As bankruptcy rumors about Chesapeake Energy Corporation (NYSE:CHK) are all around us, I am starting to get a little concerned about my short position.
I want to start with my previous trades in this company so the reader can judge by my results.
- CHK 800 shares short at 4.40 for every 100 shares CHK.PD long at 18.50. This turned out to be a nice winner along the way even though hard to borrow rate was above 30%. Here is the link to this trade. The trade gave a lot of options to be closed at about 20% profit.
- CHK vs. bonds. Here is the link that describes the logic of my initial position and the time it was taken. At current levels CHK is down 50 % and the bonds are down even more than 50%. I managed to switch to secured bonds being a non-US resident and the current result is 50 % profit in the common stock vs. 34 % loss in the secured bond. It is hard to measure my performance in every single bond vs. the common stock, but my average return on this hedge is around 10% which was not worth( keeping in mind the liquidity risk of bonds)
- CHK short vs. UNG long. This was my best trade in CHK, because after this article, UNG and CHK rallied sharp, but there was a moment that the couple lost their correlation and I managed to close around 30% in this trade (this was the one size that was allowed to be traded). At the time I wrote the article CHK was trading at $4 and UNG was trading at $7.2, current prices are $1.95 and $7.68.
Why am I concerned about the naked short I am currently holding?
Bond holders are in panic.
This would usually be very negative for any company and it really is, but the case now is different. A person in panic just wants to sell whatever the price is. A very long term investor with a lot of cash can try to buy this debt at such distressed levels and swap this debt for a better deal (but with longer maturity) that will save the company short term and will give him great value long term. Here is the scenario: Person X has enough cash to buy back debt at current levels. He makes sure that the company will make a tender offer to buy back debt. Then he gives convertible credit to the company that is senior to everything (sounds familiar?). The result is a brand new balance sheet, a decent cut in interest payments and an ownership in a company with nice long term positioning. Let's include some numbers:
source: author's previous article.
An imaginable tender offer at 40% premium based on current market prices (personal calculations):
|BONDS||nominal value||price in %||market price value||40% tender offer value||Interest payment|
|6.5% senior notes due 2017||$453||22.40%||$101||$142||$498|
|7.25% senior notes due 2018||$538||18.20%||$98||$137|
|Floating rate senior notes due 2019||$1,104||12.37%||$137||$191|
|6.625% senior notes due 2020||$822||13.43%||$110||$155|
|6.875% senior notes due 2020||$304||13.88%||$42||$59|
|6.125% senior notes due 2021||$589||13.75%||$81||$113|
|5.375% senior notes due 2021||$286||12.94%||$37||$52|
|4.875% senior notes due 2022||$639||13.75%||$88||$123|
|5.75% senior notes due 2023||$384||12.50%||$48||$67|
|8% 2 lien secured bonds due 2022||$2,368||36.00%||$852||$1,193||after tender (8%)|
*all data in millions
The current market prices of bonds value 7.5 BLN of debt at 1.6 BLN.
If the company tries to tender those bonds it will have to offer a higher price (50% in the example). Even a 100% premium would result in cutting the debt significantly. The scenario provided is what I consider worst case scenario for my short position in CHK and it only gives an idea. The calculations in reality will differ from those numbers for many reasons.
Why would bond holders participate in the tender?
Small bond holders will participate because they are in panic and because this investment is probably not a big percentage of their total portfolio.
Large holders would probably participate, because this is their best case scenario and because they are probably hedged either with direct shorts of the common stock, or with options, or with CDS (I seriously doubt that large bond holders buy and hold without any reaction). A well structured tender offer that gives them a chance to close their hedge will make them participate.
What happens to CHK if this idea works out (very low probability in my opinion)?
We are looking at a company that managed to pass almost 7BLN of capital loss to its bondholders, reducing debt to healthy levels. The yearly interest payment will be reduced almost 70% as well. The convertible preferred stocks of the company will probably receive some tender offer to limit the future payments of cumulative dividends and after all, the main burden for the company is gone. CHK has never had a big problem with its operating earnings. All the big misses in EPS were due to revaluation of reserves, which is just oil and gas price related. A strong enough investor knows how cyclical commodities pricing is and instead of buying commodities why not make his life a little bit more interesting and save a distressed company by outsmarting everyone.
CHK has negative value and this will probably be official on next earnings release, but in trading not everything is so easy. We have seen far more distressed companies survive on the mercy of bond holders, government and luck.
When you have a position in a certain stock you have to look at the worst possible scenario. I consider the above state really imaginary, but isn't it time to close the shorts and just stay on the side, because what was obvious already happened and now might be the time for the big players to do something unusual.
Disclosure: I am/we are short CHK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long the 8% CHK secured bonds at $53, I am long the 3,25% bonds maturing 3/15/2016 at $85