Chesapeake Energy: Capital Structure Needs To Improve Further

| About: Chesapeake Energy (CHK)

Summary

Recent reshuffling moves have balanced the cost of financing for the company.

Exchange of preferred shares is a net positive for the company.

Common shareholders will have to bear some dilution.

Preferred dividend expense will come down substantially.

There have been a lot of changes at Chesapeake Energy (NYSE:CHK). Most of these changes have been positive, which has resulted in a fourfold increase in stock price. Asset sales, debt reduction, private placements and conversion of preferred shares into common equity are some of these steps that the company has taken to improve its position. All these efforts have changed the business mix as well as the capital structure. Chesapeake management was also quick to highlight this fact in a press release on October 5. The management stressed that the exchange of preferred stocks has resulted in an improved capital structure, which is true to some extent. However, this improvement has come at a cost for the common stock holders. The exchange of preferred shares has resulted in some dilution for the shareholders and the option of conversion for $1.25 billion private placement (convertible notes) has the potential to cause further dilution. Despite these concerns, the net effect of these steps is positive for shareholders because these steps ensure the business continues to operate smoothly in these difficult market conditions. Liquidity has improved with $1 billion in cash and unused credit facility. There is enough cash to meet debt maturities in the next two years.

The preferred stock exchange has helped the company to improve its capital structure but the main idea behind this move looks to be cost related. One of my biggest concerns was that Chesapeake had raised $1.5 billion through the term loan facility at a considerably higher cost than the previous debt. The company used that cash to pay off some of the cheapest debt it was carrying. As a result, the overall interest expense was going to go up which was weakening its interest metrics.

In order to understand how this conversion of preferred stocks will affect the cost and capital structure, let's first look at the current mix of preferred shares. Chesapeake has four series of preferred shares outstanding. A total of 5,932,435 preferred shares are outstanding after the exchange. The series carrying the lowest dividend rate (4.5%) was ignored, which shows that the company's main focus was to bring down the cost. 1,293, 278 preferred shares were exchanged for 110.3 million common shares. Conversion price comes out to be just below $11 per share, substantially lower than the specified conversion prices for all these issues.

It should be kept in mind that these preferred stock series are cumulative convertible, which means that the dividend accrues if the company decides to suspend it. Chesapeake had suspended dividend for all these issues but it was still accruing. In each of the last three years, the company recorded $171 million in preferred dividends. Since the payment was not being made to the preferred shareholders, Chesapeake had to adjust it in the stockholders' equity section. There was a reduction of $128 million in paid-in capital during the last year. Previous two years did not show any adjustment for preferred dividends or common dividend. This information can be found on page 84 of the 10-K in statement of stockholders' equity section. Suspending preferred dividend is not like cutting common dividend. The company has to record this dividend somewhere and make adjustments. By suspending preferred dividends, the management can control cash outflow but there needs to be accounting adjustment, which will finally show in the balance sheet.

Chesapeake has exchanged over a million preferred shares with annual dividend of $57.5 per share. Total reduction in annual preferred dividend obligation is above $67 million, according to my calculations. This is an interesting development and almost completely nullifies the increase in interest expense from the term loan. However, a distinction here is that the interest payment cannot be deferred. Still, the move will allow the company to balance its financial statements on accounting basis. It is all about the overall cost of financing. Increased interest expense is being countered by decreased preferred dividend obligation.

The capital structure has certainly improved but there is need to make more adjustments. The management is talking about a leaner capital structure but this move alone will not simplify it. There is still a substantial number of preferred shares outstanding and over a $100 million in preferred dividends will continue to accrue. However, it is still a positive step in terms of balancing the cost of financing and looks like the management was planning for it from the start. Chesapeake's willingness to accept high cost of term finance now makes sense.

Common shareholders have taken a small hit in the form of dilution (12.5%) as 110 million new shares have been issued. This news came out at the start of the month and the stock price has not been adversely affected by the news. It shows that the shareholders are happy to absorb this dilution keeping in mind the bigger picture. The capital structure needs to be further adjusted. We might see more conversion of preferred shares in the future as the discount is attractive.

I am still hopeful that the stock price will hit $10 mark by the end of the year. Oil prices are rising, which will result in healthy average realized price for the second half of the year. This trend will also strengthen the balance sheet because the year-end valuation of reserves will be at higher prices for the second half of the year. However, next catalyst will be the further sales of its non-core assets. The management is still looking to sell some assets and these sales should further enhance its liquidity position. If these sales are substantial, then we can expect more funds being directed towards debt reduction.

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