The Sum Is Greater Than The Parts For Chesapeake And Southwestern Energy (NASDAQ:CHK)

Investment Thesis

Chesapeake Energy Corporation (NASDAQ:CHK) and Southwestern Energy Company (NYSE:SWN) primarily produce natural gas in the Marcellus and Haynesville basins and have announced plans to merge into a single entity. Both companies have strengths and weaknesses on their own, but a combined company may help overcome some of their deficiencies while deepening their advantages. I think Chesapeake represents the better investment between the two standalone companies, but would hope for a successful merger if I were to invest.

Company Overview

Chesapeake Energy was founded in 1989 by Aubrey McClendon and Tom Ward and quickly became a prominent player in the U.S. energy sector as the beginnings of the shale revolution took hold. Led by McClendon, the company embarked on massive debt-fueled expansion in the early 2000s, anticipating a boom in natural gas profits fueled by new shale technologies. Ironically, the boost in the amount of gas that companies could extract from shale formations eventually brought the price of that gas crashing down as supply overwhelmed demand.

McClendon also funded a lavish lifestyle through the company, which eventually led to his departure from the company in 2013. The new CEO, Doug Lawler, stepped in and immediately started selling assets and cutting spending in an attempt to bring down debt. However, the company still had $9 billion in debt when natural gas prices collapsed in 2020 due to the COVID pandemic, which forced them to file for bankruptcy in June of that year.

Bankruptcy wiped out existing shareholders, but a new company has emerged from the process with significantly reduced operating costs and a reduction of $7 billion in long-term debt. Doug Lawler stayed on as CEO through the process before relinquishing the role to Nick Dell’Osso in October 2021. Dell’Osso has been the CFO since 2010, which raises some questions about ongoing financial management that I’ll address later. Most recently, Chesapeake announced the acquisition of Southwestern Energy in an all-stock deal (no debt this time) that they claim will create a better company with assets in both the Marcellus and Haynesville shale.

Southwestern has a less dramatic history and ironically got its start in Appalachian shale with a 2013 acquisition from Chesapeake as the company was shedding assets in an attempt to deleverage. Southwestern runs with very low operating costs compared to its peers but also carries a relatively high level of debt.

Two Gas Giants Combine

The chart below details 2023 production data from Chesapeake and Southwestern along with the comparable figures from some of their peers, including EQT Corporation (EQT), Range Resources Corporation (RRC), Antero Resources Corporation (AR), Coterra Energy Inc. (CTRA) and CNX Resources Corporation (CNX).

Click to enlarge

Chesapeake produced 1,335 Bcfe in 2023, 95% of which was natural gas. Add in 1,669 Bcfe from Southwestern in the planned merger, and the combined companies will produce around 3,000 Bcfe with 90% of production coming from natural gas.

Both companies bring leased acres that are primarily located in the Marcellus and Haynesville shale formations. The geographical location of their operations are shown in images from their websites below.

Click to enlarge

Note that the acreage listed on the Southwestern Asset map, which was sourced from their current website, appears to show assets as of the 2020-2021 timeframe, while the numbers in the table above are 2023 YE figures from each annual report.

Wells in the Marcellus shale have been prolific but are held back by limited midstream takeaway capacity. The drama surrounding the Mountain Valley pipeline illustrates the regulatory and environmental challenges around building new midstream infrastructure, which will likely cap production in the area for the foreseeable future. That does not bode well for those expecting exponential growth out of the Appalachian basin, but I am not too concerned as it almost forces conservative operations upon companies unable to overspend to boost production due to a lack of takeaway capacity.

Haynesville shale gas production is geographically appealing due to its close proximity to LNG export demand, which is expected to grow through the end of the decade. As shown in the chart above, gas production from this basin has grown significantly over the past decade, and growing demand will not be constrained by takeaway capacity as it is in the Marcellus and Utica.

