Icahn Is A Game-Changer For Chesapeake

| About: Chesapeake Energy (CHK)

It was recently announced that activist investor Carl Icahn has likely taken a significant stake in the embattled natural gas company Chesapeake Energy (NYSE:CHK).

The news served as a pre-market catalyst, sending the stock up over 10% in the early session on Monday. While these gains will likely stabilize throughout the day and the week, the entrance of Mr. Icahn is an interesting signal for the stock. Clearly the market likes the move, having been looking for some reason to stem the slide that is largely blamed on the company's Chief Executive Officer, Aubrey McClendon. Since news broke about a month ago, linking Mr. McClendon's personal finances to activities of the company, shares have tumbled at an alarming rate for shareholders of the world's second largest natural gas producer; this fall was capped with a 14% decline last Friday. Many investors have already called for Mr. McClendon's resignation from the company, but the appearance of Mr. Icahn does not bode well for the CEO's future.

Regardless of what one thinks of Mr. Icahn, and there are plenty who are not fans, his involvement with a company has an impact. For example, Mr. Icahn recently seized controlling interest in CVR Energy (NYSE:CVI). In this deal, Mr. Icahn purchased a significant interest in the company and then the fun started. After months of fighting with the Board of Directors, Mr. Icahn successfully forced through his $2.6 billion takeover bid, giving him 69% ownership of the company. The result is that seven of the company's nine Board members will likely be replaced and the direction of the company will be driven be Mr. Icahn and his nominees to the Board. Speculation abounds that given his great success with CVR, Chesapeake is next on his list. With the current weakness in the stock, and the swirling controversy around Mr. McClendon's role, this is not a huge stretch.

Corporate Raider or Guardian Angel?

The debate will now intensify as to what light Mr. Icahn should be cast in given his history and the current position of the company. His role in the Yahoo debacle earned him some fairly harsh critics who see him as a corporate raider who benefits himself and not the shareholders, at least not their long-term interests. Given the death spiral under way at Chesapeake, however, some will say it is too soon to fit Mr. Icahn for a black hat, preferring to elevate him to savior status. The truth is likely somewhere in between. Mr. McClendon has clearly exercised some horrible judgment, which has led for his need for an emergency loan of around $3 billion. However, the chief executive has been behind the proverbial eight ball in the past and successfully led the company to significant profitability.

A Liquidity Crisis

Liquidity has a great many meanings with the realm of finance, with practitioners often assuming that the context speaks for itself. When one is discussing the stock market, liquidity usually means the number of shares that change hands each day. The higher this number, the more likely it is that any shareholder will be able to trade his or her shares without significantly affecting the price.

Liquidity is generally considered a good thing as it protects shareholders - if a stock is liquid, one can turn those shares into cash with little fear that the price received will differ significantly from the market price. In this context, however, liquidity has a different meaning. Chesapeake announced late last week in 10-Q filing that some of the asset sales it had promised may be delayed due to certain liquidity constraints within various debt covenants. What this means is that while the company had planned to meet various cash needs by selling assets, those very assets produce cash flows which are the basis for other loans the company has taken. If the assets are sold, the company's cash flows will be affected in such a way that the terms of some of its loans would be pushed into default.

If this is all starting to sound like a house of cards, well, that's a great analogy, but one that is more common than one may think. While no one would necessarily choose to throw money at such an unstable structure, cross-collateralization is a fairly common process and not nearly as scary as it sounds at first blush.

The Peers

The fall in the price of Chesapeake shares has had a dramatic impact of some of the company's key financial metrics. While it is often hard to compare Chesapeake, a pure natural gas play, to competitors like Exxon Mobil (NYSE:XOM), ConocoPhillips (NYSE:COP), BP (NYSE:BP) and SandRidge Energy (NYSE:SD) because of the more diversified nature of their balance sheets, it is always prudent to at least be aware of some of these figures. Chesapeake is currently trading at a price-to-earnings (P/E) ratio of 6.3 relative to 20.4 for SandRidge, 10 for Exxon Mobile, 5.8 for ConocoPhillips and 5.1 for BP. This places Chesapeake at the value end of this spectrum, but this is hardly the complete picture. The pressure on natural gas has had an impact on these numbers and should be taken in context. The reality is that natural gas prices are likely to rise and life Chesapeake's earnings.

Trade Today or Run Away

The question that any investor really wants to know is "so, do I buy or sell?" The answer is fairly complex, but boils down to the fact that the stock looks pretty attractive in multiple lights. If one thinks that Mr. Icahn will take control through a buyout, the shareholders may receive a nice premium for their shares. If Mr. McClendon is able to endure the storm and lead the company to safety, the recent weakness will reverse and the return potential will also be solid.

The single biggest risk is that Icahn sucks the company into a long and costly fight that he loses, or that drives down the stock so far that the premium will not justify owning the stock at current levels. Because the company is in the commodity business, underlying all assets is a product with value that is likely to increase. Based on this last point, the risk of own the stock seems attractive relative to the return potential.

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