Dividend Quality Analysis on Chesapeake Energy Corp. (NYSE:CHK)

While traditional dividend analysis focuses on dividend payout from net income, we focus on the cash flow coverage of dividends (paid to the common stock) in order to determine their quality and sustainability. We assess whether dividends are being paid from operating, investing and issuance cash flows or whether the beginning cash balance is needed to make this payment. We make the assumption that cash dividends are paid only after net debt repayments. We consider the cash outflow from share buybacks to be discretionary and thus ignore its impact on cash required to support the dividend policy.

Dividends that are fully covered from operating and investing cash flow net of any cash outflow from debt repayments and net of a decrease in deposits (for banks) are considered to be “high quality”. Those that require an additional net cash inflow from issuance are categorized as “medium quality”. If operating, investing and issuance cash flows are not sufficient to fund the dividend and the beginning cash balance is used, the dividend is referred to as “low quality”.

This last category is most at risk of a dividend cut though we recognize that companies that have a large cash balance could continue to pay dividends even with a “low quality” dividend profile. For all these definitions, we assume the cash outlay for share buybacks is discretionary and can instead be used to support dividends.

Over the last twelve months (prior to 2012-09-30), CHK-US’s dividend payout of -24.3% and the corresponding dividend yield of 2.1% (relative to the current price) compare to a peer median level of 15.1% and 0.9% respectively. Relative to its peers, the firm is generating a high dividend yield. However, its dividend payout is negative which suggests a likely downward pressure on the dividend based on this traditional analysis.

The source of the company’s cash to support the dividend paid over the last twelve months is operating cash flow (coverage of 10.4x), investing cash flow (coverage of -25.8x), issuance cash flow (coverage of 16.4x) and twelve-month prior cash (coverage of 0.3x), for a total dividend coverage of 1.8x.

These coverage ratio factors imply that the firm’s net cash inflow from issuance was required (in addition to operating and investment cash) to pay the dividend, which suggests a medium dividend quality. CHK-US’s dividend quality is not in line with the majority of its peers, which comprise 1 high quality, 3 medium quality and 4 low quality.

CHK-US has paid a dividend in each of its last five years. The distribution of dividend quality over this period consists of 3 medium and 2 low. In particular, the dividends paid in the two most recent years were of medium quality. During this period, the medium quality dividend coverage has remained more or less stable at 2.2x relative to the prior year.

Though the dividend yield is high relative to peers, it is of medium quality in this period. Assuming the cash dividend paid remains constant, the medium quality coverage would need to deteriorate by 7% before the company dips into its beginning cash balance to fund the dividend payment.

This level of deterioration overall cash flows is possible in the course of business suggesting a current dividend quality that is less robust. The ending cash balance is less than the last full year dividend payment and cannot be relied on to cushion any significant reduction of cash flows in the future.

Chesapeake Energy Corp. explores, develops and produces oil and natural gas properties. Its principal activities include discovering and developing unconventional natural gas and oil fields onshore in the U.S. The company has also vertically integrated its operations and owns substantial marketing, midstream and oilfield services businesses directly and indirectly through its subsidiaries Chesapeake Energy Marketing, Inc., Chesapeake Midstream Development LP, Chesapeake Oilfield Services LLC, and Chesapeake Midstream Partners LP. Chesapeake Energy operates its business though the following segments: Exploration and Production; Natural Gas and Oil Marketing; Gathering and Compression; and Oilfield Services. The Exploration and Production segment is responsible for finding and producing natural gas and oil. The Marketing, Gathering and Compression segment is responsible for marketing, gathering and compression of natural gas and oil primarily from Chesapeake-operated wells. The Oilfield Services segment is responsible for contract drilling, oilfield trucking, oilfield rental, pressure pumping and other oilfield services operations for both Chesapeake-operated wells and wells operated by third parties. The company was founded by Aubrey K. McClendon and Tom L. Ward on May 18, 1989 and is headquartered in Oklahoma City, OK.

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