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Chesapeake's 'Profligate' Spending, Accounting Scrutinized

Shale giant Chesapeake Energy Corp. "has one of the industry's best collections of natural gas assets," but "continuing concerns about the company's profligate spending" and accounting methods led veteran analyst Philip H. Weiss of Argus Research to trim his recommendation to "sell" last week.

In a lengthy report, Weiss took on Chesapeake's "spending/earnings quality issues," noting the Oklahoma City-based driller has spent $3.7 billion to acquire gas and oil assets through the first nine months of this year. Since June 30 Chesapeake has agreed to spend "in excess of $1 billion more."

In November Chesapeake made two shale transactions that alone total more than $1 billion. CEO Aubrey McClendon confirmed that his company would pay $850 million to acquire 500,000 net acres in the Appalachian Basin from Anschutz Corp. (see Shale Daily, Nov. 5; Oct. 8). The company also agreed to pay $200 million cash for more acreage in the Eagle Ford Shale (see Shale Daily Nov. 30a).

"Although we believe that Chesapeake Energy has one of the industry's best collections of natural gas assets, we are lowering our rating to 'sell' due to our continuing concerns about the company's profligate spending and its impact on the balance sheet, as well as our worries about its earnings quality," said Weiss. "We might think differently if we saw signs that spending would slow and that management was truly interested in deleveraging the balance sheet. However, spending continues unabated..."

Other energy analysts discounted the Argus report and said they continue to believe Chesapeake remains well positioned to benefit from its extensive deal-making. One pointed to the $2 billion joint venture with China's CNOOC Ltd. (China National Offshore Oil Corp.), in which Chesapeake parted with one-third of its stake in the Eagle Ford Shale (see Shale Daily, Oct. 12).

Zacks Investment Research analysts are maintaining a "neutral" recommendation based on the company's "strong" 3Q2010 results and "several potential" shale transactions to raise funds for development activities.

"We believe these initiatives position the company to deliver industry-leading finding and development costs and returns on capital," said Zacks. However, Chesapeake's "further acreage accumulation is a cause of our concern and it remains to be seen how the company aligns its newly acquired assets with the existing holdings. Moreover, we believe improvement in its underlying valuation via liquid initiatives is a time-taking matter."

Toby Shute, who covers the energy industry for Motley Fool, had another viewpoint. "What I find, is that the company tends to acquire vast swaths of undeveloped land on the cheap, and farm it out to international partners with deep pockets...at multiples of that acquisition price."

The latest transaction in the Eagle Ford Shale, said Shute, should not "shock" the company's shareholders, even though it paid "considerably more" than Marathon Oil Co. did for a similar purchase in the play (see Shale Daily, Nov. 30b).

"If this were a major purchase, I would be more concerned about Chesapeake overpaying," wrote Shute. "As long as the company saves its higher-priced acquisitions for small 'tuck-ins'...and keeps debt levels at around 40% of total capital or lower, the business model doesn't bother me."

On Thursday Jim Cramer of CNBC's Mad Money said Chesapeake was "just too cheap," after the stock closed the day at $21.63/share. He invited McClendon to come on his television show to explain why the company wasn't trading higher with the set of assets it has in its portfolio.

Weiss might have some answers for Cramer. The Argus analyst's "pessimistic near-term view" is a reflection of "growing concerns" about the producer's earnings quality based on a review of financial statement footnotes over a period of time "and its frequent use of complex financial products, as well as our desire to see management cut back on spending.

"Our rating also reflects our belief that the company's accounting policies and heavy use of off balance-sheet leverage add unnecessary complexity and obscure true financial performance."

Two years ago Chesapeake announced that it would issue stock to raise nearly $1.8 billion to finance its U.S. activities, and shortly thereafter management said the company would remain cash neutral through 2010 to weather the economic storm (see Daily GPI, Dec. 9, 2008; Dec. 2, 2008). Two months before that McClendon had been forced to involuntarily sell "substantially all" of his shares in Chesapeake to meet margin loan calls (see Daily GPI, Oct. 13, 2008).

Concerns also have been raised about Chesapeake's "tendency to change its focus more frequently than other companies in our coverage group," said Weiss. And, Chesapeake's accounting "is less than transparent, as the company regularly enters into joint ventures that engage in off balance sheet financing, including sale-leaseback transactions and volumetric production payments to generate cash without increasing balance sheet debt."

The company, now one of the largest domestic gas producers, quickly has shifted to liquids-rich production, and McClendon has stated a desire for Chesapeake to become one of the largest domestic oil producers (see Daily GPI, Aug. 4; June 11).

Argus analysts would "like to see management rein in its seemingly insatiable desire for assets," Weiss wrote. "We believe it would be better for the company to simply manage its current asset base and slow down growth activity, especially while natural gas prices are relatively low.

Chesapeake, Weiss said, "has by far the weakest balance sheet of any energy company in our coverage group, which increases risk, particularly if the economic recovery falters."

The company uses the full-cost accounting method, which Weiss said makes it difficult to compare to peer company metrics. Chesapeake also uses "long-dated call options on oil and natural gas in order to generate greater premiums for its near-term hedges. In short, while the company maintains that it has ample liquidity, its actions suggest that it needs more cash than its operations generate." Argus analysts also take issue with the company's method of calculating finding costs, calling the results "somewhat superficial."

Chesapeake's Jeff Mobley, senior vice president of investor relations, responded to the Argus report late Thursday.

"We have read Mr. Weiss' report, which is basically a repeat of a report he wrote in October," Mobley told NGI's Shale Daily. "As a matter of corporate policy, we do not comment on analysts' reports and so all we will say here is that we do not agree with the comments and implications of the report.

"We would direct you to the investor slide deck on our website, our conference call transcripts on our website and public filings with the [Securities and Exchange Commission], which we believe address any issues raised by Mr. Weiss."

Chesapeake's board has continued to back its CEO. In late 2008 McClendon, who founded the company, was awarded a five-year employment contract that included a one-time $75 million bonus for the leadership role played in negotiating joint ventures in the Haynesville, Woodford, Fayetteville and Marcellus shales (see Daily GPI, June 15, 2009; April 28, 2009; Jan. 9, 2009).

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