Does This Downgrade of Chesapeake Energy Corporation Make Sense?

Source: Chesapeake Energy Corporation, Facebook.

What: Shares of oil and natural gas exploration and production giant Chesapeake Energy tumbled $0.78, or better than 4%, in Thursday's trading session to close at $17.20 following the Wednesday morning release of its fourth-quarter earnings results and a downgrade from investment banking firm UBS.

So what: According to William Featherston, the covering analyst at UBS, Chesapeake's lower than expected production guidance for the upcoming year necessitated cutting Chesapeake Energy to "neutral" from "buy," and slashing its price target by $5 to $19. Note, this price target still implies 10% upside to Chesapeake's shares based on Thursday's closing price.

Based on Chesapeake's forecast, which calls for production of between 645 million barrels of oil equivalent per day, or MBoed, and 655 MBoed, which was 8% below UBS expectations, as well as its revised outlook that it'll have it sporting a $1.9 billion free cash flow deficit in 2015, UBS' Featherston notes that Chesapeake's debt-to-EBITDA would now fall below the industry average (which is a bad thing).

Additionally, Featherston points to a 90 million cubic feet per day curtailing of natural production and expected weakness in natural gas liquids pricing as a reason to be patient with its shares. Featherston and his team estimate Chesapeake will lose $0.40 in EPS for fiscal 2015 and lose $0.45 in EPS for fiscal 2016.

As a refresher, in case you missed the report, Chesapeake Energy reported an adjusted profit of $0.11 per share, down from $0.27 reported in Q4 2013, and well below the $0.23 in EPS that Wall Street was expecting. It did, however, grow its production in Q4 to 729,000 barrels of oil equivalent per day, up 12% when adjusted for asset sales from the year-ago period.

Source: Chesapeake Energy Corporation, Facebook.

Now what: What investors need to ask right here is whether or not this downgrade of Chesapeake Energy makes sense, or whether the pessimism surrounding this company has already been baked into its share price.

As usual, there are two sides to this question.

On one hand, there's a lot to like with Chesapeake below $20. For starters, Chesapeake once again increased its proved reserves in 2014, finishing the year with 2.469 billion barrels of oil equivalent. Even more impressively, its percentage of proved developed reserves rose to 75% of total proved reserves in 2014 from 68% in 2013. Couple this with increased production and growing efficiency and it's not hard to see that Chesapeake has the ability to significantly ramp production when oil and natural gas prices begin to rebound.

On the other hand, Chesapeake's free cash flow deficit is concerning. Even with the company's production shift toward liquids it just can't catch a break, and it could be looking to shed additional assets in 2015 in order to boost its cash position and cover cash flow shortfalls. If energy prices, including natural gas, persist at low levels for longer than 12 months, Chesapeake could find its share price still has substantial downside potential.

As for me, I tend to fall into the cautious camp. Chesapeake's cash outflow is a concern when taking into account its free-spending nature over the past decade. With the company expected to lose money over the next two years and few catalysts on the horizon to push natural gas prices higher I don't see any reason to rush into buying Chesapeake. I'd like to see the company work on reducing its debt load and minimizing costs even further before I'd consider dipping my toes into the water, or should I say oil?

The article Does This Downgrade of Chesapeake Energy Corporation Make Sense? originally appeared on

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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