Chesapeake Energy: An Unprecedented Mess

| About: Chesapeake Energy (CHK)

Summary

The company has about $4 billion in liquidity. But most of this is an unused bank line that nervous lenders could decrease or take away despite management assurances to the contrary.

The debt maturity schedule is very unfavorable for the next few years.

The company has about $700 million in property sales and needs at least a second $700 million in sales for its operations this year.

Fourth quarter cash flow from operations was $179 million before some help from the current accounts and the company has negative working capital of more than $1 billion.

The company is projecting operational improvements and cost savings but those savings probably won't result in adequate cash flow.

Putting Humpty Dumpty back together again was a piece of cake compared to trying to make Chesapeake Energy (NYSE:CHK) operate as well as it did some years back. Ever since Aubrey McClendon was shown the door a few years back, things just have cascaded from bad to worse. It never helped that gas prices have dropped through the floor. For the company management, it has been one challenge after another. Management has probably wondered what they did in another lifetime to be punished with the Chesapeake challenge. So exactly where is the company right now? What can be done? And should an investor be anywhere near this company right now?

Management was putting a brave face on fourth quarter results when they stated that cash flow from operations was $387 million. When that figure is annualized, the cash flow for the year would be $$1.548 billion before taking into account the latest commodity price drops. That cash flow is nowhere near sufficient enough to service the $9.7 billion long term debt the company now reports. The problem is that about $208 million of that came from changes in the current asset accounts. So that really only left about $179 million in cash flow from operations before the changes in the working capital accounts. The chances of the company being able to squeeze the working capital accounts for any more cash is probably less than zero because the company reported negative working capital. In fact it will probably have working capital changes in the unfavorable direction in the future to offset that favorable fourth quarter. Annualizing that last figure ($179 million) of cash flow from operations before taking into account the working capital accounts leads to an impossibly small cash flow and demonstrates why the company will be relying on property sales to operate and pay down debt for the foreseeable future.

The only thing the company has going for it right now is that all that debt is in the form of bonds. Bonds tend to be a far more stable (and reliable) source of debt than bank debt. While a fair amount is coming due over the next few years, management is supposedly on this and has reported plenty of sales to pay down some of the near term maturities and have some money left to buy discounted debt on the open market.

Click to enlarge

Click to enlarge

Source: Chesapeake Energy Howard Weil Conference, Slide Presentation From March 22, 2016

The company has trumpeted the asset sales of $700 million and those asset sales will be a big help. With the bank line unused at this time, the company is probably free to allocate the money where it will do the most good. However, enough of these sales will, at some point cause the lenders to reevaluate all aspects of the credit line. Banks get notoriously nervous when their customers run into difficulties such as the kind Chesapeake has now, and tend to cut back the lending just when a company such as this one might need that credit line, so investors will have to wait and see how this works out.

The company showed a working capital deficit of roughly $1.2 billion in the fourth quarter. As long as the bank line is there and the company can access that bank line, this working capital deficit will not be a concern. However, credit line re-determinations will have extra importance as long as that deficit exists. The company has mentioned about $700 million in asset sales (with sales agreements signed) which will definitely help liquidity. But with a potential more billion in asset sales, shareholders have to be concerned that the best and lowest cost projects may have to be sold to save the company. The surviving entity may not have a bright future.

The fourth quarter cash flow was roughly $179 million, and with the decrease in commodity pricing since this, this company may have to rely on cash flow throughout the summer, which is the time when gas prices are their weakest. In the latest environment, operations may not produce much cash flow (if any) until the company can drill enough high return wells.

Click to enlarge

Source: Chesapeake Energy Howard Weil Conference, Slide Presentation From March 22, 2016

The company has made good progress with its debt, and its outstanding debt is basically all bonds, which is far better than bank debt. However, this maturity schedule is very unfavorable for a company with some large cash flow challenges. The company expects to be able to pay off the 2016 debt with available liquidity and by selling assets as needed. But that 2017 is the next large challenge for the company that needs to be handled this year. Management is probably working on it but there will be market uncertainty until that situation is settled appropriately.

The company either needs a major commodity price rally, or it will be selling assets for the foreseeable future to meet this debt maturity schedule.

Click to enlarge

Source: Chesapeake Energy Howard Weil Conference, Slide Presentation From March 22, 2016

Competing with the debt repayments is the capital budget for new wells. The company is migrating to its better leases and more profitable areas, however, the cash constraints will limit how much cost improvement the investor can expect. The returns in some areas are clearly excellent, and the company may have a new very profitable area with the Stack acreage in Oklahoma (that is located away from the earthquake problems so far), however, a company this size has a tremendous number of older wells, so a production decrease will work against overall cost reductions. Management is predicting operational improvements that will save money in the new year, but the company needs to find a profitable mix for the current pricing environment. It may not be able to given its cash constraints which may make the company even more reliant on asset sales than it is projecting for the foreseeable future.

When viewing the budget for the new year, and looking at the progress that needs to be made, unless the new wells are far more significant than the old wells, the operational improvements don't appear to be enough to restore the company's cash flow, even with hedging. The company may need more than a year for that to happen. While the company does have its bank line, both the bankers and the market would probably take a dim view of the company using that credit line without the cash flow to support the debt repayment. There is the possibility of some kind of very favorable acquisition that could materially change the outlook but that would be a very slim possibility.

The largest cost of these wells is with the completion, especially the fracking part. So the fact that the wells are drilled will save some costs, however, most of the costs to get these wells operational is yet to come. With the latest technology and well design improvements, possibly the wells will be more profitable than originally projected. But there are definitely no guarantees.

Summary

Click to enlarge

Source: Chesapeake Energy Howard Weil Conference, Slide Presentation From March 22, 2016

The company clearly needs to make more large improvements on its debt situation. Bondholders are not in an enviable position because the threat of using the bank credit line would make the assets that the bonds have a claim on less valuable because the bank has a first lien. So right now there is a fair amount of risk investing in the bonds of this company, and therefore a potential investor should wait until the company finances and cash flow clear up a lot more than they are now. While management has made some major improvements, there are still a lot of major challenges ahead.

Similarly, the operating costs projected above are a decrease from the previous amounts, but the company produces mostly gas. Therefore those costs need to decrease more for the company to achieve adequate cash flow and profitability. There is a good chance that the company will not achieve adequate cash flow and profitability for at least two years without a major commodity price rally or a major acquisition. The company is countering this by drilling in more areas with oil and natural gas liquids, as well as high return areas to improve its profitability. But with the cash constraints, as well as some necessary debt deals its results could be limited. Clearly the breakeven point will drop this year, but that breakeven point is highly unlikely to drop enough. Without adequate cash flow, and with all the debt claims ahead of the common stock, the shareholders claim is really not worth anything plus there will probably be considerable dilution in the future for the company to reorganize properly. If anything, the stock may be a short candidate through the summer when gas prices are seasonally weak. Long term investors need to wait for the company to achieve more cash flow and profitability. "All the kings horses and all the kings men" may not be able to put Chesapeake Energy back together again in viable form.

Disclaimer: I am not a registered investment advisor and this article represents my personal views. It is not an investment recommendation and readers are advised to evaluate their own risk profiles and determine whether or not this investment fits their own risk profiles. The reader is also advised to read the government filings of the companies mentioned for further information (they include but are not limited to 10-K, 10-Q and as well as the press release filings). There is no substitute for doing your own due diligence as due to the financial leverage of the company, these securities would be considered to be speculative.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.