The right Chesapeake to buy: Midstream Partners

The master limited partnership has a far more favorable future.

By InvestorPlace Jun 13, 2012 9:53AM

By Aaron Levitt

 

The problems facing former energy darling Chesapeake Energy (CHK) certainly do make a good soap opera. From secret hedge funds to the fact that it developed commercial real estate and shopping malls as natural gas prices fell, the inner dealings of CEO Aubrey McClendon should be enough to make investors stay away from CHK.

 

Corporate governance issues aside, perhaps the most troubling is Chesapeake's financial position. As the company has expanded its portfolio of gas fields and unconventional assets, it has outspent cash flows in 19 of the past 20 years, and its debt has continued to balloon out of control. That outsize debt forced the company to put the "For Sale" on a number of prized properties and assets.

 

So far, Chesapeake has shopped its 1.5 million acres in the key Permian Basin, as well as a half-million acres in Colorado and Wyoming. The stumbling driller also is on the hunt for a joint-venture partner in the liquids-rich Mississippi Lime basin as it struggles to raise an estimated $10 billion to avoid breaching a loan covenant.

 

One of the more interesting assets now earmarked for sale is Chesapeake's vast network of pipelines and natural gas storage facilities. For investors, these cash-flow-rich gathering assets could be the best way to play Chesapeake shares.

 

An infrastructure giant

In a move to appease its new board of directors led by Carl Icahn and raise much-needed cash for operations, Chesapeake recently reported it would sell its entire 45% interest in Chesapeake Midstream Partners LP (CHKM) to private equity firm Global Infrastructure Partners for $2 billion.

 

Additionally, the former poster child for America's quest for energy independence will sell some mid-continent gathering and processing assets, as well as a pipeline development unit to Chesapeake Midstream for a similar amount. All in all, the deal should net Chesapeake more than $4 billion and put it on track to generate cash proceeds of between $11.5 billion and $14 billion this year.

 

Aside from raising cash, Chesapeake said these deals would reduce capital spending by nearly $3 billion over the next three years. That's critical because the company continues to struggle to pay for operations. Rising operating costs is one of the main reasons Chesapeake needed to take out a $3 billion bridge loan from investment banks Jefferies (JEF) and Goldman Sachs (GS).

 

While the deal puts necessary cash in Chesapeake's bank account, the real winner could be GIP and CHKM unitholders. GIP already has a long history with Chesapeake. The infrastructure private equity powerhouse purchased some of the firm's natural gas gathering assets in 2009 for $588 million, and these new pipeline assets will add to GIP's $10 billion worth of gas conduits, electricity plants, ports and airports. According to its website, GIP's various infrastructure investments produce annual revenues of more than $4 billion and employ nearly 12,000 people.

 

The infrastructure group plans to sell shares in a new fund in order to finance the purchase of Chesapeake's stake in the midstream assets as well as to buy additional pipeline and gathering facilities from the cash-strapped firm. Chesapeake Midstream and GIP expect to buy as much as $500 million in assets from Chesapeake every year over the next decade. That could be a huge win for GIP because these pipeline assets are structured to pay an increasing dividend as profits rise. They basically create a virtual "cash machine" for investors.

 

Currently, Chesapeake Midstream owns more than 3,900 miles of natural gas gathering pipelines fed by producers such as integrated giant Total (TOT) and Norway's Statoil (STO). Incidentally, the two have been some of the biggest buyers of Chesapeake's unconventional assets over the last few years. The natural gas producer still holds about 1,950 miles of pipelines, which analysts expect GIP and Midstream to purchase over the next few years.

 

Buying the pipeline player

While the jury is still out on whether the pipeline sale is a good long-term move for Chesapeake, unitholders in Chesapeake Midstream should be jumping for joy.

 

First, much of the problematic headline risk is gone. No longer are the midstream's units tied to the dual misfortunes of Chesapeake's fiscal and CEO woes. Chesapeake Midstream can now focus on the job of moving energy across the country. As I've pointed out, continued pipeline expansion will be necessary to unlock America's new-found energy bounty, and logistics is the key ingredient when it comes to energy prices.

 

Second, CHKM is now a member of a stronger team. GIP's vast assortment of infrastructure assets and their underlying cash flows can be used to support the midstream firm. That includes buying additional facilities from its former parent, funding outside deals and building new pipelines. Chesapeake's cash crunch certainly made expansion difficult. Ratings agency S&P recently highlighted concerns relating to CHK's ownership, and CHKM's credit rating was ultimately tied to Chesapeake Energy's junk status. However, many of those concerns have been alleviated.

 

All of this means it could be time to buy units in the midstream firm. Set up as a master limited partnership, Chesapeake Midstream is required to pay out most of its cash flow as a tax-deferred distribution. Currently, the MLP pays a juicy 6.2% dividend compared with Chesapeake's 1.9% yield. Given all of CHK's cash flow problems and other issues, those dividend payments may not be sticking around, anyway.

 

More important for investors is the dividend growth story. The partnership has hiked its dividend by nearly 70% over the past year as more assets were added into the tax-advantaged structure. That will only get better as GIP purchases more pipeline, gathering and natural gas storage units. Plus, most of the MLP's assets lie within critical new shale regions like the Marcellus. As these fields ramp up production, that'll help boost Chesapeake Midstream's distributions even more.

 

It's no wonder why shares of CHKM popped more than 3% on the news of the sale. However, with much of the growth story still ahead and its former owner's problems behind it, now could be the best time to add the MLP to an energy income portfolio.

 

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

 

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