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Carl Icahn Bought Chesapeake Energy, Should You?

Last week, it was announced that corporate raider Carl Icahn was up to his usual antics, acquiring a 7.6 percent activist stake in the natural gas E&P giant Chesapeake Energy Corp (NYSE: CHK).  In a move that makes him the company’s third largest shareholder, Icahn bought 50 million shares of CHK worth nearly $800 million between April 19th and May 24th.  Icahn has pledged to make a host of changes within Chesapeake, beginning with his appointment of four new board members.  In the longer term, it is expected that he will look for CHK to shore up its troubled business model, which has led to cash flow shortages, and large declines in shareholder wealth.  Over the past year, the company’s stock has lost nearly 50 percent, having recently hit a post-recession low below $14 a share.  The everyday investor may be wise to consider following Icahn into Chesapeake now, due to stock’s undervaluation, strong earnings growth, and future expansion potential.

Hedge Fund Strategies

One thing that sets this E&P operator – which stands for exploration and production – apart from its competitors is its dominance in the unconventional natural gas arena.  In layman’s terms, unconventional natural gas is not extracted from traditional well-based platforms; instead, it is gathered in a less economical manner.  In CHK’s case, it extracts natural gas from six distinct sources: (1) gas below 15,000 feet underground, (2) gas trapped in sandstone or limestone, (3) shale deposits, (4) coalbed methane, (5) geopressurized gas, and (6) methane hydrates.  The latter is the newest form of natural gas in Chesapeake’s energy staple.  From a macroeconomic standpoint, unconventional natural gas usage has nearly doubled in the past decade, and currently comprises 42 percent of all natural gas production in the U.S.  It is estimated that this figure will reach 64 percent by 2020, driven by growth in the shale and coalbed markets.

Looking at its income statement, CHK has seen revenues remain stagnant since the recession, though the industry’s average has actually shrank during this time period, as it has yielded a 3-year average growth rate of -2.8 percent.  More notably, competitors like Devon Energy (NYSE: DVN) at -6.2 percent, Anadarko Petroleum (NYSE: APC) at -2.7 percent have also experienced shrinking revenues, though EOG Resources (NYSE: EOG) and Apache Corp (NYSE: APA) have seen positive top line growth.  From an earnings standpoint, CHK has been more impressive, generating a 3-year average EPS growth of 35.6 percent, higher than the industry average (-5.4%) and peers DVN, APC, and EOG.

From a valuation standpoint, CHK is undervalued, as it currently sports a P/E ratio (6.4X) below the industry average (16.3X), and it’s own 10-year historical average (13.5X).  Moreover, shares of CHK have historically traded at a 20 percent discount relative to the S&P’s average over the past decade.  This year, the stock is cheaper than usual, trading at a 58 percent discount.  Using the industry average P/E in conjunction with a modest year-ahead EPS forecast of $1.80, we can set a target price of $29.34 by next spring.

It should also be pointed out that Chesapeake has had a host of cash flow problems, reporting negative free cash flows of at least -$3.0 billion since 2007.  Interestingly, the company reported recently that it was expecting a positive FCF in 2012, due to sales of assets in its Mississippi Lime, Permian Basin, and Texas Panhandle Granite Wash regions.  Icahn and other CHK shareholders are hoping that these sales can offset historic lows in natural gas prices, and it seems that the markets are responding favorably.  Since company execs announced these plans on May 14th, shares of CHK have risen nearly 2 percent.

Looking to the hedge fund industry, CHK has a favorite of mega-fund managers like Mason Hawkins, Curtis Macnguyen, John Rogers, and Peter Eichler over the past few years.  Moreover, this month’s 13F filings show that funds like Millennium Management, Tetrem Capital Management, and Samlyn Capital increased their holdings in CHK in the first quarter of 2012.  Whether its Carl Icahn’s promise to restore shareholder value back to this natural gas E&P, or the stock’s attractive valuation, investors may be wise to consider a long position in Chesapeake (CHK).

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