The Price Is Wrong At Chesapeake

Summary

• High debt and low prices doomed Chesapeake long ago.
• Securities filings and bond prices tell you this company will not repay its creditors.
• Day traders will be in for a dramatic surprise in short order.

Chesapeake Energy (NASDAQ:CHK) was once of the leading shale companies in the United States. After years of losing money and re-financing debt, recent filings make it clear that the company is nearing the end of its financial rope. The ongoing short squeeze appears "irrational" to say the least in light of ongoing developments. I anticipate the company will have to file for bankruptcy within the next month when it will be unable to make a substantial bond interest payment, and I am short.

1. Financial condition

Chesapeake is an oil and gas producer, suffering from the same problem of low prices brought on first by overproduction and second (and more importantly) by the sharp drop in demand following the outbreak of the Corona virus. As the company reported in its quarterly filing on May 7,

Thus in two paragraphs, the company said that it expects to miss financial covenants this year, it has engaged bankruptcy advisors, and it may not be able to continue as a going concern.

In light of the companies bad results and poor prospects, one might understand why the executives would make the folllowing unusual move described in special filing on May 8:

The total amount paid to these 21 employees will be approximately $25 million. Our named executive officers’ target compensation will be earned 50% based on their continued employment for a period of up to 12 months and 50% based on achieving certain specified incentive metrics. As a condition to participating in the revised program, our named executive officers and vice presidents are required to waive participation in the Company’s 2020 annual bonus plan and waive their rights to all equity compensation awards with respect to 2020.

That is to say that the executives waived their compensation in stock in exchange for a bonus pool of $25 million in cash. I interpret this change to mean that the executives do not believe the company's stock will have value in the future, and they are choosing cash instead. That's a pretty bad sign of a lack of faith on the part of the executives, and it adds stress to the company's balance sheet at a time of financial distress.

2. View from bond prices

As one can see from the 10Q, Chesapeake has almost $9 billion in financial debt outstanding:I've used the red boxes above to separate the 2nd lien secured bonds from the unsecured debt ("senior notes"). These 11.5% senior secured second lien notes have to recover 100% of principal and interest due to them before principal payments can be made in a bankruptcy. As of Friday, these bonds were trading for 5 cents on the dollar:Source: Bonds Detail

The bond comes with an 11.5% interest payment due in two annual payments of 5.75% each, so this price indicates that the marginal seller of the bonds does not believe he will receive that 5.75% payment due July 1.

It follows from the rules of bankruptcy priority that all the debt junior to the 2nd lien bonds will not be repaid, either. That is to say that the bond prices are telling you that the company will likely default on more than $2.2 billion in secured debt and more than $3 billion in unsecured debt less than one month from now! These bond prices and this conclusion that the company will not make interest payments in the near future are further supported by the statement on page 35 of the quarterly filing which states, "We currently have no access to capital and other financial markets."

3. Ongoing short squeeze

Even though all this information has been available for over a month, Chesapeake stock is quite volatile of late making tremendous moves:

Source: https://finance.yahoo.com/quote/CHK?p=CHK&.tsrc=fin-srch

As you can see from the chart above, the share price is climbing rapidly and trading volume is increasing. While any two people have the right to trade stocks at any price they choose, in light of (1) the high cost to borrow shares and (2) lack of availability of stock to short and (3) no move in the bond prices:Source: https://iborrowdesk.com/report/CHK

....it appears reasonable to conclude that recent share price action is result of a short-squeeze and does not reflect a change in the prospects for success or failure of the company.

4. Considering the bull case

To the extent that there is a bull case here, one would say that oil prices which have recovered from negative territory to almost $40 per share should show that the company's prospects are improving. While I would grant that this company's assets and operations are more valuable at $40/bbl than zero, I observe that the problematic results were all obtained in the first quarter ending March 31, before prices went negative. Similarly, the lack of recovery in bond prices is another sign that higher prices don't make any difference here.

5. Conclusion

For the reasons stated above, I believe Chesapeake will file for bankruptcy in less than one month from today. I am short shares of stock and I own puts.

Analyst’s 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.

Comments

[ASB Capital]

I've been selling the puts that I own Chesapeake, and actually started selling uncovered puts with short expirations to earn some money selling what i believe is overpriced volatility. I remain short shares, but I'll probably be done with my puts this week. Too much risk of another squeeze with no time value left.

[ASB Capital]

WSJ: Chesapeake Skips Interest Payment, Countdown to bankruptcy starts

www.wsj.com/...

[Raw Energy]

If there is one E&P co. less likely to put out any announcement of the above than CRC, it is CHK ....

[Raw Energy]

Yawn ... "Exclusive" article that CHK may file BK as early as this week ... which is also options expiration for those who might wonder about the timing of the article.

www.reuters.com/...

[This2ShallPass]

It's interesting on the big 2L move today (clearly folks knew about this). Could it be because of the below? Eliminating $7B in debt puts post-BK CHK in a really solid footing.

