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Ride the waves of change - Chesapeake Energy

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March 19, 2008 – Comments (3)

A tidal wave is coming to the US, and Chesapeake Energy will be surfing like a pro! This change I am talking about is the use of natural gas in the US. Many economic experts agree that pollution taxes, or a cap and trade pollution system will become reality in the next few years. I have written in February about my vision of the future of natural gas.

For me to invest in an equity, I like to see two things. The firm is in an industry with positive future dynamics, and the discounted cash flow value of the firm is much higher than the current stock price.

Chesapeake  has both of these points covered. Chesapeake reported another stellar quarter last month, with adjusted EPS from continuing operation of .93, and cash flow of 1.3 billion. EPS was only up 3% from 2006, but the NG prices were 8% higher in 2006. Other highlights from the quarter:

Production increases of 23% year-over-year

Proved reserves increase of 21% year-over-year

Preferred stock redemptions saving 55 million per year.

Reserve replacement rate of 369% 

 

For 2007, Chesapeake's  adjusted  EPS was 3.21.  EPS was down about 11%, but again the natural gas prices were 7% higher in 2006. Cash flow from operations was 4.6 billion, up 15% from 2006.

These adjusted EPS numbers are net of one time charges and Chesapeake's unrealized gains/losses from its hedging program. Chesapeake's GAAP numbers can be complex, but cash flow is not. This is reason # 15 I focus on cash flow analysis, and not GAAP accounting numbers.

The Chesapeake conference call was also positive. Chesapeake stated that it will stay with its plan of managed growth. For 2008, Chesapeake expects the range for natural gas prices to be in the range of 8-10, verses the old range of 6-8. For every .10 cents increase in NG prices, Chesapeake's reserves increase by 400 million.

Looking at longer term growth rates, here are the impressive 3 and 5 year averages:

        
                                      3 yr               5yr

________________________________________________ 

Revenue                         42%               60%

EPS                              20%                70%

Net asset value               60%                65%

Cash flow from Op's        55%                67%

 

Chesapeake current cash flow yield is over 20%. With higher 2008 natural gas prices, and Chesapeake reserve replacement rate over 350%, the stock looks very strong. With clean natural gas becoming a larger part of our electric generation, Chesapeake's cash flows should grow 20% per year over the next 5 years. My current DCF valuation for CHK is now around 70.

 

      

 

 

 

3 Comments – Post Your Own

#1) On March 19, 2008 at 5:34 PM, ricoy5 (26.06) wrote:

Bellard,

can you explain why you are valuing Operating CF only?  I see almost $6.7b of CAPEX in 2007... leaving FCF of ($1.8B)...

While I definately agree with the rest of your summation (and especially reliance on DCF for valuation), do you have info that the large CAPEX will taper off, allowing future FCF to more closely reflect their excellent OCF?

 

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#2) On March 19, 2008 at 9:55 PM, bellard (99.22) wrote:

Ricoy5;

I actually use 5 different metrics of cash flow. I favor cash flow from op's over free cash flow. The reliance on free cash flow as a metric is a mistake imho. Firms with high free cash flow, vs their cash flow from op's(hence little capex), are firms with very little future growth prospects. 

My favorite cash flow metric is maintance free cash flow. This takes some work - listen to the CC, and read the investor presentations. Then you can estimate MFCF - the amount of free cash flow if the firm only had minimum capex to support the current level of operations.

CHK has large capex since it has been purchasing NG assets and gear to drill even more NG per year. This CAPEX becomes future depr. - so even more cash flow in the future. Look at the return on invested capital to see how much this capex will increase future earnings and cash flow.My research suggest CHK could reduce capex to about 1B - so MFCF would be 3.6B - a 15% current yield...

I have been critical on CHK in the past for too much capex - and debt. CHK has adopted a balanced growth plan - no new large debt, or stock floats...So now I feel more comfortable about CHK future.

In summary - don't fall into the value trap of low PE's or high free cash flow...... 

  

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#3) On March 20, 2008 at 2:34 PM, ricoy5 (26.06) wrote:

Bellard,

I have indeed noticed the corelation between excellent growth expectations and low FCF.   

I have begun putting together an integrated (7-10 different valuation metrics) and had been puzzeling whether my FCF valuations were "fair" to non-safety play.

I will perhaps translate my projections onto OpCF for a test (or just to have a counterballance to FCF.  I see exactly what you mean about the "maintenance CAPEX" when looking at their StmtCF... I think a manual adjustment will be necessary to determine MFCF... but it will likely be worth the efforts.

 Thanks again...

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