If you are going to invest in a natural gas company, I doubt you can do any better than shares of Chesapeake Energy (CHK). CHK has everything investors should want; a great management team, a low valuation, and strong business fundamentals.
The company did little to sway my opinion after reporting first quarter earnings last week. Net income excluding one-time items came in at $1.07 per share, well ahead of expectations. The conference call was equally impressive, but you wouldn't really know it from the share price. After jumping about 4% after the numbers came out, the stock has barely budged.
I want to point out a few things that I think investors are missing when it comes to analyzing Chesapeake. As is the case with many commodity-related companies, the day-to-day movements of the stock tends to track commodity prices (in this case, natural gas) and not company-specific fundamentals. Of course, the prices energy companies get for their production is a key component of how their financial results will turn out, but focusing simply on daily fluctuations in natural gas prices, and trading CHK shares based on that, is very misguided for long term investors (yes, it does make sense for day traders since we know that is how the stock has been trading lately).
What is interesting about Chesapeake is that they are actively engaged in a natural gas production hedging program that seeks to lock in prices for their gas well into the future, in order to ensure that they can earn returns on capital that are acceptable for shareholders. Amazingly, CHK has hedged 80% of their 2006 natural gas production at $9.45 per mmbtu. Why is this amazing? The current natural gas price is about $6.65, so CHK is getting 40% more for their gas than their competitors who have not hedged. As a result, it doesn't take a rocket scientist to figure out that not ALL natural gas stocks should track natural gas prices.
Let's take this silliness one step further. For some reason (which I cannot explain in a way that makes logical sense) Wall Street analysts exclude any gains from CHK's hedging program in their quarterly earnings estimates. The company's first quarter numbers were reported as $1.07 versus estimates of $0.98 per share. Estimates for 2006 are around $3.40 per share, putting Chesapeake's P/E under 10. But the hedges aren't even factored into these numbers!
Chesapeake made $122 million in Q1 from their hedges, which comes out to $0.29 per share. In reality, the company reported $1.36 in earnings, not the $1.07 that was reported by the press and analysts. Since this is real money that the company is generating, I can't ignore it when valuing the company. After all, investors haven't ignored the hedging program at Southwest Airlines (LUV), which is a big reason they have performed so well even with $70 oil.
Including adjustments for hedging gains, CHK could earn north of $4.50 this year (annualized Q1 hedging), which puts its adjusted P/E at around 7 rather than 10. Yup, that's right, the stock appears cheap and is actually even cheaper!