Chesapeake Still Working For Its Bondholders

| About: Chesapeake Energy (CHK)
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Summary

Chesapeake's shares continue to be pressured in a soft oil and gas pricing environment, even as the company has returned to profitability.

While GAAP earnings can be reported, the reality is that cash outflows continue, and management is willing to dilute equity holders in order to please bondholders.

Amidst these conditions, the situation for equity holders continues to look very bleak, as continued dilution naturally limits the upside, even if a recovery in oil & gas prices materializes.

Chesapeake Energy (CHK) continues to struggle to create value for its investors even as natural gas has stabilized at +$3, while oil prices have recently seen another leg lower.

After a spectacular recovery from the lows of $1-2 during the turmoil in early 2016, shares have recovered to a high of $8 late in 2016 and early in 2017. The reality is that shares have fallen back to levels below $5 again at this point in time, driven by the recent weakness in commodity prices as the winter season is over.

Even after this drop, I have reasons to remain cautious despite the fact that the company posted a decent adjusted net profit number in the first quarter. It seems that investors are no longer buying these adjusted accounting tricks.

What About Those Earnings?

In early May, Chesapeake posted first quarter adjusted earnings of $212 million and GAAP earnings of $75 million, equivalent to $0.23 and $0.08 per share, respectively. The difference between both metrics is driven by hedge gains, impairment charges and losses on the exchange of preferred stock and debt, among others.

Even if we assume that the $212 million profit number is correct, actual cash flows are not compelling at all. Part of the reason why earnings were higher are lower depreciation charges, resulting from divestment of assets and multi-billion impairment charges being taken in recent times. Depreciation & amortization charges for the quarter came in at just $216 million, as capital expenditures (including capitalized interest) already totaled $576 million for the first quarter. These net investments of $360 million comfortably exceeded the adjusted earnings number, indicating that cash is still leaving the door, even in a quarter in which pricing is typically stronger in terms of natural gas pricing.

Even worse, production is not even increasing anymore. The company reported production of 528,000 barrels of oil-equivalent per day in the first quarter, down 144,000 barrels from the first quarter of last year.

If we take the net investments into account, which exceed the adjusted earnings number, cash flows are still negative. Despite this issuance of shares and sale of non-core assets, the debt situation remains challenged. Total net debt still stood at $9.26 billion at the end of Q1, which remains a very substantial amount as first quarter adjusted EBITDA totaled $525 million. If the seasonally stronger first quarter would be representative for the entire year, leverage ratios would come in at 4.4 times.

In comparison, Chesapeake operated with a net debt load of $10.05 billion this time last year, indicating that debt has been reduced by just $800 million. In all fairness, the nominal value of preferred stock has come down from little over $3 billion to $1.8 billion as well.

While the company has been selling some assets, most of the debt reduction has come from selling new shares which have been used to buy debt at a big discount to the nominal value. The number of shares has risen from 668 million at the end of Q1 of 2016, to 907 million shares by now. This 35% dilution over the time frame of a year is pretty substantial, certainly if we take into account that net debt is down just 8%, while production is down significantly as well.

Situation Remains Challenged

The sad reality is that the fate Chesapeake remains heavily tied to natural gas prices, despite its aim to produce 100,000 barrels of oil per day by the end of this year. The continued pressure on the production base has resulted in total production having fallen dangerously close towards the half a million barrels of oil-equivalent per day mark.

The 907 million shares still represent $4.5 billion in equity value, but these claims only come after the $1.8 billion in preferred stock and $9.26 billion in net debt. In essence equity remains a call option on the enterprise value of Chesapeake exceeding $11 billion, as the best estimate of the value of the company now comes in at $15.5. billion, at least if you believe the equity holders.

While debt holders feel more secured on the back of the remaining assets, improving pricing environment (compared to Q1 of 2016) and willingness of Chesapeake to issue common shares to buy back debt, equity holders are last in line. As a result, they continue to face a highly uncertain future.

To have any outlook for better days ahead, resource prices have to recover quickly as the so-called PV-10 measure, which measures the present value of the collateral, stood at just $6.5 billion at the end of March of this year. This was even the case with oil and gas prices trading at slightly higher levels as they do today.

A lot of continued operational improvements and big spike in prices is needed before there is any value left for equity holders, as one should not be blinded by even GAAP or adjusted earnings metrics, which are aided by artificially depleted depreciation charges. The harsh reality is that cash flows are still negative, as lower depreciation charges create cash outflows versus capital spending levels, while debt continues to create dilution for equity holders and production is still under a lot of pressure.

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.