Chesapeake Energy Corporation (CHK) is on a mission to the moon again. Richard Zeits wrote this article right on time, which just goes to show what a great place Seeking Alpha is. I do not even try to understand the fundamentals of CHK anymore. A stock that moves 100% up or down every week is hard to analyze. I prefer to play poker or to bet on a football match instead. Arbitrages on the other hand, are easier to analyze and can bring very nice returns that have stronger logic.
This article is about Chesapeake Energy Corp.'s 5.00% Cumulative Convertible Preferred Stock (CHKDG). This stock has a suspended cumulative dividend of $5 yearly, a par value of $100 and a conversion ratio of 2.7669 shares of CHK (the preferred shares are convertible any time at the holder's option into 2.7669 common shares of CHK). Let's start with the charts:
CHK made a 30% move on a volume that is almost 10% of the float, while CHKDG traded around 10,000 shares (3,000 of which were mine). Why did the big buyers forget about CHKDG? It is a low volume stock, but usually, these are the ones that get overvalued.
How to evaluate a traditional convertible stock with no stated maturity?
This stock is a preferred stock with a fixed dividend. It also has value based on its conversion option. This stock is never supposed to trade lower than its conversion value, because this will result in an obvious arbitrage. The current conversion value of CHKDG is 2.7679*6.05 (closing price of CHK) = 16.75. The closing price of CHKDG is 21.31. This means that CHKDG currently trades $4.56 above its conversion value. This is how the market currently values a $5 cumulative preferred perpetual dividend of CHK.
By buying 100 shares of CHKDG and shorting 277 shares of CHK, theoretically, you are buying the perpetual dividend at this price of $4.56. Here is what happens in five years to your position if CHK trades at $6 or higher:
Source: author's database.
The model is really simple. We receive the cumulative dividend in the fifth year and both securities pay 0 dividend until the fifth year. Assuming the company survives, this model shows the worst possible scenario for CHKDG, because it assumes that CHKDG has only conversion value after 5 years. Even this model, which really undervalues CHKDG, proves that CHKDG is currently the better investment. This is not an opinion. This is just the numbers and they don't care about any short squeeze or sentiment. In reality, CHKDG will outperform even more by the time CHK reaches $30 per share as a preferred stock has added value. If you have CHK long and intend to hold it, this calculation is a must.
What prevents CHKDG from rising?
My guess is that no one really trades this stock and the public tries to keep the price lower than the bonds. The 5.375% bonds maturing on 6/15/21 currently give a yield to maturity of nearly 25%. This yield is dependent only on the company's survival up until this date and is not dependent on common stock performance or dividend recovery.
The chart above may give you another perspective. Buyers of the bond know exactly what they are getting if the company survives. Compared to the best-case scenario in CHKDG, the yield compares favorably.
The inefficiency in CHKDG's price comes from the conversion value, because if the common stock rises, CHKDG will appreciate based on its conversion value, but also has to appreciate due to the value of being a preferred stock. The second has still not happened. The most simple conclusion would be that it should have a preferred stock value at least equal to the conversion value and this is a theoretical dispute that I would really enjoy in the comments section.
On the chart below, you can see the Internal Rate of Return of CHKDG with an addition that also assumes that the preferred part of the stock holds extra value. This added value remains proportional to the conversion value until the price of the preferred stock gets close to the $100 par value. Above $91, the added value levels off and the preferred stock will trade based only on the conversion rate.
Source: author's database.
Possible ways to trade this inefficiency.
- You are an extreme bull: Buy CHKDG now and monitor closely, because once CHK nears $20, CHKDG will be left without any capital appreciation (see the chart above). Since you are extremely bullish and want to go to the moon on the CHK ship, you will have to switch to the common stock.
- You are bullish on reinstating the dividend, but do not expect CHK common stock to appreciate: Buy 100 shares CHKDG and short 277 shares CHK. This way you will benefit the most from a static common stock that survives and you just bought $5 of perpetual dividend for $4.56
- You are bearish on the common stock, but believe the company will survive with lots of dilutions: Just increase the ratio of the CHK shares short. In my most bearish scenarios, I have used 800 shares short for every 100 shares long.
- You are extremely bearish: Short the common stock naked and use CHKDG as a plan B hedge while it is still undervalued.
How I trade it
I managed to buy some CHKDG shares at $20 today and have 5.5 times more shares short in the common stock. I will add this position to my arbitrage trading portfolio as of closing prices on 04/12/2016.
Depending on the way you chose to trade this inefficiency, the risks will be different. I am just slightly bearish on the CHK move, so my risk is a continuation of the sharp rally. I believe that this risk will be eliminated by an appreciation of the preferred part of CHKDG's value.
I am also closely monitoring the hard to borrow rate and am ready to switch to put options on a sharp increase in the borrowing price.
CHKDG exists even though it trades over the counter (OTC). The market gives us a chance to lock a nice perpetual cumulative dividend at a very cheap price while being able to hedge. An arbitrage trade does not get much better than this and it is just a matter of time while the market realizes how mistreated this stock really is.
Disclosure: I am/we are long CHKDG.
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 short CHK 5.5 shares for every 1 share of CHKDG