Chesapeake's Fundamentals Are Getting Better

| About: Chesapeake Energy (CHK)

Summary

Final results of the tender offer show a small reduction in total debt.

Interest coverage should not change much despite an increase in interest expense.

EBITDA will likely go up due to rising natural gas and oil prices.

Debt maturities for the next two years have come down by 16% due to these tender offers.

Oil markets have become bullish after news came out that OPEC members have agreed to a production cut. The WTI crude price has gone over $47 and there is a prospect of it crossing $50 mark over the next few days. This is good news for Chesapeake (NYSE:CHK). Despite being a predominantly natural gas producer, the share price of this company responds to oil price in a big way. While this is good news and further strengthens my long-term bullish views about oil prices, it is the internal restructuring steps that should drive the stock price.

Chesapeake has announced the final results of its tender offer for non-convertible notes as well. The company had extended the date for this tender offer. As the results for both the tender offers have been finalized, we can estimate the effect of these transactions with a fair bit of accuracy. I have tried to explain the effect on debt metrics in my previous articles but these numbers can help us estimate a more accurate change in debt and debt metrics.

Valid tenders for the offer reached $933.3 million. The tender was capped at $800 million. The interest in this tender offer has been less than impressive as it had 10 debt issues up for redemption. As I expected, there was not much interest in the bond issues maturing through 2018. These bonds were also priority I issues and $400 million were reserved for this category. 100% subscription for priority I bonds would have meant a reduction of more than 33% of debt obligations maturing in the next two years. As it stands, total tendered and accepted value will result in a reduction of just over 16%. Not what the management wanted. Even with the early tender premium, bond holders were not willing to offer their bonds. As I have said before, these bond holders have little incentive to give up their bonds as the market price currently more than makes up for the premium offered by the company. In fact, both issues maturing in 2017 are now trading at a premium. Bondholders are clearly more interested in collecting their steady coupon payments than having to find a new investment candidate.

Almost $195 million will be accepted from the priority I notes, meaning $205 million will be spared from this category. We can assume that these funds will be used in full to pay floating rate notes maturing in 2019. A total of over $444 million were offered for redemption from the 2019 issue. Priority III notes also did not receive too much attention as the total tendered amount was just below $260 million. Management had earmarked $400 million for this category and it was capped at $610 million. However, the tendered amount falls below the limit and it is likely that all of these will be accepted.

The company announced that it has accepted $897.7 million worth of notes for an aggregate price of $800 million. Since the priority I and III notes were under-subscribed, we can assume that management decided to accept more of the 2019 notes. Funds from the priority level III notes also have been diverted to the floating rate notes. We will get a clearer picture about the reduction in each issue. However, the total redemption amount for both issues is clear and it goes over $1.6 billion. This transaction has been good for the company in terms of overall debt level. New term loan adds $1.5 billion to the total debt while the tender offers reduce the debt by more than $1.6 billion. Net effect on debt is a reduction of more than $105 million. A lot of investors were worried the term loan going up from $1 billion to $1.5 billion was a bad thing. However, it looks like management has turned this into good news by accepting more notes for redemption. The press release clearly states that the company will continue to buy notes from the open market, indicating that the debt will come down further.

A reduction of $105 million in debt will not have a big impact on the total leverage ratio. However, an increase in EBITDA will magnify this change. There are chances that the adjusted EBITDA for Chesapeake will be higher than the previous estimates due to the expected rise in oil prices. My estimate for full-year adjusted EBITDA was $1 billion - the company has already generated around $500 million in adjusted EBITDA for the first two quarters. My previous natural gas price estimates are proving to be conservative as the spot price has crossed$3 and the NYMEX futures price has reached $2.9. The average price for the last year was just $2.31 and it has been close to $2 for the first few months. Natural gas is ending the year strongly and it should cause the adjusted EBITDA to go up. I'm now expecting full-year EBITDA of around $1.2 billion assuming natural gas prices remain near the current level for the next three months.

Now this means the interest coverage ratio should remain above 3x despite an increase in interest expense from the new term loan. However, total leverage ratio should come down slightly due to the dual impact of increased EBITDA and reduced debt levels. My previous estimate put the debt/EBITDA ratio at over 7x but the increased EBITDA should bring it down to 6.3x. However, it should be kept in mind that this leverage ratio is still too high. From a credit ratings perspective, it will need to come down to around 3x to have a favorable opinion from the ratings agencies. Growing EBITDA and extended maturities will certainly get attention from these agencies but further measures are needed for a favorable opinion.

Overall, Chesapeake's management is doing well and if the trend in commodity prices continues to be favorable, then the stock price will rise. The OPEC accord regarding production cuts has pushed the whole energy market up but investors should be careful. It will become clearer over the next two months how these nations will share the burden of reduced output. Chesapeake has now become an interest turnaround play in this industry.

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.