Point/Counterpoint: Will An Attractive Valuation Offset Chesapeake’s Worrying Debt Load in Investor Eyes?
Chesapeake Energy is in the hot seat these days, and not just because natural gas prices are languishing at remarkably low levels. And that is why this is the company we have chosen to launch a new feature, Point/Counterpoint, in which AlphaNow will introduce two sides of an argument over the future prospects of a company, industry or an issue that is grabbing headlines and generating debate among investors. Just as in a traditional Oxford-style debate, we’ll introduce a question – in this case, does Chesapeake’s attractive valuation help to offset concerns about the company’s debt and the difficulty it might have in selling assets this year? Then we’ll invite you, our readers, to weigh in with your own opinions – to vote on which scenario you think is more compelling and to add your comments to the discussion.
Chesapeake is certainly a company facing plenty of headwinds. It hopes to raise $10 billion by selling some of its assets to pay down a debt load that is so large it prompted Standard & Poor’s to cut its rating on the firm to BB and put it on negative credit watch. Nor, as Reuters Breakingviews points out in this recent article, can Chesapeake count on one of its traditional sources of cash, a master limited partnership in which it has a 50% stake. That’s because of Chesapeake’s other big problem, a governance crisis involving its CEO, Aubrey McClendon that has prompted shareholder lawsuits and now an unofficial SEC investigation. (For an analysis of the governance missteps by both McClendon and Chesapeake’s directors, see this analysis from Breakingviews.) The controversy has already cost McClendon his post as chairman of the company he helped to found.
Is the outlook for Chesapeake Energy really as bleak as it seems, however? Certainly, investors aren’t giving it much benefit of the doubt; its share price has declined steadily since its recent highs last summer, as natural gas prices have retreated and revealed a big funding gap at the company. Even as it has had success in raising capital – a series of deals early last month, including the sale of preferred shares and some productive acreage raised $2.6 billion – that decline turned into a plunge after Reuters News revealed that McClendon had borrowed $1.1 billion against his stake in thousands of natural gas wells drilled by Chesapeake, a transaction not disclosed to the company’s shareholders. Today, Chesapeake’s shares trade at $17.09 a share, less than half their 52-week high and only slightly above their 52-week low. The question today is whether the share price is now low enough, and the company’s core business solid enough, for it to be considered a “value” investment at current prices.
POINT: The conventional wisdom is that Chesapeake is in deep trouble, and at least two key StarMine models suggest that the growing ranks of short-sellers may find their bearishness proved correct. The company scores only 2 out of a possible 100 on the StarMine Analyst Revisions Model (ARM), a proprietary model that overweights the most recent forecasts by the analysts with the best track records for accuracy. The fact that Chesapeake has nearly the lowest possible rank on this model indicates the extent to which those analysts are slashing their estimates of the company’s earnings and revenues, not only for the second quarter and the year, but into 2013. Since our research has shown such revisions are predictive of future such downward revisions – and correlated to future price movements – that’s a bearish signal for Chesapeake.
So, too, is the fact that the company scores only 7 out of a possible 100 on the StarMine Structural Credit Risk model. That model evaluates the stock market’s view of the probability that a given company will either default on its debt obligations or file for bankruptcy in the coming 12 months: the lower the rating, the higher the probability. (The model is a proprietary extension by StarMine of a framework introduced by Nobel laureate, economist Robert Merton, which models a company’s equity as a call option on its assets.) That score suggest that the market is taking a bleak view of Chesapeake’s ability to cope with its hefty debt load.
COUNTERPOINT: But whenever a company’s stock price has been driven sharply down, that decline may have created fresh value. That is what some StarMine models suggest may have happened in Chesapeake’s case. The StarMine Intrinsic Value model gives Chesapeake a score of 84, suggesting that at its current price of just above $17 a share, the stock is undervalued. (The IV model accounts for systematic biases the StarMine research team has identified in sell-side analysts’ forecasts and ranks all companies in a region, relative to each other, based on their intrinsic value.) Using a dividend discount model, StarMine estimates the stock is worth closer to $29.75 a share.
Chesapeake ranks still higher – scoring 86 out of a possible 100 – on the StarMine Relative Value (RV) model, a ranking that again suggests the company may be undervalued relative to its peers. The RV model blends several informative valuation ratios and StarMine’s SmartEstimate scores for the company, overweighting forward estimates, to produce a score that cuts across sectors, industries and regions. Chesapeake scores particularly high – a rank of 96 – on the price/cash flow component of this metric, given that the company current trades at a mere 2.6 times trailing cash flow and 3.6 times forward cash flow. The company earns a rank of 91 on the price/book component of the RV model, since it currently trades at only 0.7 times book value of its assets.
THE VERDICT: That’s up to you, our readers. Our models are sending different signals, with one group highlighting Chesapeake’s valuation and another identifying its credit risk and the probability that its earnings will suffer as the company struggles to address challenges ranging from rock-bottom natural gas prices to corporate governance snafus. Is the stock a value – or a value trap, whose stock will be slow to recovery in the wake of a negative shock and controversy, as commonly occurs? We invite you to weigh in below as to which factors you will believe will be most important in driving Chesapeake’s share price over the coming year. If you’re a bear – if you believe that the company will fail to address its debt, as the credit model suggests – click the button on top marked “bear”. If, on the other hand, you believe that a cyclical upturn in the price of natural gas might help offset some of the company’s fundamental woes, and that its board will move swiftly to address the governance issues, then click the lower button below, the one marked “bull”. Once you’ve done so, you’ll be able to see how others have voted – and then we encourage you to comment below and explain your own conclusions.
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