Chesapeake Energy Preferred Shares: Aggressive, Unconventional Energy Play Plus Big Dividends

Sep. 5.11 | About: Chesapeake Energy (CHK)

Many of the more aggressive U. S. Oil and Gas producer stocks exhibit high beta and low cash dividends. For the income-minded investor who wants to participate in the potential boom in the North America unconventional shale plays, there is a potential solution:

Buy the Chesapeake Energy Corp., Cumulative Convertible Preferred shares (CHK.D).

Let's begin by examining the underlying holding company, Chesapeake Energy Corp (CHK). Here's the one-year chart and volume. Click to enlarge:

Click to enlarge
Indeed, I advocate first settling upon a sound company and reason to invest, then reviewing the associated securities.

Investment Thesis

There are a number of good companies out there that are aggressively growing via U. S. unconventional oil and gas leasing and production. However, Chesapeake has some unique characteristics:

  • They arguably have the best properties in the business. CHK gas over 3 million net acres in the best natural gas fields. This includes Marcellus, Haynesville, Bossier, Barnett, and Pearsall. The company also has nearly 6 million acres in the most prolific unconventional oil plays: Anadarko Basin, Eagle Ford, Bakken, Permian, and Utica. Recently, David White, another Seeking Alpha contributor, wrote a comprehensive piece expanding upon this here.

  • Chesapeake is the second largest U. S. gas producer, behind only ExxonMobil (NYSE:XOM)

  • CHK has set a strategy to become a more “oily” producer, given the historically unprecedented disparity between the price of oil versus natural gas.

  • The company appears to be making a concerted effort to improve debt levels and run the operation more efficiently. A recent “25/25” corporate strategy includes increasing production by 25 percent over the next two years while reducing debt by a similar percentage over the same time frame via asset sales, monetizing through Joint Ventures, and reducing go-forward leasehold spending.

Fundamentals

Chesapeake fundamentals are spotty, exhibiting both strengths and weaknesses.

The balance sheet is noteworthy, but not in a good way. Long-term debt levels are high, and the Debt-to-Equity ratio of 90 percent confirms that the company is highly leveraged. The 0.7 current ratio indicates the company's short-term liquidity is relatively weak. I was less than enthralled with the fact that CHK books reflect only 17 cents of cash per share.

The Return-on-Equity and Return-on-Assets are 8 and 3 percent, respectively. This is lower than many of Chesapeake's peers. Furthermore, the Return on Capital Invested (ROCE) is an annualized 4 percent. Nothing to write home about. Looking backwards, one may conclude operational efficiency has not been a management success story. The CEO, Aubrey McClendon, has made the news via several corporate governance hiccups, further complicating the picture.

On the flip side, revenues have increased by 15 percent a year for the past five years. CHK gross margin (TTM) is 42 percent, well above the peer group average. The Enterprise Value per share is nearly $48; the stock closed at $32.11 last week.

Management has beat the Street EPS estimates seven of the last ten quarters, though that does require the use of “Operating Earnings” versus “Actual” EPS figures. Nonetheless, the ability of management to beat the street is impressive. Forward PE multiples appear attractive based upon current EPS projections. Given management's demonstrated ability to meet estimates, this is a positive.

The 5.6 Price / Cash Flow ratio is strong.

My overall view is that Chesapeake represents a company whereas management has pressed for growth: emphasizing revenues and production. Capital and Expense management, along with corporate governance has been weak.....a typical oilfield “wildcat” mentality? Recent boardroom proclamations have indicated a change of direction.

Therefore, another key investor premise is whether or not one believes change and execution are forthcoming.

Technical Charts

The charts look neutral to positive.

The stock price versus the 50 and 200-day moving averages have remained positive during the recent market downturn. The one-year MACD appears to have turned bullish. The share price has failed to crack the $35 mark several times, but has not fallen apart. At such time the stock breaks $35 resistance, the technical upside is considerable.

Chesapeake Energy Corp., 4.50% Cumulative Convertible Preferred Stock

Investors will note that most of the unconventional oil and gas producers exhibit relatively high risk/reward profiles. CHK common shares are no different. However, the equity structure of the company also includes a preferred offering that mitigates a significant part of the risk, while still permitting the investor to enjoy the upside of the common shares.

Specifically, the Chesapeake preferred shares have several attractive characteristics. Here is an overview:

  • The shares pay a quarterly dividend of $1.125 or 4.50 percent on a liquidation preference value of $100. Currently the shares trade below $100, at $97.34. Therefore, the effective yield is a bit higher. Please note the dividend is eligible for the current preferential 15 percent tax rate.

  • The shares are convertible. This means they may be exchanged at the investor's option into common shares. Unlike many other preferred issues (which act largely like a bond) this equity offering permits the investor to share in the upside of the common shares while obtaining a sound cash return on the investment.

  • The dividends are cumulative. If the board suspends the preferred dividend payments, it may only be after suspending the dividend on common shares. Furthermore, the back dividends must be paid to the preferred shareholders before resuming a dividend on the common shares.

Here is some additional information.

Chesapeake Energy Corp., 4.50% Cumulative Convertible Preferred Stock, liquidation preference $100 per share, not redeemable at the issuer's option at any time, and with no stated maturity. Distributions of 4.50% ($4.50) per annum paid quarterly on 3/15, 6/15, 9/15 & 12/15 to holders of record on 3/1, 6/1, 9/1 & 12/1 respectively. The preferred shares are convertible any time at the holder's option into an initial 2.2639 common shares of Chesapeake Energy Corp. (NYSE: CHK), an initial conversion price of $44.172 per common share (now 2.2727 at $43.9998) . On or after 9/15/2010, if the price of the common stock exceeds 130% of the conversion price for 20 of any 30 consecutive trading days, the company may, at their option, force the preferred shares to be converted into common shares at the then prevailing conversion price. In regards to payment of dividends and upon liquidation, the preferred shares rank equally with other preferred issues (none outstanding a present) and senior to the common shares of the company.

I have attached the SEC filing for the issue here.

Bottom Line

The U. S. unconventional natural gas and oil formations may present a tremendous opportunity for investors with the patience and fortitude to let the business play out. Current technical advances for drilling and developing wells have unlocked huge reserves of BoEs that were previously considered unrecoverable.

Chesapeake Energy has accumulated an impressive portfolio of assets that within the heart of many of the most prolific fields in North America.

However, like many of their Oil and Gas peers, CHK shares are volatile (1.2 beta) and offer a meager dividend. The fundamentals indicate a mixture of strength and weakness. The charts are decent.

The Chesapeake Preferred issue permits the investor to enjoy the potential upside of the unconventional oil and gas business via its convertible features. In addition, this equity sports a cumulative dividend yield that is twice that of the 10-year T-Note and senior to the common shares.

Since it tends to be a lightly traded security, interested investors should set limit orders and may choose to patiently wait for the price to “come in” to your desired entry point.

Disclosure: I am long CHK.PD.