Chesapeake: 'Let Them Eat Cake (Shares)'

| About: Chesapeake Energy (CHK)


Chesapeake Energy’s debt stack, or its long-term debt obligations outstanding, is implying by price and by profile that much, much dilution is yet to come to common shareholders.

This, it should be noted, is in addition to the dilution which has already occurred.

I believe this equity issuance will continue to provide downside pressure on pricing of the common stock as well as provide “overhang” to pricing in upward movements.

I provide a data-based breakout, but not data-blind, of exactly what market signals are telling us Chesapeake will have shareholders "eating cake" for a long time going forward.

Chesapeake Energy's (NYSE:CHK) debt stack, or its long-term debt obligations outstanding (as defined by GAAP; ex. preferred stock, ex. contractual obligations and off balances sheet arrangements), is implying by price and by profile that much, much dilution is yet to come to common shareholders. This, it should be noted, is in addition to the dilution (by way of prior swap transactions) which has already occurred. Chesapeake most recently issued common stock on September 30, 2016 in a swap transaction. I believe this equity issuance will continue to provide downside pressure on pricing of the common stock as well as provide "overhang" (i.e. selling inventory) to pricing in upward movements.

First, it's important to understand how "debt stacks" or "debt profiles" work from a structural standpoint as it is relevant to pricing. In the most convenient explanation, even if at the same level of seniority (i.e. claim-priority to recovery value in a bankruptcy filing) longer-dated debt is priced lower than nearer dated debt (both dates referencing maturity dates). This is a simple implied-risk pricing being factored into the debt; which isn't too sophisticated a concept.

This concept does have exceptions, however, which usually apply only to the most credit worthy, secure borrowers. One of the exceptions is that a debt stack will show no (or very little) variance to pricing regardless of duration, seniority level, and/or coupon in the most remarkable of examples (i.e. all debt regardless of listed factor will trade at, say, 100 cents on the dollar). A randomized debt stack analysis will show this concept-exception proving out time and time again. Again, you'll find a direct correlation (a causation, really) to the concept-exception and credit quality of borrower. That's important to keep in mind.

However, a review of Chesapeake's debt stack - to which not even the most adamant of Bulls will claim Chesapeake is of the "highest credit quality" - shows that Chesapeake's debt stack examples this exception:

Indeed, nearly all of Chesapeake's debt trades at 100 cents on the dollar (and, really, it is all Chesapeake's debt absent one unique issue creating a blemish on what is otherwise a perfect example). So, what gives? How can this stressed, over-leveraged E&P be trading at such levels given its credit quality?

The answer lies in the fact that:

  1. Chesapeake has been vocal that it has no priority higher than deleveraging its balance sheet;
  2. Chesapeake has exampled time and time again in execution that it is willing to use its equity float as an ATM - issuing shares to satisfy swap obligations of many kinds; and
  3. the market generally understands that Chesapeake must reduce its leverage [which is different than having this as a strategic priority] on a go-forward basis [via swaps, tenders, exchanges, etc.]

Regarding the additional security to bond ownership provided by Chesapeake being willing to engage in swaps, this additional "security" (or exit/monetization opportunity) allows the longer dated issues to price at PAR; in-line with issues of shorter dates and varying coupons. The fact that Chesapeake has been so active and so consistent with executing swaps (i.e. exampling the exit-liquidity provided by the issuance of shares) gives this additional ownership "security" credibility. Regarding that the market generally understands that Chesapeake is at no point of negotiating leverage in swaps (by way of it needing to delever on a go-forward basis), this allows the market to bid up the debt to PAR on a uniform basis (even longer dated issues) knowing that the opportunity to monetize at PAR will presumably be present for a long-time forward. My guess is, if at this point of desperation, Chesapeake would pay greater than PAR to retire certain issues. If it meant solvency, why wouldn't it?

I reiterate, if this wasn't the case and if this wasn't believed with "full faith and credit" by the markets - we wouldn't be seeing Chesapeake's debt stack price the way it is. The liquidity provided by way of being able to execute swaps, for the bondholders, is quasi-insurance on ownership of the bonds. This is made no more obvious than a data-visual review of pricing by maturity date:

You can see clearly, despite large gaps in maturity, Chesapeake debt has very little variance to pricing (some issues do have a ~10-point variance to pricing which is a normal function of the wider spreads which are normal in bond trading, etc.).

Another data-based example of how skewed Chesapeake's debt pricing is to the credit quality of the underlying enterprise is provided by Kamakura Corporation's (a risk-management software and consulting firm) KRIS engine. KRIS assigns a ~97% probability of "3 notch" UPGRADE to Chesapeake credit (each notch representing a single S&P rating class qualification); this is based largely on the fact that Chesapeake's debt is trading at such high values (to which the risk-management engine believes, as it often is, is correlated with credit quality). Put simply, the engine is saying that Chesapeake debt is pricing as if it is rated a full three S&P rating class qualifications higher. A stunning, data-based revelation. S&P, of course actually assigning rating classes based on data and the human element of analysis, begs to differ.

But what if Chesapeake truly is deserving of higher credit quality (i.e. it is lower risk than given credit for)? What if Chesapeake's risk is simply misunderstood? This would mean its bond pricing is justified and that the thesis of the "equity dilution security addition" is meritless.

In an admittedly more subjective (partially) review of Chesapeake's risk, we find when using 12-Month Default Probability metrics (via Kamakura Corporation) and Credit Default Swap pricing that Chesapeake is quite clearly identified as a risk outlier to peers and to the Energy Complex (at least the 92 names within the ATLAS SandDance Index - the coverage universe of ATLAS Consulting):

In conclusion, Chesapeake's debt stack is exampling that it is at a greater level of security than is being provided by the underlying enterprise. This additional security is being provided by way of additional exit-liquidity at PAR pricing; which is a result of Chesapeake being willing to issue equity in swap transactions. Comparative risk analysis, to both peers and the Energy Complex, shows Chesapeake to be a risk outlier - not organically worthy of such high debt pricing; negating the counter thesis that Chesapeake is simply mispriced from a risk standpoint. The market believes that Chesapeake will continue to engage in swap transactions with debtholders on a go-forward basis. Because of this, I recommend avoiding or selling Chesapeake equity if holding for the long-term. Chesapeake common should continue to have inorganic downside pressure on pricing as well as "overhang" (i.e., selling inventory) to pricing in upward movements.

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.

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