Last week Chesapeake Energy (NYSE:CHK) announced a plan to increase shareholder value over the next 24 months by reducing the company’s net debt by $3.5 billion over that time. By doing so, the company hopes to attain an investment grade credit rating, something that has been out of the firm’s reach as it has accumulated a sizable debt load as a result of growing the company into one of the largest natural gas exploration and production companies in the United States. The plan is being sold to investors as a way to increase CHK’s stock price but it appears to me that they are simply issuing one form of capital to repay another.
Chesapeake’s plan has two prongs, so to speak. First, the company expects to raise $5 billion from a combination of asset sales and preferred stock issuances in order to repay $3.5 billion of senior debt. This would reduce the company’s net debt position from just under $12 billion to about $8.5 billion. The remaining $1.5 billion in funds will be used to expand the company’s oil exploration activities, as crude oil prices have rebounded far more quickly than natural gas prices in recent quarters (CHK currently has about 90% of its reserves in natural gas).
On the face of it, this plan does look promising for shareholders. Reducing net debt will boost equity value in the absence of any dilution from the capital raises. Unfortunately, on Tuesday afternoon Chesapeake announced that it has raised a total of $1.7 billion from the sale of new 5.75% convertible preferred shares. Typically convertible preferred is attractive from a corporate standpoint because it tends to carry very low interest rates (in exchange for having equity-like upside from the option to convert into common stock). However, since this new preferred stock is costing CHK 5.75% per year in interest, it hardly looks like a way to boost shareholder value.
In fact, Chesapeake has also announced that it is using most of the proceeds from the new preferreds to redeem $1.334 billion of senior debt. This debt carries interest rates of between 6.875% and 7.5% with maturity dates ranging from 2013 to 2016. As a result, CHK is replacing $1.3 billion of senior debt (average interest rate: 7.2%) with $1.7 billion of convertible preferred stock (interest rate: 5.75%). How is this helping shareholders? The interest on the new preferred will actually cost CHK $98 million per year, more than the annual interest payments ($96 million) paid out on the senior debt they are retiring! Not surprisingly, Wall Street has yet to cheer these announcements with a higher stock price.
Now to be fair, there are some marginal benefits associated with this capital swap, which I am sure the company would point out if asked. First, if Chesapeake does get a credit rating upgrade over the next two years as a result of this plan, it could possibly see a small decrease in the interest rates it needs to pay on future borrowings. Second, CHK is extending the average maturity schedule of its debt by replacing senior notes due to mature over the next six years with convertible preferred shares that come with no maturity date.
These small benefits aside, this type of capital exchange is not likely to help equity holders. Few people are going to be overly impressed by debt reductions accomplished by issuing other forms of capital to replace them (and in this case, raising more new capital than the amount of the senior debt repayments). If Chesapeake really is serious about increasing shareholder value, they are going to have to use free cash flow from operations to reduce their debt load.
A big reason the stock price has lagged, aside from the fact that natural gas prices are in the tank right now, is because the company insists on using all of its profits (and more oftentimes) to continue to grow the company. As borrowings have grown, even increases in production and operating cash flow have not been enough to increase shareholder value. In fact, consider the data below, which I compiled from CHK’s 2009 annual report. (Click to enlarge)
Although the company has grown its oil and gas production and operating cash flow, it has taken a lot of new debt and common equity raising to accomplish these growth objectives. Not surprisingly, equity holders have reaped a negative benefit despite CHK being a much larger company today than at the end of 2005. This latest plan to increase shareholder value seems to me to just be more of the same. The company likes to say it is trying to increase shareholder value, but does not go anywhere far enough to actually make it happen.
Disclosure: Peridot Capital was frustratingly long shares of CHK at the time of writing, but positions may change at any time