Operating Efficiency & Capital Management

Chesapeake’s 2020 bankruptcy filing was preceded by poor operating efficiency and an unsustainable capital structure. The company now has two full calendar years of post-bankruptcy operations under their belt, so let us evaluate how they stand on those metrics now alongside their merger partner, Southwestern.

Click to enlarge

Chesapeake compares favorably to its peers in terms of debt/equity ratios, but that’s largely because they’ve just shed most of their debt through bankruptcy. This newly conservative capital structure has allowed them to repurchase almost $1.5 billion worth of shares over the past 3 years, although over $1 billion of that was spent during the 2022 bonanza resulting from the war in Ukraine at an average share price of around $92/share. Southwestern appears to be Chesapeake’s mirror opposite, with some of the lowest operating costs amongst its peers but some of the highest levels of debt. Let’s hope the combined companies are planning on retaining Southwestern’s COO!

On the topic of management, I’m unsure of what to think about Chesapeake’s CEO, Nick Dell’Osso, who will remain in that position to lead the new entity post-merger. Dell’Osso became the CFO of Chesapeake in 2010 and managed the company’s finances through a particularly irresponsible period, from piling up $13 billion in debt in 2013 to the company’s bankruptcy in 2020. Aubrey McClendon is seen as the driving force behind the company’s extravagant spending through 2013 and the company was still attempting to bring down debt before the COVID pandemic put an abrupt end to that journey. In recent earnings calls, Dell’Osso has alluded to his company’s focus on reducing costs and improving breakevens. I’ll evaluate his decision to purchase Southwestern in the valuation section below for a tangible evaluation of prudent capital allocation.

Valuation

The FTC has recently requested additional information from these two companies as they evaluate the merger, so there is some chance that the transaction eventually fall through. For that reason, if you buy one you’ll want to make sure you’re happy owning it both merged with the other and on its own. Valuing them independently first will also help us evaluate the terms of the merger. To come to a valuation, I’ll estimate a general range of earning power for each company using historical operating costs and a conservative estimate of average commodity prices over time.

Starting with Chesapeake, the chart below shows my long-term expectation of top line revenue given current production levels. Note that I convert MMcf to BTU using a 1.038 conversion factor to get annual revenues for natural gas.

Click to enlarge

To avoid the impossible task of forecasting long-term commodity prices, I’ve created my own conservative estimate of an average price for each commodity over the next 5-10 years. The result is an estimate of revenue coming in at just over $5 billion, which is significantly less than the company’s sales in 2023 ($7.7 billion) but slightly above the trailing twelve-month period ($4.9 billion). I would consider commodity prices to be relatively depressed over the past year, so I feel like my revenue estimate is appropriately conservative.

Click to enlarge

Add in operating costs at just over $3 billion (assuming the average remains around the 2023 figure of $2.31/MMcfe) and EBIT comes in at just over $2 billion. 2023 interest expense was $112 million but assuming their 5.5% senior notes are refinanced in 2026 at a rate closer to 6.75% I’ll estimate ongoing interest costs to be about $130 million. Assume 25% state and federal income taxes and my estimate of current earnings power comes out to around $1.4 billion which is good for $11/share. A quick comparison of capital expenditures to depreciation, depletion, and amortization shows Capex running just over $1.8 billion/year compared with $1.6 billion/year for DD&A. Therefore, the resulting “owner earnings” (Net income + DD&A – Capex) would be about $1.2 billion or $9.25/share. At the company’s current price of around $70/share that would represent an earnings yield of around 13% on my estimate of owner earnings power.

Turning to Southwestern Energy, I’ll employ the same method to work my way through a rough valuation.

Click to enlarge

Click to enlarge

Southwestern operates in a similar manner to Chesapeake but does capitalize a portion of their interest costs, whereas Chesapeake doesn’t appear to. I’m not going to debate the merits of this accounting policy, but owner earnings will be more relevant here, especially in comparison to Chesapeake because the resulting interest amortization will be added back in through DD&A while the full interest expense (including the capitalized portion) has been accounted for in the interest expense in the table above.

