CHK article
"Chesapeake: The Cheapest Stock Around?
Page: 1, 2
individualinvestor.com
Research Analyst: Bob Hirschfeld (6/1/00)
There's at least one corner of this mercurial market where the bulls have huddled. It's called natural gas.
Current natural gas inventories are tight, a situation that reflects low storage levels, strong electricity demand, and limited supplies at the production level. And that situation appears likely to continue, at least for the short term.
Long-term demand for natural gas is being driven by consumer demand for electricity, which is increasingly served by natural gas generators. In the shorter term, natural gas inventories are being depleted more rapidly than most analysts had previously forecast, and "injection," or replacement levels remain very low.
The results are clear. Through May 30, natural gas inventories stood at about 1.2 billion cubic feet (bcf), which is 25% less than one year ago. Last week, even though U.S. stockpiles rose -- they were up 53 bcf - the increase was far less than last year's rise of 73 bcf.
Current prices reflect this bullish backdrop. On Wednesday, the Gulf Coast spot natural gas price closed at $4.36 per million BTUs (mbt), which is well above the $2 mbt range from a year ago.
Given this bullish backdrop, analysts are increasingly enthusiastic about natural gas specialists. One company that seems especially attractive is Chesapeake Energy (NYSE: CHK - Quotes, News, Boards) , which has about an 85% exposure to natural gas production.
Tom Price, Chesapeake's senior vice president of Corporate Development, confirmed the bullish industry fundamentals. "You've got about 1.27 tcf (trillion cubic feet) in storage, according to the American Gas Association, versus the 3.0 tcf or so the utilities would like to have. That is way short. Going into the peak summer demand season, this is shaping up to be a situation we haven't seen since deregulation began, during the 1970s," he adds.
Stephen Smith, an analyst at Dain Rauscher Wessels who follows Chesapeake, is raising his earnings per share (EPS) and cash flow estimates for this year and 2001. The reason? Surging natural gas prices are forcing a change in the "average gas price" component of his Chesapeake earnings model.
According to Smith, one caution about Chesapeake is the company's "very aggressive debt profile." The debt/equity measure is unreliable, Smith believes, since the company's equity measure is "unreliable." Chesapeake currently carries a negative book value on its balance sheet.
The preferred metric, says Smith, is debt-to-cash low, and by that standard Chesapeake measures about 4.5-5 times. That is on the high end of the range of exploration and production (E&P) companies that Smith covers, "but not run for cover high," he notes.
According to R. Lewis Ropp of Frost Securities, Chesapeake's high interest expense is somewhat counterbalanced by it's low operating costs; the net is that Chesapeake is "an outstanding operator with low all-in costs."
Smith believes that for investors who have an absolute certainty about higher prices for natural gas, Chesapeake is a great selection. "Were prices to drop to $2.50 mbt, Chesapeake shares would still be worth $5-$6 at fair value. Assuming a $3 mbt, you get fair value in the $7-$8 range. And, at $4 mbt, which is where we are now, fair value is in the double-digit region," he says.
One of Chesapeake's distinguishing features is its large percentage of natural gas reserves in Oklahoma, where the typical gas profile is more dispersed than in the more compacted drilling areas of the Gulf of Mexico.
The difference, Smith points out, means that Chesapeake's reserves profile are longer-lived, at 10 years, than that of most Gulf producers, which is five years. Geologically, this difference has to do with "how quickly the rocks give up their gas," Smith says.
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Chesapeake's longer production profile means that its replacement schedule is not as demanding as that of many other E&P companies, and with other things being equal, "Chesapeake doesn't have to run as fast to stay in place," Smith says.
"Can they grow their business with $3 gas?" Smith asks. "That depends on finding costs. Chesapeake's finding costs are less than $0.80 per 1000 bcf, which is better than average for their mid-Continent (Oklahoma) region," the analyst says. "That $0.80 compares with an average cost of $1.15 for Gulf of Mexico producers, but that's for a region offering faster production profiles."
Chesapeake also offers an extremely high exposure to natural gas prices. Each $0.10 jump in the mbt price of natural gas produces a $0.11 boost in Chesapeake's cash flow, according to Ropp of Frost Securities.
Chesapeake's Price notes that the company has been hedging part of its output based on the futures prices and had, for example, hedged one-third of July production at a price of $3.11. Asked if more would be hedged, Price says, "Frankly, we're not sure we've seen the apex on these prices."
To measure overall efficiency, Smith notes, finding costs must be measured against cash flows, and Chesapeake ranks in the top quartile among the E&P companies that share a similar regional focus. "They are good," Smith says.
Valuation? Assuming a natural gas price of $3 per mbt, which is a conservative assumption given that gas now trades above $4 per mbt, Chesapeake's current year cash flows are in the $1.60-$1.85 per share range. That means shares are trading under 3 times cash flow, which is inexpensive when compared to an industry average of 5.5 times.
However, Price says analysts' estimates of a $1.60-$1.85 range for year 2000 cash flows, are "very conservative" forecasts. According to Price, "If prices stay north of $4, a more reasonable forecast would be for $1.10 in EPS and $2 in cash flows."
On Smith's forecasts, Chesapeake's 2000 EPS and cash flow are now at $1.08 and $1.88, respectively, up from an earlier $0.62 and $1.64. Smith's target price is changing as well, and is now "about $8," up from an earlier $6. Shares currently trade about $5.
If natural gas prices remain at $4 per mbt, one hedge fund manager believes that Chesapeake's stock will be worth $20 per share.
Natural gas' price consistency seems likely because tightness in the market isn't in danger of being reversed any time soon. According to Christopher Eades of UBS Warburg, "Until we see sustained mild summer weather (not forecasted) and/or a material and sustained increase in gas drilling activity, we do not expect a retreat in gas prices in the near term," he wrote.
Bottom Line:
Chesapeake's shares are appropriate for those investors who are looking for leveraged participation in the ongoing rally in natural gas prices.
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