Monday, April 23, 2012

Is Chesapeake Energy a Turnaround Play or Just a Dog with Fleas?

It's been a rough year for Chesapeake Energy (CHK). Since June of 2011, the stock has fallen 45%, trailing the overall stock market significantly. It is almost universally despised as an investment. Many pros think it is headed for single digits due to numerous issues with the company. Does opportunity exist in the midst of all this pessimism?

Chesapeake Energy is one of the nation's leading natural gas and oil producers. As of the last quarter, it had interests in more than 45,000 wells across U.S. It was founded in 1989 in Oklahoma City and is one of the pioneers of fracking, keeping it front and center in the oil and natural gas boom on private lands here in the US.

The knocks on Chesapeake have remained consistent over the years---- 1) too much debt, 2) too aggressive in land rights acquisitions in the major shale plays, 3) over-reliance on the price of natural gas for cash flow, 4) capital expenditures exceed cash flow year after year, 5) corporation is run for the benefit of the corporate officers, not the shareholders, and 6) a Board of Directors that fails to provide appropriate governance and oversight.

To combat some of these criticisms, the company has adopted a strategy to reduce its level of debt by 25% by the end of this year through assets sales and divestitures, increase its production by 15%, increase its production of higher priced and higher margin liquids as opposed to dry gas, and actively help to develop the market for natural gas as a transportation fuel for trucks and cars.

The record low prices for natural gas have suppressed the price of the stock. Many analysts view Chesapeake as nothing more than a proxy for the price of natural gas. However, the stock plunged this past week on several not very flattering revelations about the company to settle below $17.50 after Friday's trading.

Aubrey McClendon, CEO of Chesapeake, is a flamboyant character and an incredible evangelist for both Chesapeake and natural gas. It was disclosed last week by Reuters that he borrowed $1.1 billion over the past 3 years against his 2.5% stake in the company's wells, a perk known as the Founder Well Participation Program (FWPP). The FWPP has been public knowledge for years. McClendon has taken part in the FWPP since 1993. Under the plan, McClendon receives a 2.5% share in assets from every well the company drills. He is also responsible for a 2.5% share of the well's costs, one reason for the sizable borrowings. According to company proxy statements, McClendon lost some $258 million on the FWPP in 2009 and 2010. In all likelihood, McClendon will see long-term returns, but the amount of upfront costs required for his participation in the FWPP necessitates this massive borrowing.

The borrowing was not  disclosed by Chesapeake until after the story broke, and initially sent the stock down by some 10%.  The fear is this level of borrowing could compromise McClendon's fiduciary duties to Chesapeake in favor of serving his own self-interests. This deal brings back memories of 2008, when he bought nearly $1 billion in Chesapeake stock on margin. In the market tumult of 2008, the stock slid, falling 40% one week in October as McClendon's stake was force to be liquidated on a margin call. The CEO received a $112 million pay package that year, and yet sold his map collection to Chesapeake for $12 million (why an oil and gas company would want to own antique maps in beyond me other than it was bailing the CEO out of a financial jam). That transaction was later reversed after a shareholder lawsuit.

This latest action by the company has also brought a slew of shareholder lawsuits and disgust with its Board of Directors, and reinforces the perception the company is run strictly for the benefit of its executives. After the drop this past week, Chesapeake is selling at 8 times this year's earnings and 6 times next year's estimates. Is now the time to invest in Chesapeake?

My view on Chesapeake is that it is not a long-term buy and hold play. At best, it is a speculation, with the hope that it isn't using Enron style accounting to hide its true level of debt. Perceptive bargain hunters such as Southeastern Asset Management are big investors in Chesapeake. But with every turnaround situation, the investor must ask what is the catalyst for the turnaround. In the case of Chesapeake, I see two potential drivers: 1) an increase in natural gas prices, and 2) a more independent board of directors that will refuse to loan money to the CEO and will concentrate on production side of the company and being cash-flow positive. If the investor believes natural gas prices will recover from their sub $2 levels to the $5 - $7 range, Chesapeake could easily double from these prices. Chesapeake certainly is betting that prices have bottomed since they are now going naked, with no hedges in place to protect them from negative price movements. I think Chesapeake is a decent speculation on a turnaround in natural gas price for a small portion of investor dollars, but don't bet the farm, and don't expect a fundamental change in management practices unless there is a full scale shareholder revolt.  As always consult your financial adviser before committing any funds.

1 comment:

  1. The chart of the stock looks just terrible. It almost looks like the stock went off a cliff the last few months.