Chesapeake Maintained at Neutral

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We maintain our long-term Neutral recommendation on Chesapeake Energy Corporation (CHK) -- the second largest natural gas producer in the U.S.

Oklahoma-based Chesapeake is an independent oil and gas company engaged in the acquisition, development and production of onshore U.S. natural gas resources. The company remains one of the industry’s most active players in managing assets through a combination of acquisitions and disposals.

With an inventory of unconventional resource potential bigger than probably any other domestic independent, Chesapeake boasts a leading position in 12 of the top 15 unconventional liquids-rich plays in the U.S., comprising the Anadarko Basin, the Utica Shale, the Eagle Ford Shale and the Niobrara Shale.

Although Chesapeake’s average daily production in the first quarter of 2012 increased nearly 18% year over year, natural gas accounted for 81%. Hence, given the downtrend in natural gas prices, the company registered lower-than-expected earnings of 18 cents that declined 76% from the year-ago quarter.

It was the weak gas price environment that shattered the company’s financial strength. The company has been in the news recently as it is struggling to fund its capital budget amid diminishing cash flows in a weak natural gas price scenario. Chesapeake intends to devolve as much as $11.5 billion to $14.0 billion worth of assets this year in order to bridge the funding gap of $9 billion to $10 billion.

At the end of the first quarter, debt balance stood at $13.1 billion, representing a debt-to-capitalization ratio of 44.2% (versus 39.0% in the preceding quarter). Chesapeake took $4 billion of an unsecured term loan to pay down its revolving credit line. The new loan comes at an initial interest rate of 8.5%, which could eventually exceed 11.5% if the company fails to pay it off by the year-end.

Though Chesapeake’s ongoing asset monetization initiatives are working well, its balance sheet is still more leveraged than its peers. The company also exhibits a weak financial profile with a huge debt balance.

Given the current gas price scenario, Chesapeake intends to deploy more funds toward liquids, with 90% of its capex planned for drilling liquids-rich plays this year. In particular, Chesapeake plans to invest heavily in the development of its holdings in the Eagle Ford Shale, Granite Wash and Mississippi Lime. We also appreciate management’s focus on the Utica Shale, which is expected to contribute highly to the company’s growth momentum going forward.

However, we prefer to remain in the sidelines as the embattled company is still trying hard to minimize capital expenditures through its divestiture program. As such, we see the stock performing in line with the broader market.

Chesapeake, which competes with EOG Resources Inc (EOG), holds a Zacks #3 Rank that is equivalent to a Hold rating for a period of one to three months. We maintain our long-term Neutral recommendation for the company.

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