Chesapeake Energy (CHK) released first-quarter earnings on May 1, amid serious concerns about the business practices and strategies of the company and its beleaguered CEO Aubrey McClendon. The earnings report did little to ease shareholder unease, with Chesapeake reporting a loss of $0.11 per share.
CEO Aubrey McClendon's Future Tenuous
The U.S. Securities and Exchange Commission is informally investigating Chesapeake's "Founders Well Participation Program," the plan that granted CEO Aubrey McClendon a 2.5% stake in each of the company's wells. The Internal Revenue Service is also investigating the program. In addition to this, Senator Bill Nelson is now expected to request the U.S. Justice Department's Financial Fraud Enforcement Task Force to conduct a formal investigation for "evidence of fraud, price manipulation, conflicts of interest, or other illegal activities."
Chesapeake's board of directors backtracked on earlier statements that it was aware of and approved McClendon's mortgages on his ownership stakes, and is now indicating that they "did not review, approve, or have knowledge of the specific transactions engaged in by McClendon or the terms of those transactions." The board is reviewing McClendon's financial arrangements with the firms that backed these transactions. The company then announced that McClendon will be replaced as chairman, which will end the arrangement by which McClendon was granted ownership in the wells.
Amid these disturbing revelations, it was also reported that McClendon ran a private hedge fund that "traded energy and other commodities" separately from oversight of Chesapeake's fund managers and risk analysts for years during his tenure, at least from 2004 to 2008. As trading managers and consultants for other energy companies pointed out, at best McClendon's commodities trading represented a conflict of interest, and these activities would be cause for termination according to the guidelines of other firms. This trading activity was never disclosed to shareholders before initial reports surfaced this week.
Given the interest in these activities evidenced by multiple entities and the poor judgment exhibited by McClendon and the board, I think that Chesapeake would be able to enter a turnaround if it were to relieve McClendon of all of his duties and give in to shareholder calls for a more independent board.
McClendon is alone in predicting that natural gas prices will increase to $5 per cubic foot by 2014, and is staking plans for the company's recovery on his forecast. Chesapeake, as the second-largest producer of natural gas in the U.S., is partly responsible for the low prices that are currently battering its stock, as overproduction from the shale gas boom (which Chesapeake drove) is depressing prices. In a twist of irony, I think that the only way gas prices would reach to $5 in such a short time would be if Chesapeake were to substantially reduce its operations while planning a complete operational turnaround.
Chesapeake is warning that it may need to sell more assets than planned and curtail more drilling activities than anticipated. It plans to sell its assets in the Permian basin in the third quarter of 2012, which in my opinion is a poor decision for a company trying to transition into oil. The Permian, next to Eagle Ford, is one of the most oil-rich proved plays in the lower 48, and Chesapeake's plan to exit this play is baffling as it plans to keep its dry gas plays but curtail drilling activities in the meantime, generating no income. What's worse is that the company invested $1.7 billion in drilling around the Permian in 2011.
Despite its previous guidance that it would cut production, Chesapeake's first-quarter 2012 production of 271 bcf nearly equaled first quarter 2011 production of 272 bcf. Chesapeake is facing a problem that goes much deeper than low prices for its top commodity. The company is overleveraged to the point where it cannot afford deeper production cuts even at current prices, but by continuing to keep production at current levels it is only helping to ensure prices remain low.
Approaching Overleveraged Status
In the first quarter, Chesapeake realized $6 million in income from operations, which was not enough to cover $12 million in interest expense and $5 million losses on investments. Despite its cash flow problems, Chesapeake spent $900 million in net leasehold and unproved properties in the first quarter and plans to spend $700 million more on these acquisitions in 2012.
With a current debt to equity ratio of 0.9, in order to continue surviving Chesapeake will need to come up with considerable amounts of cash, which I think is probably beyond what it would be able to raise in selective asset sales. With its unhealthy balance sheet and credit rating now downgraded to BB by Standard & Poor's Rating Services, few financial firms will be looking at Chesapeake as a borrower.
Chesapeake's debt-to-equity ratio is above the industry average and compares unfavorably with its competitors. Crowd favorite Apache (APA) currently has a debt to equity of 0.3. Cabot Oil & Gas (COG), which holds gas plays in many of the same areas as Chesapeake, has a debt to equity of 0.5. Devon Energy (DVN) has a debt to equity of 0.3. EOG Resources (EOG) has a debt to equity of 0.4.
There are indications that McClendon's poor decision making reflect the deeper culture at Chesapeake, as Chesapeake Senior Vice President of Investor Relations and Research Jeff Mobley recently responded to concerns over the company's debt pile by stating: "If we lived within cash flow we'd miss the opportunity."
Matters are not helped by Chesapeake's complicated corporate structure, which sees portions of the company held in trust, other portions held by joint venture, and yet other portions preparing to trade as separate entities. The waters are muddied further by the balance sheet, and lead to an increasingly valid question: What kind of company is Chesapeake? Is it a real estate company, an oil company, or a hedge fund? If we look only at where Chesapeake has made most of its income over the past years, the answer should be hedge fund. Chesapeake reported gains from commodities trading and hedging activities totaling $8.4 billion from 2006 to 2011. Its gains from operational income in the same period were a comparatively paltry $1.8 billion.
Chesapeake is currently trading around $17, with a forward price to earnings of 6.2 and a price to book of 0.8. Apache Corporation is trading around $92 with a forward price to earnings of 6.6 and a price to book of 1.3. Cabot is trading around $34 per share with a less-than-desirable forward price to earnings of 34.5 and a price to book of 3.4. Devon is trading around $66 with a forward price to earnings of 9.1 and a price to book of 1.2. EOG Resources is trading around $108 with a forward price to earnings of 15.9 and a price to book of 2.3.
Chesapeake, given its current problems and the apparent failure of its leadership to realize and adequately address shareholder concerns over its management and balance sheet, should be operating with a much more serious focus on its core business while shedding unoperated leases. As it is not, and all indications are that the stock will go lower before a turnaround is enacted, it is not a stock to buy in the near future.