Summary
Chesapeake Energy Corporation was incorporated in 1989 and trades at the New York Stock Exchange under the Ticker Symbol (CHK) (Bloomberg). The company operates in the oil and gas industry. The company share price has declined form a 52-week high of $16.98 to a 52-week low of $1.50. As at April 4th, the share closed at $3.86. Over the past 1 year investors have lost 74.46% of their wealth. The share performance is 75.40% lower than the market return (S&P Index). The share price is likely to experience further declines and therefore recommend investors to sell of the company shares.
Source: Bloomberg
Company Review
In the Fiscal year ending December 31, 2015, CHK reported a net loss of $14,856 million down from a net income of $1,273 million in 2014 (Yahoo! Finance). Revenues fell by 44.80% from $23,125 million in 2014 to $12,764 million in 2013. Other than the low oil prices huge debt is another factor that make the stock unattractive. The company debt level has rose from 44.8% in 2012, to 83.4% as at December 31, 2015.
Source: Morning star
Energy Information and Administration (EIA) expects crude oil prices to average $37.52/bbl in 2016, much lower than the initial projection of $40.15/bbl. The drop in crude oil prices is largely driven by a surge in global oil inventories that are forecast to increase by an average of one million b/d in 2016 (Oil and Gas Journal). The lower crude oil prices are expected to reduce the cash flows of oil and gas companies in 2016 and 2017.
Low crude oil prices are expected to persist over the next couple of years despite the declining prices due to the heavy investments that were made when oil prices were higher. However, by 2020, global demand will have increased causing the oil prices to a projected $79/bbl (Amadeo). Interest rates are expected to increase as the Fed raises the Fed Funds rate through 2016 (Amadeo). The possibility of tighter credit and higher interest rates are likely to limit the amount of capital available to many smaller producers triggering distressed sale of assets and consolidation of acreage holding by firms with financial resources (Oil and Gas Journal).The U.S. economy is forecast to grow at 2.2% in 2016, slightly higher than the 2015 growth rate of 2.1%
Valuation
The valuation used five models to project the company share price 12 months from now. The analyst consensus model predicted the share price 12 months from today would be $4.42. The ratio valuation model estimates the 12-month forward PE to be 10.47 and the 12-month EPS to be $0.44 and thus the 12 month price is projected to be $4.61. The CAPM model requires the estimation of the risk free rate, the beta factor and the market premium in order to calculate the return required and project the share price at the end of the 12 months. The risk free rate was assumed to be equivalent to the 10-year Treasury bond with a yield of 3.5%, the beta factor was drawn from yahoo finance, and the S&P 500 projected return was taken to be the market return. CAPM estimated the required rate of return on the company’s share price to be 4.2%.
Assuming no dividends, the model projected the share price to increase from $4.39 to $4.57 at the end of 12 months.
The Company has had constant dividends over the last five years of $0.35 per year. Assuming the company will retain a constant dividend of $0.35 over the next ten years the estimated share price would be.
$4.39 +$0.35/(1.042) = $4.
The free cash flows valuation model assumes that the FCF per share by the end of 2016 will be $0.6. The growth between 2016 -2020 is expected to be 4.6% after which it will slow down to a constant growth of 1%. The market risk premium is assumed to be 3.7308% and the stock beta is 3.5. The model estimates the value of the share to be $4.34.
The different valuation models gave different prices at the end of 12 months ranging from $4.34 for the FCF and $4.73 for the DDM. To average price of the five models estimates the share to be worth $4.52. The average is a more reliable estimate of the price because it avoids bias that may be present in any one method.
Sensitivity
The FCF valuation model is sensitive to changes in growth rates, for instance, if the growth rates are assumed to increase by 1%, the intrinsic value of the share would change by 7.3% from $4.33 to $4.65. Dividend valuation model is particularly sensitive to the dividend policy the company will pursue. A change in the dividend policy will cause a change in the estimated share price.
The PE ratio model is sensitive to the earnings and the PE multiple used. A change in any of the two variables will cause a change in the price estimate. CAPM model is sensitive to a change in any of the three factors, a change in the interest rate, a change in the company’s systematic risk (beta factor), or a change in the market rate of return.
Conclusion and Recommendation
The company is facing declining revenues in the wake of falling crude oil prices. It is unlikely that the company will be able to return to profitability unless there is a sustainable rise in the global oil prices. The company has extremely high levels of debt with debt accounting for over 83% of its capital structure and has a negative equity of -7.2%. With the expectation that interest rates are going to increase the company will have limited amounts of capital. The company is likely to face higher financing costs that are likely to push the company into more losses.
The price forecasted of $4.52 is highly sensitive considering that in the last twelve months the share has fallen from a high of $16.98 to a low of $1.50. The company’s prospect looks poor and I would recommend a sell on this shares. Some may view the current decline in prices as an opportunity to buy the share at a bargain or to average the price, but such a move would be a highly speculative bet. I therefore strongly recommend a sell of the company shares.
Work cited
Amadeo, Kimberly. "What Will the Economy Do in 2016?". Amadeo News & Issues, 2016.
Online. Internet. 4 Apr. 2016. . Available: http://useconomy.Amadeo/od/criticalssues/a/US-Economic-Outlook.htm.
Bloomberg,. "CHK:New York Stock Quote - Chesapeake Energy Corp". Bloomberg.com, 2016.
Online. Internet. 4 Apr. 2016. . Available: http://www.bloomberg.com/quote/CHK:US.
Morning Star,. "CHK Chesapeake Energy Corp debt, bond, rates, credit - Morningstar".
Quicktake.morningstar.com, 2016. Online. Internet. 4 Apr. 2016. . Available: http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=chk.
Oil & Gas Journal,. "EIA forecasts lower oil prices, higher inventories in 2016". Ogj.com, 2016.
Online. Internet. 4 Apr. 2016. . Available: http://www.ogj.com/articles/2016/02/eia-forecasts-lower-oil-prices-higher-inventories-in-2016.html.
