Why You Should Be Greedy for Chesapeake

NEW YORK (TheStreet) -- Warren Buffett once said, "When a management team with a reputation for brilliance tackles a business with a reputation for poor economics, it is the reputation of the business that remains intact." Sometimes, though, we are asked to judge the inverse case: a sound business under poor management. What part of its reputation survives?

Such is the case for natural gas and oil company Chesapeake Energy ( CHK) and its embattled CEO, Aubrey McClendon. As "questionable" as McClendon's recent decision-making has been, the fundamentals of the company remain solid.

What does that mean for Chesapeake as an investment? Of late, Chesapeake has been in the news for all of the wrong reasons -- not the least of which is the fact that McClendon has been alleged to have obtained loans and interests on the company's wells.

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While it would appear the CEO demonstrated confidence in the company's assets, to many shareholders it presented some causes for concern or more specifically, some potential conflicts of interests.

As a result, the stock has recently gotten punished, as it seems investors have lost confidence in management. But then again, this might be a case of overreaction, similar to the experience several years ago of Ford ( F) or better yet, Bank of America ( BAC). Today both companies are solid, and in particular Bank of America has regained its status as one of the top financial institutions on the market, reemerging stronger amid all of the turmoil regarding the housing crisis.

Warren Buffett also said, "Be greedy while others are fearful." With that in mind, I was looking to the Chesapeake's earnings report to affirm which should prevail: the market's current fear or greed?

The Quarter That Was

For the quarter, Chesapeake reported a net loss of $71 million or 11 cents a share. The loss was a disappointment because it came after an increase of 50% in revenue for the first quarter, $2.5 billion, but short of analysts' estimates of $2.75 billion. Adjusted earnings were 18 cents a share and missing Street estimates of 29 cents. On the bright side Chesapeake was able to increase daily production to 3.658 billion cubic feet equivalent or by 18%.

Overall things could have been a lot worse and this is something investors need to understand. It is no secret that energy companies -- and in particular those that focus on natural gas have had some challenges this year due to fallen shale demand. As a result natural gas prices have dropped an average 55%, from $5.31 a year ago to $2.35 today. But it is not because Chesapeake has not been working to mitigate this situation. The company has invested in oilfields in an attempt to increase crude production, as well as diversifying its offerings.

When the company announced plans back in January to help improve the fundamentals of the natural gas market, it said it would reduce the number of rigs it had operating -- representing a cut of 50% by the second quarter. At the time, it seemed a bit aggressive. However looking at the results today, it appears not only that the company had the right idea, but perhaps it was a bit underestimated.

What this tells me is that for as much criticism as the company's management has received for some "internal indiscretions," the company deserves a considerable amount of credit for having been the first to assess what was hurting the industry and acting appropriately to lessen the impact -- a move that many other companies soon followed.

Moving Forward

Though the numbers were not great, they were certainly far from horrible, all things considered. It is clear that the company is working to maintain its status as one of the country's top natural gas producers. To that end, the company plans to deliver an average output of 250,000 barrels per day -- representing an increase of 70% above its 2011 output. It will do that by investing heavily for the development of its holdings in Mississippi Lime, Granite Wash and Eagle Ford Shale.

I can't ignore this opportunity for investors. Remarkably, with Tuesday's close of $19.60 the stock is now down 45% from its 52-week high of $35.75 -- if you count the after-hours drop to $18.60, that number increases to just under 48%. Also, on March 20, the stock hit a 2012 high of $26.09. Tuesday's closing price represents a decline of 30% in only one month-time of trading.

It is unlikely the fundamentals of Chesapeake changed drastically enough to justify this punishment. Instead, investors have been driven by fear - perhaps justified. But it's time for greed to take over. The stock trades at a price-to-earnings ratio of only 8 while names such as EOG Resources ( EOG) and Range Resources ( RRC) carry multiples of 27 and 270 respectively.

Another comparison is Console Energy ( CNX). While the company is fundamentally sound in its own right, its P/E of 14 is still almost twice that of Chesapeake and it offers a smaller dividend.

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To top it all off, in terms of profitability, Chesapeake offers both higher profits and operating margins than each of these names that sports higher multiples.

Say what you want about McClendon's "internal affairs" but absent some gross SEC violations it is hard to not see this as an opportunity to be greedy.

Bottom Line

Obviously Chesapeake has more than its share of challenges, but they are not of the death-sentence variety and the company should be able to overcome them. The earnings results as well as its outlook demonstrated that the company has not lost its focus. Confidence in management is an entirely separate issue. Chesapeake is in a business that presents a critical need and costs will eventually normalize.

While there is short-term volatility, the natural gas industry and in particular stocks such as Chesapeake will continue to be important players on the market. Investors would be wise to become greedy on this weakness as Chesapeake may prove to be an excellent recovery play.

At the time of publication, the author was long BAC.

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