Is Chesapeake Biting Off More Than It Can Chew in This Transformative Acquisition?

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If this was a decade ago, investors might not have flinched at hearing that Chesapeake Energy Corp. (NYSE: CHK) was going to make a large acquisition. In 2018, things are quite different. There may be a silver lining here in that its shares have recovered, but that is also happening on a big up-day in the stock market.

Along with earnings this week, Chesapeake announced that the company is making a $4 billion acquisition of WildHorse Resource Development Corp. (NYSE: WRD). That tab is measuring the enterprise value in over $900 million in debt assumption, but the cash and stock value is 5.989 Chesapeake shares per WildHorse share, or a combination of stock and cash. Chesapeake shareholders are expected to own roughly 55% of the combined operations after the merger closes.

Chesapeake is getting hard assets here. The acquisition was shown to be adding about 420,000 net Eagle Ford Sale and Austin Chalk formation acres in Texas. The merger is also said to help save $200 million to $280 million annually in combined costs over the first five years of the deal.

Analysts are mixed on the deal. Sanford Bernstein indicated that the deal would lower Chesapeake’s gas-to-oil split to 68% (gas) from 72% currently. The firm also sees this leading to sooner than expected free cash flow with the deal.

Still, Chesapeake has been in the process of paring down assets to pay down debt, and the $275 million to $400 million cash needs for the deal are expected to come from Chesapeake’s revolving credit facility.

Credit Suisse also was cautious about this merger. Chesapeake’s rating was left as Underperform, but the firm lowered its price target to $3 from $4. While the merger is shown to improve Chesapeake’s position, it is deemed an expensive deal that leaves Chesapeake overleveraged afterward.

Susquehanna raised its rating on Chesapeake to Positive from Neutral after the deal was announced, and Merrill Lynch maintained its Neutral rating and $6 price objective. Merrill Lynch’s investment rationale said:

Given the sale of its Utica assets and acceleration of Powder River Basin growth, we believe the worse has passed for Chesapeake with the company poised to generate free cashflow for the first time in several years in 2019. While the commodity remains a headwind, debt metrics appear on the route to improvement.

Several other analysts have lowered their price targets:

  • Imperial Capital to $5 from $6.
  • Jefferies to $2.60 from $3.
  • SunTrust Robinson Humphrey to $4 from $5.

CFRA (S&P Global) lowered its target to $4 from $5 while keeping its Hold rating. CFRA’s report explained the target cut rationale as follows:

We believe Chesapeake paid a competitive price for the assets at $9,500 per acre and it will make Chesapeake’s portfolio more diversified between higher-return oil and existing gas assets. However, to finance, Chesapeake will dilute existing shareholders and borrow $275-$400 million, as well as add an additional net debt of $930 million from Wildhorse to a balance sheet that is already stretched thin.

One serious issue to consider about the price being paid here is that Chesapeake had a market cap of almost $3.4 billion ahead of the earnings and acquisition news. Adding in a new $4 billion in enterprise value (debt and equity combined) is a game changer. And for historical comparisons, Chesapeake shares were close to $30 back in 2014 — with an exponentially higher market cap.

Chesapeake Energy shares were last seen up 8.4% at $3.54 on Wednesday, but this stock was at $3.72 two days ago, before the earnings and merger announcement, and they were down at $3.27 as of Tuesday’s post-news close.