. Chesapeake’s IPO of its oilfield services dividsion is viewed in some quarters as a desperate attempt to raise cash, the interest payments on its income statement seem unusually low, its cash flow statement reveals massive amounts of capex that make the firm appear Free Cash Flow negative, and its CEO Aubrey McClendon’s financial dealings with the firm and its partners (specifically its lenders) appear less than shareholder-friendly to be charitable. As Zweig says in its favor, however, the stock is trading below book value. We estimate net tangible assets to be around $16 billion, and the stock is trading at around $11 billion currently. If we add the $28 bllion in depreciation, then it’s worth a lot more. This analysis on the Value Investors Club website,, evaluating each of the firm’s shale plays seperately, actually puts the equity value at over $50 billion. However, a more negative one, putting the company’s fair value at $10/share, says the company is only a reasonable investment if gas moves to the $7 range — more than triple where it is now — because of tremendous debt and stock issuance, the likelihood of tripping debt covenants, dormant acerage, and lack of free cash flow generation.
We wouldn’t bet the ranch by any means on Chesapeake without considerably more study, especially on its interest payments and its maintenance capex, but a change in management and some elevation in gas prices could make this a profitable bet.
