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Chesapeake Energy: Penny Stock Madness

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About: Chesapeake Energy Corporation (CHK)
by: Quad 7 Capital
Quad 7 Capital
Research analyst, Deep Value, special situations, short-term horizon
Summary

We have traded CHK numerous times the past year, but ate a nasty stop loss this week following a devastating earnings report.

It wasn't so much the earnings as it was the fear over an inability to pay debt.

Sizable debt always has been the issue here and the market has priced the debt year-after-year.

We're at penny stock status here, and in the madness, a reverse split could loom.

Those who follow energy know that any stock associated in any way with natural gas production has been crushed this year, and many weighted toward oil have also suffered. This included the long troubled Chesapeake Energy (CHK). We will not rehash the disaster the stock has been, but this week, a new bomb hit the stock, sending the name into penny stock territory. That may sound extreme, but we are sub $1 and at multi decade lows. In this column we discuss what's going on and what we see happening as frequent traders of this volatile name.

The good

We will say operationally that we think it's good news the company has shifted to a larger focus on oil. Chesapeake is producing the highest amount of oil that it ever has, and is shifting more and more toward oil and away from natural gas. This is likely wise considering the pricing of the underlying commodities.

The company also is reducing capex to save money, and is exploring continued asset sales. This is positive. It's also good news that so far winter is coming early, and energy prices have rebounded. However, performance is a concern.

Performance

Q3 performance was mostly better than we expected. We believe that the market would have agreed, but the name began selling off hard after some warnings on its debt obligations in a weak pricing environment. We will discuss more on that in a moment. The quarter, overall, was OK, with some notable strengths and weaknesses.

The headlines showed a revenue beat despite the declines in pricing, though a wider than expected adjusted EPS loss. We think it's worth noting on a GAAP basis EPS losses were better than expected. Chesapeake reported net losses of $61 million and net losses available to common stockholders of $101 million, or $0.06 per diluted share. That actually was ahead of our expectations for losses of $0.08 per share. We were more bullish than the pack as market consensus was -$0.10. Adjusting for items net loss attributable to Chesapeake was $88 million or $0.11 per share. That was wider than expected and perhaps the biggest blemish on the quarter, not counting news on debt.

We did like the company's production of more oil and that margins were solid. Average daily production was approximately 478,000 boe and consisted of approximately 115,000 bbls of oil, 2.034 billion cubic feet (BCF) of natural gas and 32,000 bbls of natural gas liquids (NGL). We were unhappy to see production grow year-over-year by 3%. We have long held that these names need to curb production, but we understand there are production quotas and agreements in place. Long term for the industry the supply and demand curve needs to improve. We digress. Oil production represented approximately 24% compared to 17% in the 2018 third quarter. That is a big positive. However, pricing was a problem, yet margins were flat.

There's no doubt energy prices have been down as far as these producers are concerned. Despite lower average prices for oil, natural gas and NGL sold, Chesapeake's operating margins remained flat year-over-year primarily due to a higher oil production mix and a decrease in expenses. This was a very solid result and unappreciated by the market, which seemed to focus on survival. All told, Chesapeake reduced its cash operating expenses on an absolute basis by $57 million, or approximately $0.40 per boe. We will take it.

Survival in question?

We won't deny it, we dumped the stock at $1.34 after the report, subsequently having picked up more ahead of the quarter and eating a loss. Some say the stock has overreacted. Perhaps. But the reality is that debt is coming due and current pricing brings into question the ability to fully meet convenants. While they will likely get waivers/extensions, etc., if pricing declines, they are in serious trouble. This is why the stock is imploding on an otherwise OK quarter.

Management stated in the 10-Q:

"If continued depressed prices persist, combined with the scheduled reductions in the leverage ratio covenant, our ability to comply with the leverage ratio covenant during the next 12 months will be adversely affected which raises substantial doubt about our ability to continue as a going concern."

The company is going to pull out all the stops to keep it going. And the stock could rebound, and do so sharply. However, a lot of questions remain. Even in the last two months when energy really started rebounding, CHK remained depressed more so than peers. That was problematic. Debt concerns are everything here. While the company has managed debt, it has a lot of notes due.

Source: Q3 earnings slides

Here's another look at some of the obligations coming due:

Source: Q3 earnings slides

So those are out there. The spending cuts are a positive sign, but with such massive debt, leverage is not going down enough given there's a lot of outspending of cash flows in this pricing environment.

As the balance sheet is concerned, it is ugly. As of Sept. 30, 2019, Chesapeake's principal amount of debt outstanding inclusive of Brazos Valley debt was approximately $9.732 billion, compared to $8.168 billion as of Dec. 31, 2018. At quarter's end, the company had borrowed $1.504 billion under the $3 billion Chesapeake credit facility, utilized approximately $53 million for various letters of credit, and had additional borrowing capacity of approximately $1.443 billion. Under the $1.3 billion Brazos Valley credit facility, the company had borrowed $900 million and had additional borrowing capacity of approximately $400 million. The borrowing base of the Chesapeake credit facility was re-affirmed in November 2019, so there's some room.

But does this change the story? Well, nothing "new" came out of this. The numbers were what they were. It's just that time has been running out for a major rally in energy prices. While our firm believes energy prices will rise a bit more into winter, lifting many names in the sector, we believe we need a sizable rally, otherwise we are just kicking the can down the road for Chesapeake. There's additional risk.

A reverse split

As you know, Chesapeake trades on the NYSE. The criteria to remain listed on an exchange differs from one exchange to another. On the NYSE, if a security's price closed below $1.00 for 30 consecutive trading days, then the exchange would could initiate a delisting process. Let us be clear, we do not believe CHK will let itself go to the pink sheets, so that would mean it would need to do a reverse split if it cannot retake $1. It may still do one to shore up some ability for firms to invest. More often than not it has been our experience that reverse splits are band aids on failing company stocks. On occasion they come back to life, and rally to be worth more than they were pre-split, but we fear a reverse split would lead to newfound selling and further declines. It happens quite often.

Will oil and gas rebound?

Yes they will, but that does not mean it cannot get uglier before its gets better. That said, oil and gas will rebound, at some point. They have started too. We see more upside into winter, but are not overly bullish. We think natural gas has another few dimes left to rally and oil maybe another $5 a barrel, but the supply is so heavy we just do not see much more than this barring a severe prolonged arctic blast in the U.S. that really drives usage up. While that is a "what if" if we assume an average winter, prices are likely to trade mostly sideways. But the production curve MUST shift, or gas prices will be stuck here. That is the problem right now.

Take home

This selloff and implosion in CHK stems from the warning on debt payment and meeting covenants. There's a lot of debt, and investors are bailing on perhaps what was already known, but it took a statement in the 10-Q to really drive it home. If energy rebounds some more CHK can retake $1 easily and avoid a reverse split to stay listed. That's the next big risk to being invested here. While we have traded the name, we're on the sidelines here under $1.

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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.