Chesapeake Energy Corp (CHK) has been the subject of much investor attention. Its CEO and Founder, Aubrey McClendon has been the subject of some less than flattering investigations into his lack of fiscal responsibility both from within and without the company. These indiscretions, coupled with the all time low natural gas prices, which affect Chesapeake more than other companies because of their unusually high exposure to the commodity, have caused the share price to sink more than 30% over the past year. Recently, a lot of smart money, led by Dan Loeb of Third Point, and Carl Icahn, have started to pick up the debt (though most news agencies incorrectly reported that Mr. Loeb bought the common equity) and equity of the company respectively at an impressive clip. Mr. Icahn used his 7.5% equity stake as leverage to install some of his preferred choices to the company's board.
In Mr. Icahn's letter to management, he cites a looming $16bn funding gap as one of the biggest risks facing the company, Fitch Ratings echoed the same concerns, but put the funding gap between $7-$8.5b. Mr. Loeb has not publicly disclosed if he has any issues with management, or any changes he wants to see the company make. In this article, I will discuss this funding gap, the ways Chesapeake has dealt with the issue, and what it means for investors.
The Funding Gap
Chesapeake has gone on a pretty aggressive spending binge in order to transition away from a purely natural gas E&P company, to a more balanced portfolio split between oil and natural gas. This costly transition, however, has left them with a pretty deep funding gap. On page 58 of their most recent 10-K Chesapeake outlines their FY 2012 capex program. Their they give the following estimates for 2012 spending:
- Drilling and completion expenditures -- $7.0-$7.5 bn
- Midstream and oilfield services businesses -- $2.5-$3.5 bn
- Net undeveloped leasehold expenditures -- $1.4 bn
Taking the average of the first two figures, $7.25bn and $3bn, you get a total of $10.25 bn, with the addition of the property acquisitions the company's total capex comes out to $11.65bn.
How much has the company made this year? Despite Chesapeake's aggressive move away from NG and into oil plays, doubling oil production in 2012 over 2011 figures, they still got destroyed by the increasing free fall in NG prices. Their income statement, simplified, runs as follows
- Sale/mcf $3.89
- Expense/mcf $1.60
- Profit/mcf $2.29
- Production (MCF) 557.1
Total Income $1,276
On an annualized basis Chesapeake will make approximately $2.5bn this year, while spending $11.65bn, in higher mathematics that comes out to a $9.15bn shortfall, a number very close to the Fitch numbers referenced above. Clearly the exact figure for the full year shortfall involves some guesswork, and on p. 71 in the company s most recent 10-Q Chesapeake put their potential shortfall somewhere around $10bn, but the point remains the same. Chesapeake has a huge shortfall, now we must examine what steps have they taken to close this gap?
Company's Steps To Close The Gap
The company plans on making between $13-$14bn in asset monetizations this year, more than enough to close the funding gap. In Q1 2012 the company completed $2.5bn in their asset monetization program, and in Q2 2012 they completed $2.7bn in asset monetization, for a total of $5.2bn. The company accomplishes this both through monetizing its specific plays, and by spinning off subsidiaries into separate companies, like Chesapeake Midstream Partners L.P. ((CHKM)). It doesn't seem like the company breaks out the specific plays it has monetized, but I think we need to make an important point here.
Namely, with Chesapeake monetizing their assets either through JV's, VPP's, or outright asset sales, we have to hope management does not make the wrong decision under the gun and sell something very valuable. Management has a lot of pressure to fill their liquidity gap, and investors must question whether management can make the correct decisions in these adverse conditions.
Asset Sale Impact In More Detail
Warren Buffett famously said that the value of the business is the amount of cash you can take out of it at its present value -- discounted cash flow (DCF). Luckily for us, Chesapeake on p. 12 of their most recent 10-K, like all other E&P companies, does all the hard work for us, and projects their cash flows based on a few assumptions and discounts the cash flows at a 10% rate. Truthfully, Chesapeake's WACC is lower than 10%, closer to 9% probably, which would positively impact cash flows at their present value, but we will use the industry standard of 10% as our discount rate. Given their projected future cash flows, at a 10% discount rate, the present value of Chesapeake's cash stands at $19.9bn. This figure trades at par with the book value equity of the company, and at about a 36% discount to market cap. This discount provides you with a nice, margin of safety , but in my opinion does not take into one main problem.
The problem with this $19.9bn figure is that it hasn't taken into account the most recent asset monetizations, and future monetizations. To come full circle, this $19.9bn could see a significant hit if management does not properly execute their asset sales, and sells some of the more valuable properties. I could imagine about 100 better conditions for management than their current predicament. Trying to pull off such a large amount of asset sales, in such a short period of time, during a period of such deep financial distress, I don't think provides the ideal conditions for a successful asset monetization plan.
In fact, Chesapeake felt the heat of this pressure earlier this year when they had to take a $3.8bn loan, at a usurious interest rate, and while this allowed them to sidestep some of their problems, and give them more breathing room, I think this shows the perilous situation management finds themselves in.
I have not seen any releases from Chesapeake giving a line-by-line account of their asset monetization program. As far as I can tell, management has only given the broadest outlines of their asset monetization plan. In order for investors to fully evaluate the long term sustainability of Chesapeake's cash flows, we need more color on that topic. Therefore, while Chesapeake trades at a significant discount to market cap, providing a nice margin of safety for investors, the haziness of Chesapeake's future plans cast a dark cloud over those cash flow projections.
Additionally, despite Chesapeake's recent revamps of their corporate governance, they still seem to find themselves in dicey corporate governance situations. Consider, one of Chesapeake's asset monetizations plans calls for them to spin off their oil services company (COS) into a separate publicly traded company, basically the same thing they did with CHKM. Both CHKM, and if successful COS will trade separately, yet have more or less one customer -- Chesapeake. I don't know, but this sort of exotic type of left pocket, right pocket accounting sort of rubs me the wrong way.
I think I have raised some pertinent issues with regards to Chesapeake. Mr. Icahn clearly disagrees with me, and I guess he feels confident that the company will execute their assets sales effectively. If investors feel comfortable with Mr. Icahn's view, then I would tip my hat to a company trading at 36% to market cap. However, if you don't feel as comfortable with Mr. Icahn's view as it relates to asset sales, and feel uncomfortable about some of Chesapeake's other practices, then you should think twice before investing.