Why Investors Are Selling Chesapeake Like Crazy

| About: Chesapeake Energy (CHK)

Chesapeake (CHK) is an undervalued and risky investment for those looking into the energy industry. The low stock price for the second largest producer of natural gas in America is certainly appealing, but there a number of factors that make Chesapeake an extremely risky investment for the short term or long term investor. Chesapeake is currently dealing with problems in its board, high debt combined with lowered credit ratings and all-time natural gas pricing lows that are hampering earnings. It's doubtful that Chesapeake will be able to sustain or overcome its current issues. It seems more probable that the oil and natural gas provider will be dismantled or acquired by a larger organization.

The current stock price is hovering around $15 since increasing in response to recent news about ensuing changes to the board. The price is still at the low end of the 52 week range between $13 and $35. The positive sign is that the market cap is only around $9 billion while the enterprise value is around $23 billion so there is room for growth after improving operations and the balance sheet. The beta is over one, while the price to sales ratio is on par with larger competitors like Exxon (XOM) and Chevron (CVX). Operating margins and return on equity have been decreasing each quarter while net income is on the rise. Sales growth is improving while price-to-earnings ratio is around six to eight. However, the current ratio is currently less than one.

The low stock price is certainly attractive for assertive investors, but this low price is certainly warranted as well. It's probable that the stock price could decrease even more and Chesapeake may not be able to recover. The issue with capital expenditures, corporate and board governance are the catalysts behind the lowered credit ratings. The S&P, Fitch Ratings and Moody Investor Service have all downgraded Chesapeake to junk rating, double B minus, below investor grade.

These ratings are based on the doubt that Chesapeake will be able to sustain with its limited amount of cash and high degree of debt and level of capital expenditures. Expressed conflicts of interests among the board and CEO are also a serious issue. Both the SEC and IRS are conducting informal investigations into Chesapeake and its CEO. According to Fitch, there is a $10 billion gap between cash flow from operations and capital spending along with leasehold acquisitions. Cash flow will be negative for at least the next three years.

Chesapeake managed to raise its stock price by announcing cuts in the benefits and salaries of executives and outside board members. It also bought some goodwill with investors by separating the chairman and CEO position, although a replacement still has to be named. These efforts are somewhat futile and not enough to solve the core problems in the board. The conflicts of interest and lack of objectivity or independence by the board has been made more than evident. Lavish spending on travel arrangements has also been an issue.

To put this in perspective, Chesapeake has more shares and four times the investment in jets for traveling than the second largest investor Microsoft. The New York City comptroller is pushing investors to vote in an entirely new board opposed to just lowering their compensation and benefits. He cites Chesapeake for neglecting to properly disclose over $1 billion liabilities and loans made in-house, the CEO had a separate hedge fund that created a conflict of interest in his role with Chesapeake, and questionable payments were made to the family members and associates of board members.

Chesapeake did receive a $4 billion loan from Goldman Sachs (GS) and Jefferies Group in order to buy more time to cover its liabilities but this creates a dilemma as well. Chesapeake had to use the same assets for collateral that it planned to sell over the next few years. The firm planned to sell up to $14 billion in assets in order to sustain for the next few years. This initially caused the stock price to rise but announcing the delay in selling the assets also put off many shareholders.

Chesapeake is caught in a hard position where it will not be able to cover its liabilities due to a lack of cash from operations or it will have to be absorbed by large competitors or sell a significant stake of the firm or assets to a smaller competitor like ConocoPhillips (COP). The lack of operating cash flow is due to the recent 10 year low in natural gas prices driven by the progress made by Chesapeake and the industry alike.

Chesapeake is not alone in taking a loss on earnings from natural gas; this is an industry-wide scenario. The problem is that Chesapeake is so inundated in natural gas and too small to sustain for the long-term. This is combination with poor management, exorbitant spending and climbing debt is a hard scenario to escape. It's unfortunate that the innovation and progress in technology employed by Chesapeake is the reason for the turmoil. It did such a good job of finding natural gas that the industry created an abundance of a supply that lead to low prices that in turn hampered their own earnings.

Revenues continue to increase, but net income is persistently unstable for this firm. Chesapeake is looking towards Ohio to increase its holdings of fluid-based natural gas since the price of dry natural gas is so low right now. It plans to increase the number of working wells from 10 to 13 by the end of 2012 and to 22 by the end of 2013.

This could create a competitive advantage for Chesapeake in the industry and could also entice larger competitors to eventually acquire or invest in the second largest natural gas producer in the country. This is the best case scenario for Chesapeake as the situation currently presents itself.

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

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