Southwestern’s owner earnings at about $1/share represent a yield of 16% on the current share price of $6.25, which reflects a lower multiple than Chesapeake, likely due to elevated debt levels. Recall from above that Southwestern carries the highest debt/equity ratio in their peer group (0.7) and the reason for the discount becomes apparent. An all-stock merger would bring Chesapeake’s squeaky clean post-bankruptcy balance sheet (0.2 debt/equity) together with Southwestern’s more highly leveraged one. I’ll add together the numbers from the tables above to evaluate how the combined companies would look.

Click to enlarge

Click to enlarge

Given my average commodity price assumption, the combined company would have sales in the neighborhood of $12 billion and “owner earnings” of around $2.3 billion. Long-term debt would stand at around $6 billion against assets of $23 billion and equity of $17 billion, good for a long-term debt-to-equity ratio of 0.35. Importantly, I estimate the combined companies would operate at a breakeven natural gas price of around $2.60. Gas prices currently stand below that level at around $2.20 at the time this was written, but producers are busily curtailing production to manage supply after a warmer-than-average winter. It may take some time for demand from LNG export facilities and gas-fired power generation to catch up to the current supply, but the producer curtailment and recent remarks on earnings call show that suppliers are rational and are working towards returning the market to equilibrium. Recall that the market was out of balance in the opposite direction just two years ago in 2022.

Concerning the terms of the merger transaction, Southwestern shareholders will be receiving 0.0867 shares of Chesapeake, which represents a value of $6.24 based on Chesapeake’s current share price of $72. Based on my valuations from above, it would appear that Southwestern’s shares trade at a discount to Chesapeake, making the transaction fairly attractive for both sets of shareholders as Chesapeake gets a vast amount of proved reserves in the Haynesville and Marcellus basins while Southwestern blends their sizable debts into a much larger entity. I would ordinarily look dimly upon Chesapeake diluting existing shareholders with stock-funded acquisitions, but given the fact that Southwestern maybe even more undervalued relative to its earnings power, this one actually appears to make good sense. It’s appropriate to be skeptical of mergers, but the resulting company appears to be well-positioned for both low prices and increasing demand.

Risks

Chesapeake’s recent bankruptcy illustrates the culmination of prioritizing growth over prudent capital management. Volatile natural gas prices produce an opportunity for wise management teams that aggressively acquire quality assets at discount valuations during market swoons but hold back during market hysteria (see 2022). Demand for natural gas is strong and rising while supply remains rational as evidenced by the industry curtailments mentioned above. The biggest risk to long-term investors taking a position in either Chesapeake or Southwestern is that the management team prioritizes growth over maintaining a strong balance sheet.

International LNG supply is another risk, although it is difficult to define quantitatively. Part of the allure and potential upside of investing in shale gas production companies lies in the spread between international LNG prices and domestic Henry Hub prices.

The chart above shows historical LNG prices in Asia, a region which is expected to experience strong demand growth over the next decade. While prices over the past five years range from under $5/MMBtu to over $50, an attractive spread while Henry Hub prices sit below $3/MMBtu, it’s important to note that processing and shipping charges add roughly $5-$8/MMBtu.

Another factor to consider is the growing LNG supply. While America is expected to build the most export capacity through the end of the decade, other countries, including Qatar and Russia are busily working to bring liquefaction and export facilities online. Demand for natural gas will remain strong worldwide, but it may be unwise to assume sustained $5/MMBtu gas prices when valuing shale E&P companies.

Summary

Chesapeake and Southwestern both have a lot going for them despite their flaws. Near-term pressure on natural gas prices has muddled the bright outlook producers have as demand catches up to supply. The key to success for the industry will be strong operating efficiency and wise capital allocation. The merger of these two firms will put them on strong financial footing, but it remains to be seen how efficiently the combined entity operates. I plan on researching the remaining shale gas producers on my list before choosing one for investment, but I would favor Chesapeake between the two discussed in this article. Southwestern’s large debt position raises red flags around management’s hunger for growth that may be irresponsible in an industry which is prone to long periods of depressed prices.