(Chesapeake Energy, Carl Icahn story updated for analysis of Chesapeake reserve valuation)

Part 1: This is the second part of a two-part story on Carl Icahn and Chesapeake Energy. Click here for Part 1.>>

NEW YORK (

TheStreet

) --

On Monday, investors reacted to the news that Carl Icahn was getting into the

Chesapeake Energy

(CHK) - Get Report

fray enthusiastically, sending Chesapeake Energy shares up to their highest price since June, on the hope that, finally, the long frustrated group who have thrown in their lot with Chesapeake's stock would see the embedded value unlocked.

Icahn is now the second-largest shareholder in Chesapeake Energy, with a 5.9% stake, behind only Southeastern Asset Management, which owns more than 12% of the independent oil and gas producer's shares. Icahn was previously the 6th-largest Chesapeake shareholder, with a 2.5% stake.

Icahn has been actively increasing his Chesapeake Energy play throughout the year, starting with a first quarter 2010 investment of more than two million shares.

It all raises a host of issues: From the outlook for natural gas prices in 2011, to the calculations going through the mind of Carl Icahn and the long-range, long-debated strategy of Aubrey McClendon, not even to mention the long-held Chesapeake shareholder frustration.

We've already detailed

two burning questions raised by Icahn's move.

. Now, click on for

two more.

.

QUESTION 3: Will the rest of the major Chesapeake shareholders have Icahn's back?

There is certainly little love lost between Chesapeake CEO McClendon and the major institutional investing class.

As one energy analyst quipped to

TheStreet

, when discussing energy sector stocks with clients that might be good value plays over the long-term, the first name offered is Chesapeake Energy, and the typical response from a major institution is, "OK, what company is next on the list?" Or, the question is raised, "Fine, the company's assets are undervalued, but what kind of management discount are you baking into Chesapeake's shares?"

McClendon's infamous $600 million margin call on his own company's shares back in 2008 still lingers as a bitter taste in the mouth of Chesapeake investors, as does Chesapeake management compensation during years when Chesapeake stock has floundered.

Yet when it comes down to it, the real debate and real frustration for Chesapeake shareholders is about the real estate "flipping" approach to management that McClendon says is creating value in Chesapeake, but hasn't exactly returned value to shareholders.

"It's a 'now we see it, now we don't' approach to cash management. The cash immediately evaporates the second Chesapeake jumps on a new play," said Oppenheimer's Gheit.

When Argus Research analyst Phil Weiss recently downgraded Chesapeake to a sell, the analyst cited Chesapeake's "profligate spending."

The downgrade to sell might have turned out to be badly timed given Icahn's bid, but the criticism of Chesapeake is still timely.

"At some point shareholders do need to look at whether Aubrey is the right guy, and there's already been lots of push back and concern about the management team and cronyism, " said one energy sector analyst. "Lots of people think there are more attractive management teams and that Chesapeake wouldn't have lots of baggage without Aubrey," the analyst said.

From this perspective, Icahn has picked a company where the board might be in the CEO's back pocket, but the shareholder base might be ripe for the calculated fomenting of long-bottled rage. McClendon doesn't have a controlling stake or golden shield, even if he has the ears of the board.

"Lots of shareholders will be willing to back Icahn. He puts his money where mouth is and there are so many frustrated Chesapeake investors," Oppenheimer's Gheit said. "McClendon can be a reckless driver if he wants to, but in that case, don't put shareholders in the car with you."

QUESTION 4: Just how undervalued is Chesapeake Energy?

Major institutions can gripe about the management discount that should be applied to Chesapeake shares, but by most peer company comparisons, Chesapeake is an undervalued company. It must be, or Icahn wouldn't be wasting his time on the opportunity. Yet cheap stocks can be cheap for a reason and remain cheap for a reason and 2011 won't be the first year that the argument will be made that Chesapeake is so cheap it has to finally rebound.

One of the reasons that Chesapeake has been beaten down is the continuing churn of its assets and the impact on the balance sheet.

Chesapeake has made some recent progress on de-levering the balance sheet. One recent estimate had debt-to-total-assets ratio down from 49% to 43%, and Chesapeake has reduced its debt to EBITDA ratio from 2.5 times EBITDA in 2009 to 2.3 times.

Nonetheless, the balance sheet progress has to be viewed relative to the billions of dollars that the company has raised over the past few years to fund its operations.

Critics say that while there's plenty of cash coming in the door, it's going right back out the door instead of to Chesapeake Energy shareholders.

McClendon's strategy rubs some shareholders the wrong way because for every billion that the Chesapeake CEO claims he has secured, it's less cash upfront than it is money to support the drilling on claims to which the company is arguably overcommitted. "Every time they buy a new lease they have lease obligations, and so McClendon drills a hole, and then needs somebody to get him out of it," Oppenheimer's Gheit said.

Chesapeake runs from one lease to another and repeats the same real estate "flipping" strategy over and over again, leading to the charge of profligate spending. At the end of the day, McClendon says the strategy results in leases that generate more than what was paid for the lease and given up by selling a fraction of it. Yet if the lion's share of cash coming in for assets that Chesapeake has bought is going back out into the field to protect leases at a time when natural gas prices are low, the cash being "raised" by Chesapeake is at best debatable as an economic strategy.

It's definitely a valid concern in the last year and half been that Chesapeake Energy has been in the house flipping business," said one energy sector analyst.

Still, it's not to say there is a lack of numbers that make Chesapeake look like compelling value bet. And it's not the just being undervalued because natural gas prices are depressed. There are companies in its peer group that trade at a much higher PE ratio and are as dependent, if not more dependent, on natural gas prices.

Oppenheimer's Gheit noted that

Southwestern Energy

(SWN) - Get Report

and

Ultra Petroleum

(UPN)

are more or less one-trick ponies, but they provide double digit growth on capital invested. In this way, the "tragedy" of Chesapeake Energy is not a tale told by the natural gas price implosion, but by its unique approach to generating returns for shareholders, which is distinct from just about every peer company.

What follows is a quick tale of the tape on Chesapeake.

It's the only company in its peer group of independent oil and gas producers trading at less than 10 times earnings.

Chesapeake's price to cash flow - or cash flow per share -- is 3.8 times, while the average for its peer group if 6.2 times cash flow.

On a EV (enterprise value)/EBITDA basis, Chesapeake Energy trades at 5.4 times earnings, whereas a basket of large-cap independent producer stocks trades at 7.7 times. Chesapeake is the lowest in the group.

Chesapeake Energy is also at the bottom of the list in a proprietary ranking of independent oil and gas producers from Oppenheimer & Co. that looks at a data point called implied reserve value (IRV).

IRV calculates the value of the company's reserves by dividing its liquidation value plus future development cost by adjust proved reserves. The liquidation value is market cap plus debt plus hedging liabilities minus working capital. The adjusted reserve is based on converting the company's proved gas reserves into oil at 15:1 ratio.

By this measure, Chesapeake has an implied reserve value of $25.79, well below the peer group average of $34.80. Southwestern Energy, by contrast, has an IRV of $63.88. Only Anadarko Energy has a lower IRV than Chesapeake among independent energy producers.

Oppenheimer's Gheit says that IRV may be an indicator of a stock being either undervalued or overvalued.

-- Written by Eric Rosenbaum from New York.

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