Chesapeake Energy: The Moves Left On The Chessboard

| About: Chesapeake Energy (CHK)

Summary

Presence of Carl Icahn may alter management's behavior in a way that will be of material benefit to equity holders.

Lack of bank debt gives Chesapeake some extra space to maneuver and the company has more freedom to pursue aggressive debt reduction strategies.

Short term lower share prices can be beneficial to any debt reduction plans due to a lesser probability that shareholders will be able to bail out debt holders via dilution.

Chesapeake Energy's (NYSE:CHK) quantity of debt is often cited as a reason for concern over the existential capability of the equity class. Indeed, it is a big concern for any equity holders, but what's not given much attention by the financial media is the quality of its debt load. Can a company actually be affected by taking on debt of different qualities? I would argue for a resounding: yes, they can. Prior to Chesapeake's debt exchange for second lien notes, which I documented in my previous articles here, here and here, the company issued covenant lite unsecured notes for pretty much the entire debt section of its capital structure. Covenant lite unsecured debt is, almost by definition, the creation of a low-interest rate environment, yield hungry bubble. Investors and lenders alike loosen their underwriting standards in search of a few basis points more in returns. The debt is poor quality for the investors and lenders who own this debt. Inversely, this type of debt is desirable and high quality for the counterparty who borrows the money if the borrower is aware of how to exploit its advantages. I know of very few people better than Carl Icahn who understands how to exploit them.

Bank debt still undrawn

The bank debt of any company tends to have the most restrictive covenants and conditions out of all the classes of debt. Hence, Chesapeake can only be forced into bankruptcy from an actual default in their interest payments and not from breaking the covenants on their undrawn first lien debt as long as it remains undrawn. The worst that can happen right now from breaking the covenants is to have the revolver taken away. However, even then, there will be alternative moves to make to realize values for shareholders albeit the fact that liquidity is taken away.

To successfully engineer a debt reduction, you must look danger in its eyes

Any equity issuance by Chesapeake or any other distressed oil and gas company is essentially the equivalent of writing a cheque to their creditors. Needless to say, there aren't too many investors willing to put money into a distressed company without the belief that the company will gain a solid financial footing after the equity capital raise. Even if the company was somehow successful in raising equity capital by issuing stock at a price lower than market value, the market price per share will likely drop precipitously after such a move. A debt exchange that involves exchanging substantial equity as partial payment for outstanding debt may also collapse the market value of equity without actually materially reducing the probability of bankruptcy. So the $64 dollar question is a matter of how can companies optimize their debt reduction with minimal harm done to equity's value per share.

Most company managers are ill-equipped or ill-incentivized to look danger in its eyes

To actually implement a plan that optimizes debt reduction and minimizes harm done to equity's value per share requires preparation before the market is actually in distress and skills that operational managers simply do not have. Furthermore, if a company is in a dire enough situation that bankruptcy is an accepted possibility, management may actually have a conflict of interest in their actions. An exchange of lower priority unsecured debt for secured debt is often used as a method for face value debt reduction. This method implies a transfer of value to equity holders at no expense to themselves but at the expense of unsecured note holders through a greater proportion of higher priority claims and secured lenders through greater competing claims via the exchanged debt. Hence, the creditor class is generally greatly angered when such an exchange is successfully pulled off. Since in bankruptcy, ownership of the new equity generally gets transferred to the debt holders, a management that anticipates bankruptcy may wish to act in a manner that does not upset their future employer. In short, depending on management's commitment to saving equity holders versus saving their own jobs, management may or may not act in a way that really optimizes a firm's chance of survival.

Understanding management's point of view is vital to understanding the value that Carl Icahn brings to the table via his share ownership and activism. Carl's brand of activism involves persuading or forcing management into taking action for the sake of realizing shareholder's value. As we've seen with Xerox (NYSE:XRX) and AIG (NYSE:AIG) lately, these actions do not necessarily entail some innovative change or brilliant scheme to realize the company's financial value. They often do involve implementing a plan that goes directly against the company management's self-interests. Hence, the actions that will be taken by distressed companies controlled by Carl such as Freeport McMoRan (NYSE:FCX) and Chesapeake are likely to be different in nature compared to other distressed concerns such as Peabody Energy (NYSE:BTU), Linn Energy (NASDAQ:LINE), BreitBurn Energy (NASDAQ:BBEP) and numerous other companies where management remains in control of the situation. While having a guy like Carl help along with a company is by no means a miracle cure especially in such tough times as now, there is tremendous benefit in having him work on behalf of your interests. I certainly hope he sticks around.

Practical matters

The debt maturities from now until 2018 represent quite the headache for Chesapeake's liquidity. However, it does not represent an unsolvable problem in my opinion. The least desirable method of tackling these debt maturities is to draw upon the company's first lien revolver and pay face value for the debt at maturity. It is also undesirable to keep a significant amount of first lien revolver debt outstanding just to pay off the maturities. Much of the debt due 2017 and after are trading at less than fifty cents on the dollar so there may be a lot of merit in repurchasing some of this debt at half of face value even if it means drawing on the revolver prematurely to do so. Another possibility is to offer a new debt exchange which will include the 2037 and 2038 convertible note issues. In the new debt exchange, for the sake of extending near term maturities and rescuing liquidity, the new debt securities offered can have a greater par claim than what was offered in the last exchange. The class of the new debt offered can be a secondary offering of the original second lien notes or a new class of second lien debt on currently unencumbered assets owned by Chesapeake. The key to having such an exchange succeed is to convince debt holders that their chances of principal recovery are higher when owning the new debt securities compared to their current debt. In other words, the debt holders Chesapeake must convince to exchange their near term maturity securities must believe that there is a high enough chance of bankruptcy between now and 2018 to warrant extending their maturity for a higher priority claim on Chesapeake's assets.

How talks with respect to asset sales are going will determine the option management will decide to use. A material asset sale will provide the company with excess cash which can be used to retire any drawn revolver capacity. If an asset sale cannot be completed for an acceptable price, Chesapeake may have no choice other than to attempt another coercive debt exchange. Under any scenario, asset sales should only be announced after the debt reduction plan has taken place.

Summary

The situation is undoubtedly dire in terms of commodity prices. Unlike most of the other leveraged names in the oil and gas space, Chesapeake is not yet beholden to financial covenants as a condition for technical default due to its lack of bank debt usage. Chesapeake certainly has the capacity for more debt exchanges through a public offering or private exchanges and heavy repurchase of debt on the open market could be done if they are able to replenish their cash liquidity through asset sales. A dilutive equity offering should be kept as the final move to bring Chesapeake back to safety since this particular type of bullet is exceedingly expensive and tends to become practically useless after the first try.

Disclosure: I am/we are long CHK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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