Chesapeake Energy vs. Sasol: Sasol

It has been a triumphant run for Team Sasol (NYSE: SSL), to be sure, but it wasn't an easy one. Team Captain Bill Mann led Global Gains pick Sasol through the first two rounds over formidable challengers ExxonMobil (NYSE: XOM) and Cisco Systems (Nasdaq: CSCO). I then took the hand-off from Bill and led crushing routs over Income Investor pick Diageo (NYSE: DEO) and Stock Advisor selection Marvel (NYSE: MVL) (Note: you can still visit Team Sasol's entries from rounds 1, 2, 3, and 4).

Your gas to my jet fuel
It is only fitting that the voters chose another energy company and newsletter pick, Inside Value's Chesapeake Energy (NYSE: CHK), to rumble with Sasol in the Championship. The two are quite similar in terms of market capitalization, the correlation between their profitability and energy prices, and the fact that each has been pitched by a great Foolish investor (Bill Mann with Sasol, and Philip Durell with Chesapeake for Inside Value).

So how do the two stack up? Let's compare a few basic metrics.

Company	Forward P/E	Dividend Yield	3-Year Average Return on Assets	3-Year Average Return on Invested Capital
Chesapeake	10.9	0.8%	9.9%	13.2%
Sasol	9	3%	12.7%	17.8%

Data provided by Capital IQ, a division of Standard and Poor's. Forward P/E is based on 2007 estimates.

Both companies are priced cheap by conventional valuation metrics and provide strong returns on assets and invested capital. Heck, they're even rated five-stars apiece in Motley Fool CAPS. Popular buggers, they are.

All that jazz aside, there are a couple of subtle differences between the two in the above metrics. Sasol has consistently provided higher returns on investment than has Chesapeake. Further, while each pays a dividend, Sasol's stands a hearty 2.2% higher than Chesapeake's, something dividend reinvestors and those with more of a conservative bent can appreciate.

Perhaps the greatest threat to Chesapeake shareholders, aside from escalating extraction costs or a pronounced decrease in the price of natural gas, comes from Chesapeake's interest in funding growth through the sale of equity.

Dilution, thy name is Chesapeake
Chesapeake has drawn heat because of its repeated and likely expected continued use of issuing equity to fund its growth. Issuing stock to fund growth is not so bad if you think your shares are overpriced, but issuing shares when you believe your company is undervalued is, at a minimum, an aggressive move. Regarding the dilution, Philip Durell said, "I wouldn't mind share issuance if they were overvalued, but issuing undervalued shares is the equivalent of buying back overvalued shares -- neither of which I like!"

Now, look. I really don't want to hammer on Chesapeake like I have the other competitors I've run up against. I like this company, and I believe that energy prices, including natural gas, will stay volatile while trending upwards in the years to come. That said, it's hard to ignore the risks behind the firm's dilutive strategy. Shareholders should keep an especially close eye on the company's balance sheet and capital structure.

Chesapeake's rising cost of extraction
Another potential chink in the Chesapeake armor is its rising extraction costs, or operating costs per unit of production per mcfe. Despite its deserved reputation as a low-cost producer of natural gas, the company's extraction costs have followed a steady upward trend over the past few years, a trend that management doesn't expect to abate in the foreseeable future.

	2004	2005	2006	2007 (Estimate)
Production Cost per mcfe	$0.94	$1.23	$1.35	$1.61
Change in Cost Over Last Period	5.6%	30.9%	9.8%	19.3%

Historical data gathered from Chesapeake 10-K statements. 2007 estimate represents the center of management's guidance.

Let me put this plainly: Assuming the status quo, the smaller the margin between the price of natural gas and Chesapeake's production costs, the lower their profits and returns on investment. Chesapeake's rising production costs are a trend well worth watching.

Now, again, keep in mind that I'm trying to convince you to vote for Sasol in Stock Madness, not to sell your shares in Chesapeake. In fact, if I had a bit more personal liquidity, I would probably own shares in the company. But then, all is fair in love and Stock Madness.

The last-minute full court press!
Below are a few last-minute points on Sasol that will serve as a refresher for seasoned Stock Madness readers, as well as provide a bit more color for those who just strolled in.

• In 2006, Sasol pulled in roughly $2 billion in net income from continuing operations on roughly $10 billion in revenues.
• The company, which operates in 30 countries and recently opened offices in China and India, sees its patented gas-to-liquid (GTL) and coal-to-liquid (CTL) technologies as a potentially huge driver of long term growth.
• The CTL technology, in particular, could catch on in the U.S. given our vast coal deposits, growing desire for energy independence, and sustained high energy prices.
• Sasol has been in talks with at least two U.S. governors of coal-rich states who have expressed an interest in Sasol's patented CTL technologies. Should the technology gain traction in the U.S., Sasol's shareholders would likely be richly rewarded.

That's a wrap
I hope all you folks enjoyed the 2007 Stock Madness Tournament. It was a joy to participate... and I look forward winning again next year as well. Vote Sasol!

Does this stock deserve to move on to the next round? If you think so, simply follow this link and rate the stock "outperform" in Motley Fool CAPS. If not, rate it "underperform." Later this week, we'll tally your votes to determine which stocks will advance one step closer to the title.

Read our opposing article on Chesapeake, or see all of the other entries in this tournament.