What Is The Upside In Chesapeake?
Three weeks ago, when the hit campaign on Chesapeake was in full swing, we made a simple prediction: hate the company for whatever reasons but not because of the balance sheet. We explained that "under ZIRP, when every basis point of debt return over 0% is praised, and an epic scramble ensues among hedge for any yielding paper no matter how worthless, the balance sheets of companies just do not matter. In other words, for companies that have massive leverage, high interest rates, negative cash flow, which all were corporate death knells as recently as 2008, the capitalization structure is completely irrelevant." Alternatively, some other, far bigger, company with a pristine balance sheet and lower quality assets could swoop in and do a full management purge, removing the Mclendon overhang, firing the disgraced Board and commingling liabilities while boosting the quality of its assets. Think the TBTF putches from September 2008. Because at the end of the day, it is all about the quality of the assets. And the reality is that CHK has some quality assets, which, however, are burdened by many legacy issues. There is of course the issue of near all time record gas prices. But there in lies the rub: the prices are already at near all time lows. They could continue sliding, or in a world in which hard assets (and even gaseous) are becoming more and more precious by the day, they could go up. In which case CHK would be a very interesting bet. Needless to say, two weeks after our preliminary CHK assessment, Carl Icahn put his money, or rather $775 million of it to be precise, to essentially confirm what we had said previously.
Which brings us to the next question: is CHK really worth more? Well, in keeping with the tradition of keeping it simple, we have decided to present one delightfully simple chart from Bloomberg, which shows where the biggest downside in the stock comes from - it's well-known leverage - as well as where the upside is hiding - its asset base - which has the lowest valuation of its peers.
Chesapeake’s equity and net debt are valued at $9.19 for each barrel of oil equivalent, the lowest among U.S. oil and gas explorers with market capitalizations greater than $5 billion, according to data compiled by Bloomberg. While a stock purchase by Carl Icahn helped the $11 billion company’s shares rebound in the past week, Chesapeake is still down 27 percent in 2012 amid investigations into Chief Executive Officer Aubrey McClendon’s personal loans backed by stakes in company wells.
Obviously, a crappy management team and good assets are very easily parted, as Dan Loeb and YHOO demonstrated two short weeks ago. There are of course other concerns:
The second-largest U.S. natural-gas producer said it may face a cash shortfall as early as next year after prices for natural gas, which accounts for 83 percent of its reserves, reached a 10-year low last month. While a buyer would have to cope with seven joint ventures and $13.1 billion of debt, Exxon Mobil Corp. and Chevron Corp. may see a chance to scoop up the largest holder of onshore drilling leases before gas prices rebound, said SunTrust Robinson Humphrey Inc. Royal Dutch Shell Plc may also be interested, said Huntington Asset Advisors Inc.
So yes, debt is the biggest concern, which simply means that the proper strategy for a firm like CHK is to have it treated like a sub-TBTF bank: roll it up into another bigger entity, with the capacity to absorb its liabilities, but use its assets to generate growth over the blended cost of capital.
And as it turns out, there are quite a few willing, and capable potential suitors, especially now that an activist is in play, one whose blended entry point in CHK is $15.70 as ZH calculated last week.
A purchase of Chesapeake, which holds reserves vast enough to satisfy more than three years of U.S. household demand, may be a bet on higher gas prices. Gas prices have rallied 28 percent since the low point on April 19. The commodity is still about 85 percent below its 2005 peak.
Natural gas for June delivery closed at $2.429 a million British thermal units yesterday in New York. Commodity traders don’t expect gas to reach $3.50 a million British thermal units until November 2013 and $4 until December 2014, based on New York Mercantile Exchange contracts.
Exxon and Chevron “desperately need” to boost production and may look to acquire Chesapeake, said SunTrust’s Dingmann. Each has about $19 billion in cash and short-term investments. Phil Adams, a debt analyst at Gimme Credit LLC, said Exxon tops his list of likely acquirers because it’s the largest potential suitor and has the highest corporate credit ratings. Chevron is also capable of paying cash without damaging its rating, he said.
Shell may also be interested in buying Chesapeake to reduce its exposure to regions with higher political risks, said Huntington’s Sorrentino.
“We have more than 40 trillion cubic feet of gas in the U.S. and Canada and we bought that quite efficiently, so we have plenty on our plate,” Shell CEO Peter Voser said yesterday when asked if his company is interested in buying all or part of Chesapeake.
In other words, Shell is in the market for nat gas.
As for the price that CHK could go for?
Sorrentino said a buyer could pay about $20 a share, while SunTrust’s Dingmann estimates Chesapeake could fetch a takeover price in the “mid to high $20” range, or as much as a 77 percent premium to the closing price of $16.35 yesterday. The stock reached a record of $69.40 in 2008 and closed as high as $35.61 last year.
Will CHK sell for $20, or more, or less? Who knows - it is very much reliant on the price of nat gas, which is also reliant on market liquidity, on natgas supply and demand patterns, on what the Chinese want to do (in addition to begin importing US gas in a few years tops), what happens with the CEO, and finally what Icahn decides to do.
But one thing is certain: the company has lots of good assets, as well as quite a few legacy liabilities, combined with an industry environment that is as bad as it has ever been. And sure enough, in betting that the environment might actually improve for a change, there are quite a few big firms which may be happy to onboard the assets and the liabilities, knowing they wouldn't impair the right side of their balance sheet, while acquiring some good real estate and substantial reserves on the left, at a valuation that is the cheapest in the industry.
Because in finance, once central planning is (finally) stripped away, valuation is all that matters.