Preferred vs. Common Stock: More 'Incentive to Wait' for Chesapeake?

Includes: CHK, CHK.PD
by: Zecco

By Richard Bloch

After Chesapeake Energy (NYSE:CHK) released its latest earnings report, Wall St. Cheat Sheet posted an analysis, “Will Chesapeake’s Share Price Ever Recover?”, concluding in part:

Chesapeake has seen better days in terms of share price. Investors willing to invest in CHK will need to be prepared to wait for returns. The 1.5% dividend that CHK currently pays doesn’t offer much incentive to wait.

There is a related security that may offer more “incentive to wait,” to use that classification: the Chesapeake Energy 4.50% Cumulative Convertible Preferred (NYSE:CHK.PD) issue.

Part stock, part bond, part option

Preferred stocks often trade a lot like bonds because they have fixed dividends that are generally higher than a company’s common stock. But these shares are convertible preferreds, which means you can also exchange them for the company’s common stock. Unlike bonds, however, there is no implied guarantee that your principal will be paid back – as no maturity dates exist. Therefore, you are exposed to the same market value risk that exists with common stocks.

These convertible shares pay a dividend of $4.50 per year – now yielding about 4.9% based on the November 9 closing price of 91.79.

Each convertible preferred share can be converted into 2.2639 shares of CHK (the common stock), so in a sense, that’s like a call option or warrant built into this preferred stock.

Here’s a weekly chart showing the preferred stock at the top and the common stock below. The chart at the bottom with the purple line shows the ratio between the two.

The preferred shares now trade at about 4 times the price of the common stock. That’s a lot higher than the convertibility value of about 2.26, so further upside may be limited.

Part of that could be because the preferreds can be “called.” That means the company can force you to convert preferred shares into common stock whether you want to or not.

According to income stock information site Quantum Online, (free, but registration required):

If the price of the common stock exceeds 130% of the conversion price [$44.172] for 20 of any 30 consecutive trading days, the company may, at their option, force the preferred shares to be converted into common shares at the then prevailing conversion price.

Presumably, the common stock would be trading somewhere around $57 (1.3 x 44.172 conversion price).

Hypothetically, that means a conversion would turn one share of preferred stock into 2.2639 shares of the common stock – or about $129 worth of common stock (2.2639 shares x $57).

But the preferreds might never be converted, or they could go down along with the common stock – for any number of reasons. Yield-oriented investors may feel they can find better opportunities elsewhere. And there’s at least some credit risk as these preferred shares are rated Ba3 by Moody’s and B by S&P (according to Quantum).

You’ll want to read the prospectus, of course, before investing. And just so you know, this preferred stock generally trades only a few thousand shares per day, so it might be a good idea to use limit orders if you do decide to invest. The lack of volume may also result in a wide bid/ask spread.

Perhaps Chesapeake has seen better days, but with a 4.9% yield – and the option to convert into common stock – the preferred issue is an alternative that may offer you the “incentive to wait.”