Is Chesapeake Energy (CHK) a Buy?June 5th, 2012 by David Waring
Chesapeake Energy Is Being Forced To Straighten Up, Like It Or Not
By Author of Life, Investments, Everything Blog
(June 5th, 2012) As I mentioned in the past and has been extensively detailed in the press, Chesapeake Energy (CHK) has finally been taken to task for abominably bad corporate governance and risky management of the company’s balance sheet. The shares have plummeted, the CEO has been stripped of his Chairman role, the company has taken a hastily arranged $4 billion bank loan, and efforts at the sale of some major assets are in progress. More importantly, CHK’s largest shareholder has turned activist and last week Carl Icahn disclosed that he is now the company’s third largest shareholder and has some very specific ideas on how to improve things at CHK. The stock (and even the bonds) have become very volatile lately and a large short interest has built in this name. How will things play out from here?
CHK has significant debt on its balance sheet and has some off balance sheet obligations in the form of future oil and gas production which was pre-sold (at higher prices than the company would realize today). This leverage combined with the large amounts of cash CHK uses to acquire acreage, drill, and set up production as well as low natural gas prices have conspired to increase pressure on the company to near the point of crisis. Management has had several opportunities in the past to dial back its outsized appetite for acreage and move CHK toward a cash-flowing exploiter of what it already owns, but has repeatedly chosen no to do so. In essence, the second largest producer of natural gas in the US is still being run much like a small wildcat driller. As natural gas prices are very low, CHK is attempting to change its production mix to have more oil and natural gas liquids (which command far greater prices than natural gas), but this requires possibly more capital than CHK can access. Management has continued to say that everything is just fine, but the main way out of this mess that they are pursuing is via asset sales. It is unclear whether they will be successful selling enough assets at a high enough price to make it through the storm. Thus we have the essential problems with this company laid out (corporate governance failings aside).
Despite all these problems, management and the Board have not shown any evidence of desiring to change the way the company is run. Past challenges have either been slapped down entirely or have been addressed with wholly inadequate fluff responses that have not resulted in any material change. Even in the company’s current crisis, the Board’s response to heavy shareholder and media criticism of the way things are done at CHK has been very “light,” mostly the stripping of the Chairman role from CEO Aubrey McClendon. Since the Board is still composed of the same cronies that allowed this mess to build up in the first place, it is clear that real change is not in the Board or management’s plans. Add this to the debt/liquidity problems, and it isn’t hard to see why the company has attracted a lot of short sellers.
However, all is not dim and dark for CHK. Ethical shortcomings aside, under Mr. MClendon’s leadership the company has built up premier leaseholdings in almost all of the major onshore US drilling “plays” (oil and gas fields to the layman). Better yet, most of this acreage was acquired before everyone else figured out how valuable the drilling opportunities were so the prices paid are by and large pretty modest. As the biggest independent holder of proved and potential reserves in the US, CHK is in the position of having a unique and extremely valuable asset portfolio underpinning all the debt and controversy. This asset portfolio is ultimately worth far more than the current enterprise value of the company reflects and is the main reason why lenders still line up when CHK raises new financing (at a price, of course). The most recent loan CHK took was actually upsized from $3 billion to $4 billion when the deal went to market. The lenders know full well that the asset value is there and they will get paid back. There is always a market for these kinds of assets (as I will discuss further below).
The main risk from CHK is that management and the Board will continue frittering the company’s funds away on sweetheart insider deals (map collections, anyone?) and will continue the foolishly aggressive business posture that Mr. McClendon has maintained for many years. These sorts of things have been unfortunately synonymous with the name “Chesapeake” for many years. However, large investors seem to have had enough. There are shareholder proposals for the annual meeting that are coming from the likes of the NY State Pension Fund rather than crackpot individual investors. The largest shareholder of the company (Southeastern Asset Management) has signalled that they will be going activist with their stake. Finally (and most importantly, IMO), Mr. Icahn has signalled in no uncertain terms that he intends to force the Board to make changes and quickly. While it is a positive that Southeastern has gone activist, history suggests that activism is not a comfortable role for that organization and they tend to prod rather than kick. Mr. Icahn is different. He knows very well that time is money and he has shown over the years that he is very good indeed at making money. His initial letter to the Board demanded that 4 of the 9 Board members be replaced immediately with shareholder representatives, and he made it extremely clear that if changes do not happen in short order he is prepared to take further action (likely including increasing his position in CHK shares).
So how will this situation play out? Insiders own a de minimus amount of shares and an increasing large percentage of the company’s owners are closing ranks in opposition to current management and the Board. It may take some time, but it is unlikely that CHK will avoid substantial change this time. There are two main possibilities for CHK’s future: sale of the company and substantial restructuring as an independent organization. The sale of the company is fairly straight forward. Despite its debt and other issues, CHK has a huge and highly desirable asset portfolio that is not duplicated by any other company. Importantly, it is unlikely that such an opportunity will show up as a realistic potential target any time in the next few years, either. CHK’s assets would also solve a peculiar problem that is largely the province of oil majors. Major oil conglomerates (like Exxon, Shell, Chevron, Total, etc.) are in many ways amazingly efficient and extremely effective allocators of capital. However, they have a dirty little secret: they are not good at finding new drilling opportunities. Most oil majors are unsuccessful in replacing the reserves they tap with new ones, at least on their own. Left to their own devices, they would eventually run out of reserves and not be able to produce oil and gas. As a result, you will regularly see oil majors buy large assets or entire companies to solve this problem. The purchase of CHK would solve this problem very nicely for some time for any oil major. Obviously a sale of the company would likely result in a relatively speedy resolution of the company’s issues and a gain for shareholders.
Reorganization as an independent is also a possibility. Given the low price of the shares and low natural gas prices, the company’s shareholders may decide that a future as an independent is a better way to extract value for shareholders. If this is the path CHK follows, it is likely that the company’s finances will be shored up with some major asset sales and that a revised (and more credible) Board and management team will preside over what remains. In this scenario, CHK would likely be transformed over time to something like Devon Energy (DVN), a well-managed, much less aggressive harvester of US onshore oil and gas fields. Transformation takes time, however. It is unclear how much patience Mr. Icahn will have.
There are two important downside scenarios for CHK. One is bankruptcy occasioned by a liquidity crisis. Given the company’s size and asset base, this would appear unlikely, but it is possible. The other downside scenario is that CHK could successfully fend off activist shareholders, right the ship, and continue on with its peculiar mix of cronyism and debt-funded growth. Considering the size of the activist shareholder base at this point, it seems unlikely that management and the Board will get away unscathed, but it is a possibility.
Along the way, we could witness fun and games in the shares. CHK bottomed out at $13 and change and has since been climbing. I expect significant future volatility, given the number of headlines flying around and the large short interest in this name. However, there is also a reasonable possibility that Mr. Icahn’s maneuverings and other events could provoke a short squeeze. If this happens, investors should be ready to sell into a sharp rally, since short squeezes are usually brief and stock often drop significantly after they end.
As always, be careful, do your own due diligence, consult your advisors and take your own risks. This is not intended to as investment advice.
Disclosure: I am long CHK equity and options.