JJSpano

Chesapeake Energy Pre-Call Notes: Another Quarter, Another Beat

So here's the thing, looking at their financial statements you can see they are hedged into 2010 (at varying prices). Thus the losses on their income statement reflect the losses on the rest of their '08 & '09 & '10 hedges. Why? As per SFAS 115 which requires trading securities to be mark to market, unrealized gains or losses are also included in net income (*this is most likely the confusion*), not just 2nd quarter 2008 hedges (which are realized losses, and that was reflected in the realized $8.55/Mcfe value I gave you as they sold natural gas at $10.55/Mcfe). 2nd quarter unrealized losses taken from CHK's earnings release were $3.404 billion (these unrealized losses won't effect cash flows until later, and in fact could turn into gains!!!). 2nd quarter realized 2008 hedge losses are also given in CHK's earnings release and this number is $423 million or $2.00/mcfe, so they lost real money this quarter of that amount not the total amount deducted of $3.827 billion ($3.404 + .423). Looking at cash flows in this case is much more informative. Or look at adjusted earnings of $.89/share which is $491 million. I'm pretty sure you're going to want to know how that is calculated so I did the math and here is how it adds up approximately: -$1,649 billion (NI Loss) + .615 (1-Tax Rate) * -$3,404 billion = $444.5 million ($444.5 is my number CHK's is $436M) for just taking into account what would have happened with no unrealized losses taken into account (this would be $444.5M + .615*$423M = $705M if CHK didn't hedge at all) and CHK also adds preferred stock losses back to reach $491M in adjusted gains. Out of all those numbers I would use $436M to be on the safe side, and maybe add the interest amount they will gain on the tax benefits they recieve. Now hopefully you can see why net income and p/e ratios are often worthless to value a company; cash flow numbers aren't perfect either as depreciation and amortization numbers can be distorted when costs that should have been capitalized are instead depreciated or amortized and then added back to cash flows! The best method for valuing stocks is a stochastic DCF model with adjusted cash flow predictions that make Free Cash Flow to Equity, Free Cash Flow to the Firm, Dividend Discount, and Residual Income models all equivalent (as they should be!!!). Monte Carlo programming is used to make these models stochastic, since you're a programmer this maybe something you can do. But remember Garbage In - Garbage Out, so that is one reason most stick to a deterministic dcf model. Visit my blog in the future (sometime in the next month) as I'm about to post some simplistic models for prospective employers to look at. Also, I'm working on collecting thousands of samples of ratings (through html parsing) from value line to determine the value of their stock grades. I already have a morningstar review posted. Please leave some feedback, constructive criticism is welcomed.

JJSpano
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Chesapeake Energy Pre-Call Notes: Another Quarter, Another Beat

First off diversification is key for numerous reasons including decreasing a portfolio's stdev and decreasing a portfolio's VAR of losing money. This matters for both mathematical, psychological, and realistic reasons which I won't go into depth on.

leacabrerra - You make a lot of great points, and I would love to know more about these "FOUNDER WELL PARTICIPATION PROGRAMS". I researched it before I bought the stock and wasn't too worried about it at the time, but I'll look into it again. One major point I'd like to make however is that Enron had large positive [Total Accruals (basically NI - CFO)/Total Assets] ratios before going under, and CHK doesn't ( Q2/2008 = (-1,649 - 1,256)/38,023 = -7.64%) which puts them on different planets to say the least. Enron was accruing large amounts of income it was "suppose" to obtain years later through actual cash flows. Almost like a company saying this year that they are going to accrue let's says billions of dollars right now because they have a psychic who says in a few years they are going to land billions of dollars in contracts, this makes a company who should have negative net income display positive net income (Wiki accrual accounting for those unfamiliar with this process). Chesapeake is in the opposite category which is good because they're most likely not making up false accruals to impress net income lovers (the market), and instead are reporting more losses which are tax deductible and thus have tax benefits!! Also, you state:

"Aubrey McClendon has boasted that CHK has a fair value of $100. If so, then why did he sell out the shareholder for 57.25 cents on the dollar? Was CHK that desperate for cash?"

The answer is probably in the last question you asked. Remember debt covenants are a serious issue, and CHK sold shares to pay off debt I believe so that banks couldn't demand their money back. Otherwise you could have what has happened to banks lately. Now the $100 believed price to $57.25 offering is another issue that needs addressing. I'm going to write it in bold as what I'm about to write confuses many-

WHEN A COMPANY SELLS SHARES FOR LESS THAN A COMPANY IS INTRINSICALLY WORTH, THIS DOES NOT NECESSARILY MEAN SHAREHOLDERS ARE LOSING VALUE. FOR INSTANCE, IF A COMPANY'S SHARES HAVE A MARKET PRICE OF $75 AND AN INTRINSIC VALUE OF $100 THAN SELLING NEW SHARES AT $75 ACTUALLY INCREASES THE VALUE OF THE SHARES THAT ARE ALREADY OUT WHEN >>> THAT NEW EQUITY ALONE HAS AN INTRINSIC VALUE OF MORE THAN $100 WHEN RECEIVED BY THE COMPANY. YES, THIS IS POSSIBLE.

But new shares were sold because of debt covenants, and that helps preserve value so it wasn't necessarily that big of a deal. I have talked with professionals about this, however, and they think something interesting is going on to (some say this is good and some take the counter argument).

CT
Programmer- Nice scolding, hopefully you'll save a lot of future pain for that user! I mean psychologically alone it could kill you watching just one stock move up and down by swings of 30% or more in a matter of weeks (CHK recently did this). Warren Buffett suggests stocks you could sleep on for years with no worry for this reason. Now to answer some of your questions. Okay hedging is confusing to many, and especially how it is reported on financial statements which is I believe your question. SFAS 115 (I know this as a CFA Level II Candidate although you can google it) states that trading securities (futures,forwards, and swaps fit this category) must be marked to market. So it appears CHK is losing tons of money when in actuality it is just making less than it could have at market prices. For example (simplified heavily), lets say you hedge natural gas at around $9 for one year later as a natural gas producer (look on the sec's edgar database for actual numbers for CHK) which means you are taking the short side (selling so that you are guaranteed $9/MMBtu at a future date of one year no matter the price), if the price of natural gas goes to $10 that means a paper loss of $1 per future or $1 billion per billion futures. Now if that natural gas is delivered at $10 then is that really that bad for a natural gas producer. No (remember the price could have gone the other way!). The natural gas producer produces the underlying, so they'll just deliver the goods (or sell at $10 and deliver the cash above $9, which is the same thing). So if it costs CHK $3/MMBtu to produce natural gas (this includes fixed costs like salaries as well as variable costs), they eventually will make $9-$3=$6/MMBtu when they could have made $7/MMBtu without the hedge. Even though these hedging effects won't take place until a year later, the natural gas hedger must take the losses now. This is why CHK posted over $1.6 billion in losses. In fact looking on CHK's latest SEC filing you can see they had a realized price of $8.55/Mcfe (not MMBtu, otherwise it would be more), and costs were about -4.94/Mcfe so they are making money not losing it. Now if they hedged more than they produced, that would be a different story. Then those losses would be "real". I hope this clears up any confusion although reading back through what I wrote it seems quite messy :-).

Joe

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