Chesapeake Energy (NYSE:CHK) is building a monopoly. That’s how one investor long CHK stock recently described the Oklahoma oil and gas exploration and production company.
The rationale behind the argument is that Chesapeake is undergoing a massive transformation under CEO Doug Lawler that sees it operating in five of the country’s primary energy basins in Pennsylvania, Texas, Oklahoma, Louisiana, and South Dakota.
Proof of that, the author suggests, is Chesapeake Energy’s nearly $4 billion acquisition of WildHorse Resource Development (NYSE:WRD), which gives WildHorse shareholders either 5.989 shares of CHK stock per WildHorse share or 5.336 shares and $3 cash. The offer includes the assumption of $930 million in debt.
Most important, it significantly dilutes Chesapeake shareholders, which isn’t a good thing when you consider Chesapeake Energy stock has gone sideways for the past 30 months.
However, William Koldus, the person behind KCI Research Ltd., sees the WildHorse deal giving Chesapeake enormous scale in Texas’ Eagle Ford basin. Pre-WildHorse, Koldus reminded readers, Eagle Ford is expected to generate positive free cash flow of $560 million in 2018.
“Post-deal, Chesapeake will be the largest net acreage holder in the Eagle Ford, which is arguably the second most important shale basin in the United States, though the Bakken basin has marginally overtaken the Eagle Ford in recent oil production,” Koldus wrote October 31.
The net effect, Koldus argues, is that Chesapeake gains synergies in the basin while providing additional growth for the company.
The Deal Makes Chesapeake Stronger
The company made several arguments when announcing the acquisition:
1. It increases the company’s oil production from 19% overall (81% natural gas) to 30% overall. With oil prices rising and natural gas prices declining, it’s a move in the right direction.
2. The deal increases its profitability by adding 420,000 high margin acres that will see Chesapeake’s EBITDA margins per barrel of oil equivalent (Boe) increase 15 percentage points to 50% by 2020.
3. The deal will generate as much as $280 million in annual cost savings. By 2023, those savings are projected to add up to as much as $1.5 billion on a cumulative basis.
4. The acquisition delivers higher profitability for the company which enables it to reduce its debt levels to 2.8 times EBITDA by 2020 from 4.2 times today.
That’s all very exciting.
Free Cash Flow Neutral
Doug Lawler has been calling for free cash flow neutrality for some time. In March 2017, InvestorPlace’s Ian Bezek commented that Chesapeake Energy felt it could be free cash flow neutral by 2018.
Lawler, in the past, has also said free cash flow neutrality was possible with $50 oil and $3 natural gas.
Now, as Lawler stated in the analyst conference call regarding the WildHorse purchase, it’s likely to happen in 2020, in large part because of its latest acquisition.
So, without the acquisition, shareholders would have been looking at 2021 for free cash flow neutrality, which tells me that this goal is a rapidly moving target and that it’s possible free cash flow neutrality might not happen in 2020, despite the CEO’s best guess.
The Smart Move on CHK Stock
According to Finviz.com, 18 stocks are trading on NASDAQ or NYSE with a market cap greater than $2 billion and a share price of less than $4.
I wouldn’t own any of them. Chesapeake included.
What I would do, if you must own CHK, is buy the Invesco WilderHill Progressive Energy ETF (NYSEARCA:PUW), which tracks the WilderHill Progressive Energy Index, a collection of 40 stocks dedicated to improving the use of fossil fuels and nuclear energy.
It isn’t cheap at 0.70%, but it does give you Chesapeake, which has a 2.4% weighting, and a lot of other exciting companies to play the energy game.
It’s possible that CHK stock might be on the precipice of greatness.
However, with $10.3 billion in long-term debt (3.1 times market cap) after the WildHorse acquisition is completed, I wouldn’t touch its potential with a ten-foot pole.
As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.