Chesapeake Energy: Next 6 Months Are Important

| About: Chesapeake Energy (CHK)
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Increase in asset sales target is a positive from debt point of view.

Reduction in debt and improving commodity prices can enhance debt metrics.

Rising commodity prices will also result in higher valuation of reserves.

These asset sales might be the last from Chesapeake.

Chesapeake Energy's (NYSE:CHK) second quarter earnings did not spring any major surprises. The company is still suffering due to the weak commodity prices, high levels of debt, weak cash position and continued impairments of the natural gas assets. Reaction in the form of stock price movement was natural because the market showed concern about the overall cash position of the company. However, it is important to understand that the liquidity is not just the cash at hand. Chesapeake has only used $100 million from its $4 billion revolving credit facility. In addition to these, $813 million worth of letters of credit have been issued under the facility. In the ideal situation, you would like the company to meet its liquidity needs from internally generated funds. However, the circumstances are not normal for Chesapeake or any other business in this industry. These businesses have to survive the current slump.

There are some positives which are far more important for the long-term viability of the business. First of all, total debt has come down to $8.7 billion. As I have said before, the company should opt to buy its debt from the open market because it is trading at a significant discount. This should result in cash savings. From the most recent announcement, it is clear that the management has been doing this and it looks like they will continue to do so in the future. Over $518 million worth of debt which could be put to the company has already been bought from the market. This means that Chesapeake has made substantial cash saving from this transaction. The management did not give a breakdown of how much of the amount was bought from the open market and which bonds were settled. Therefore, it is a bit difficult to reach at the exact amount of cash savings. However, majority of Chesapeake's bonds are trading at a discount of about 4-5%. We can say that the savings should be around $20-25 million.

Another positive which I picked from the announcement was the upward revision of asset sales target. Almost a billion dollars worth of deals have already been closed and the company now expects to sell assets worth more than $2 billion. Let's say that the proceeds from these asset sales go directly into paying the debt. We can look at further reduction of about $1 billion in debt. Most likely these bonds will be bought from the open market and the maturity profile will be no later than 2017. After 2017, Chesapeake's debt maturity is longer term and there are no major cash commitments in terms of the debt. If we assume that there will be further debt reduction of $1 billion then the total debt at the end of the year will be $7.7 billion. According to my estimates, adjusted EBITDA for the year should be around $1 billion. Second quarter adjusted EBITDA was over $250 million. This means that the Debt/EBITDA or total leverage will still be at 7.7x. Looking at the leverage ratio in isolation will still make Chesapeake a risky and highly leveraged business. Nevertheless, this will be a huge improvement from the double digit leverage ratio the company had just a few quarters ago. There will be no upgrade from the rating agencies just yet; however, this might prompt them to issue a favorable view.

The total leverage will only reach the favorable threshold (3-4x) if the commodity prices rise substantially, or the debt continues to decrease. It is not likely that the company will continue to sell assets as the asset base is already getting thin and a wise management will want to keep some assets in order to grow production when the commodity prices get out of this slump. Future growth will be severely affected if the asset sales continue and the company brings down its debt to $3-4 billion. However, I do not believe this will happen. Chesapeake Energy does not have any pressing need to raise money in the next two years if they settle the 2017 maturities in the next two quarters. This will allow them to keep hold of the assets and wait for the commodity prices to make a sustained recovery. Most industry experts believe that we will start to see this recovery take place in the second half of 2017. Therefore, I expect these asset sales to be some of the last sales the company will consider. If the commodity prices make this expected recovery then the EBITDA will go up due to the efficient controls on expenses and the growing top line. The production will likely remain flat at least during the next year, so any increase in revenues will be a result of better average realized prices. Debt of around $7 billion and an EBITDA in the range of $1.5-2 billion will give Chesapeake extremely favorable debt metrics and might even result in an upgrade from the credit rating agencies.

In addition to these measures, recovering commodity prices will have a positive impact on another vital area. The proved reserves will be valued at a higher price. SEC asks the oil and gas companies to value these reserves at a 12 month average price preceding the recording date. These expected cash flows are then discounted at 10% and the total value is recorded in the annual SEC filings. In the rising commodity prices environment, this will result in a lower total valuation as the trailing prices will be lower than the current or future prices. However, the companies also report expected future cash flows based on the NYMEX futures prices, and the discount rate used for these calculations is 9%. This is called PV-9 valuation and it is more favorable for the businesses. This valuation then can be used while negotiating for loans with the banks or other lenders. Since these proved reserves are an asset for the company, they can also be used as collateral for future loans. Please follow this link if you wish to read the SEC rule in detail.

Chesapeake Energy is still under pressure and the management seems to be making efforts in the right direction. The company is facing a variety of issues which can be dealt with sound strategy and planning. In my opinion, there is progress and if the commodity prices make the recovery as expected, then this can prove to be a good turnaround story. The risk is still there as the leverage is high and the cash position is weak. A lot will depend on the management and how they deal with the events over the next six months.

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

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.