Chesapeake Energy (NYSE:CHK) is out with two 8-K's this morning which detail two transactions: one executed and one to be executed. Both, as I've written about before, are of the "toxic financing" variety. Both, should be good for Chesapeake viability (at least at surface level analysis). I continue to think that's an important distinguishment to make; that developments can be good for viability while not being good for the junior cap structure. That statement and the reconciliation of that statement will be the foundation of this update note as I'll breakout both 8-K's and what they mean in the "scheme of things".
Primarily, given that Chesapeake has made it obvious time and time again that it's willing to engage in these types of toxic transactions without abandon, I'm writing today for those owning common stock. Normally I would simply generalize the entirety of the junior cap structure (I think ultimately I will - as I believe Chesapeake ultimately defaults), but again, the junior bondholders are only one phone call away (one phone call to the Chesapeake CFO office) from being out of their position (often at par). The common shareholder doesn't have this luxury - the luxury of swapping out a vehicle, for full face value no less, which would have no recovery value in a restructuring. Even having an exchange to dump on, this isn't a luxury afforded to common shareholders.
And for that reason I find 1) the junior bondholder to have segregated itself from the general group-tranche classification with the common shareholder [which would normally be the case in this situation given that neither tranche has any recovery value in a restructuring] and 2) as is always the case but not always on an exclusive basis I find the common shareholder most exposed to the punitive toxic financing being engaged in by Chesapeake. Again, this will be the foundation of this update note; how the two released 8-K's matter to the common shareholder.
With that setting the table, let's breakout each 8-K.
The Private Placement: Chesapeake and the Pink Sheet Playbook…
Chesapeake, in a page taken straight out of the "Pink Sheet" playbook (referring to a strategy that you would most likely see being deployed by a microcap), has announced it will execute a private placement ranging from $850 million to $1 billion. This being a private placement, this offering will NOT be made available to those which are not "Qualified Institutional Buyers" or "QIB's". What does this really mean though?
It means that retail and other small investors are excluded from participation in this offering given that 1) the offering "will not be registered" [it will, but only after Chesapeake sells the full offering; this is how Chesapeake keeps non-QIB's excluded from participation - having the offering not registered at the outset] and 2) that the offering is being sold to " sophisticated" investors. Both are meaningful. I'll explain.
That Chesapeake is issuing junior debt, again debt that would have no recovery value in a bankruptcy, AND that Chesapeake is issuing this junior debt to uber-sophisticated investors is the key takeaway here. Now, you're probably asking "why would somebody who is sophisticated, and presumably understands that the investment they're making has zero recovery value in a restructuring, participate in such an offering?". The answer is one of two responses: they either believe Chesapeake won't restructure OR they don't intend to hold the junior debt - they only intend to hold it until it's registered, convert the investment to shares, and then sell. Why am I leaning toward the latter of the two? Because this junior debt is convertible. That makes a world of difference in my opinion.
All things being equal, without the conversion feature (embedded into the notes) the notes would 1) be at a higher coupon [as having the ability to convert into shares is a benefit that the company factors into the total compensation accounted for within the notes] and 2) as a result of having a higher coupon the notes would have more pricing stability, less correlation to downside elasticity of the equity, and be more defensive [all things being factored in; this isn't a lesson in debt pricing so I'll spare readers the pain of further elaboration]. The fact that the notes being offered are being done via a convertible note is a sure giveaway that the QIB's buying these have no intention of holding them. Otherwise, they would have forfeited the conversion feature for the other benefits.
But how do I know 1) that Chesapeake has presold these notes and/or 2) that the buyers, assuming these aren't presold, will convert to equity at first chance?:
Literally an NDA and an acknowledgement of trading restriction is all that would be necessary to market (READ: solicit) these notes. That's pretty easy to execute. Assuming Chesapeake is being willy-nilly about this issuance (highly doubtful) and is trotting this marketing material out without pre-marketing efforts, I have to assume those QIB's buying these notes are "sophisticated" enough to be buying them in transactional nature (i.e. to convert and dump). I don't think this is too far a stretch of the imagination.
Now, operating under the assumptions outlined so far - what does this mean for the common shareholders?
The private placement is a massive debt/equity swap in drag. That's the reason why Chesapeake equity fell 8% on the announce. The dilutive effects of this private placement being converted will be punitive and will create something serious of an overhang on the common. Considering the recent news that Carl Icahn pulled the ripcord on ~50% of his holdings and that some speculate he'll pull the ripcord on the other 50% soon, the overhang on the common could be insurmountable in the mid-term.
Even if there are buyers for the conversion-and-sell orders hitting exchanges, the float at Chesapeake will still expand in a big, big way. That means a lower equity price equates to a higher market cap (and EV), all things being equal. So, you can go ahead and walk down that price target you have pinned to your sell order (or you can walk up the valuation at which you think you should be selling Chesapeake). None of that is good for the common equity holder.
The worst part though? Chesapeake has been doing this, engaging in toxic transactions at the equity holder's expense, since early-May. Oh yeah, it can't stop doing this as it really has no other options at this point; it's fully encumbered and, I believe, primarily motivated to execute these toxic transactions in an effort to free up collateral (if even possible with scale). So, again, don't expect this to stop. It's going to be more and more dilution; but, hey, it will be dilution with a smile if the equity price continues to be bid up.
More Dilution? More Dilution! …
Giving emphasis to the concept I just tried to illustrate above, Chesapeake announced that it has engaged in swaps with certain convertible preferred stock owners. Again, all it takes is one phone call to the all-too-happy-to-take-that-call CFO's office to get a swap done. And why not? The swaps are being done using a debt-free vehicle, a vehicle which just lost its most vocal proponent (READ: Carl Icahn), and a vehicle which is way, way out the money in terms of recovery value (i.e. a vehicle which doesn't have any collateral value, any legal constraints, and/or any financial constraints).
The common stock is the perfect currency to use.
What does this mean though - that Chesapeake has engaged these parties in swaps? I'll keep this section short: dilution. It means dilution.
But, this is good for viability, right? Chesapeake taking obligations off the books is good for viability, right? It sure is.
But that doesn't make it good for the common shareholders. And folks, I've seen plenty of instances of massive debt/equity swaps and/or debt buybacks executed which were only being done to help move forward the prepackaged bankruptcy. I could be wrong, but that's what this looks like here.
Chesapeake creating a massive, massive equity float via AT PAR debt buybacks (READ: tenders) and/or swaps, Chesapeake taking out worthless-in-bankruptcy debt (but debt that could still litigate and delay a bankruptcy exit) via exchanges (into the 2L, 1.5L, the coming 1.25L), and Chesapeake selling off assets simply to relieve itself of obligations (aka the "burning furniture to stay warm" strategy) just looks like a path to a prepack. And for those cheerleading the common stock's performance over the last two quarters or so, really take account of what has happened:
- Chesapeake has become fully encumbered, priming multiple collateralized debt tranches in the process
- Chesapeake has diluted punitively Chesapeake has engaged in "Pink Sheet" fundraising
- Chesapeake has lost a hugely symbolic equity owner (at least 50% of that owner's position)
- Chesapeake has announced that it won't be growing production (even on a pro-forma basis)
What exactly is the reason folks are owning Chesapeake's common equity? The E&P has already proven that it can't drive capital productivity, regardless of CAPEX and regardless of commodity cycle. Where's the Bull Case?
Good luck everybody.
Disclosure: I am/we are short 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.