"If the company manages to emerge from bankruptcy, creditors that include Franklin Resources Inc (BEN.N), will take over Chesapeake in exchange for eliminating more than $7 billion of its debt under the outlines of a plan being negotiated"

[Raw Energy]

Big move? You mean in the retail 2Ls? The institutional/Rule 144 2Ls haven't moved at all and still trade at $6 (vs. $16 for the much smaller but available to retail securities). Clearly the "smart money" isn't impressed, and that includes the existing holders of 2L who were likely approached and involved in discussions re a pre-pack.

The "terms" of the plan, according to the article, involve an additional $1- $2 B in DIP financing, which will have to be taken care of upon exit. To accomplish that, CHK is proposing that creditors add equity to the deal = a rights offering. In that case, the debt is simply the equivalent of an "opener" in poker terms. The rights offering could be a whopper given the need to keep the company viable with normal debt/equity ratios post-BK. Then, of course, there is the issue of carving out enough value for the 3%+ that will be given to equity because ... well, just because. XOG became the latest to join the "3% to equity" club yesterday.

So many articles on "filing expected imminently" that even I tend to ignore them, especially in options expiration weeks, when existing shorts may actually be trying to move the stock price down because of their underwater positions. This time looks like BK may actually be real, but doing so before June 30/July 1 doesn't seem to possess any particular advantages.

GLTA.

[matthewxjr]

FINRA not showing an institutional trade since Friday. Doesn't look like they are "trading" at all, much less for six bucks.

[This2ShallPass]

Any update on if they paid interest due today? Do they have to put out a press release if they decide to take the 30 day grace period?

I think it's a major positive if they paid. Since the big $125+M payment is due Jul 1 which they're highly unlikely to pay, the more likely scenario is they take the 30 day grace period on today's payment.

[This2ShallPass]

Big move in 2L today and lot of activity...I see some trades at $15+. Payment must have been made.

[ASB Capital]

That is a big move. Very interesting that the stock is flat but the 2Ls are up.

[DT Now]

@This2ShallPass

No one seems to know if and/or when the company is required to put out a PR or otherwise notify stakeholders that they intend to default or take a grace period.

Just like no one can explain why the reverse split was done much sooner than it had to be done.

And no one here seems to be able to confirm (or deny) that if the bond interest due today gets paid (not to mention that May 15th bond interest was paid), any intention to file for BK would have to carefully evaluated for consideration by the court and possibly rejected, especially since Lawler stated the earliest they would need to file would be in the beginning of fourth quarter.

Finally, no one seems to care or understand that CHK is required to have a shareholders meeting and issue notice of such meeting by the end of this month.

So, how about it shorts or naysayers? What are the answers?

[ASB Capital]

For everyone who was interested in the discussion of where the first lien loans are trading, I just talked to a high-yield trader who says the bid/ask is 55-60 and though there isn't much activity there has been some. He says his clients have traded in the 2nd lien bonds in the mid-single digits.

[MarionPolk2017]

I bought more of the bonds in that price range this morning.

[Q2000]

I just spoke with my grandma and she says the opposite

[DT Now]

Just a polite reminder...CHK is tops when it come to holding cards close to their chest. They kept a major acquisition secret right up until the day earnings was reported. Maybe they will do something similar here in the near future. If I understand correctly, they are required to put out a notice of a shareholders meeting this week and hold one during the last week of June. If true, I can only imagine some of the items to be voted on.

And yes, up to now, the WildHorse acquisition has been a bad call, but higher oil prices could change that real quickly. No one, except maybe The Simpsons, expected COVID-19 nor its consequences.

www.youtube.com/...

[Raw Energy]

And movies like 'The Andromeda Strain' (1971), 3 movies inspired by 'I Am Legend' book (1954), '12 Monkeys' movie and TV series, 'World War Z' and any # of zombie movies, 'The Walking Dead' and other TV shows ... as well as real examples like the Spanish flu and several other flu pandemics, Ebola, HIV/AIDS, bird flu, etc. Of course, the health impacts (so far) are far less than any of those which, after all, were "only entertainment."

[taketake1]

I’ve got 200 of the 11/2020. You can have them for par!

[Aleksandar Knezevic]

It seems highly unlikely that such plan , that term loan gets 90% or more equity will go through the court fast, ther will be a huge battle and it will take time,if oil and ng prices go up ther will be new plans and it could last for more than 12 or 18 monts. It is better for term loan to give 2L 30% and it will zoom through the court

[Raw Energy]

If the Term Loan is considered impaired, or if the 2L is considered impaired and roughly 2/3 in value approve (Franklin owns 50%), it becomes a done deal if there is a pre-pack in place. Unhappy groups can submit their own valuation opinions, but at a hearing when the possible approval of the plan is being considered. A pre-pack can be accomplished in 3+ months, and that time period is spent merely accomplishing what needs to be done to complete the pre-pack, not more negotiating. You are thinking of a "freefall" filing, with no pre-pack in place, where the process can drag on. That is still a possibility.

Of course it would be better (for the 2L holders) if they get 30%; even better at 50%. If the Term Loan is impaired, the TL holders will disagree with taking a haircut on their share so that junior creditors get a recovery, which should not happen due to their priority. The valuation will be key in establishing where the fulcrum security resides, and that security's interest will be considered first. Based on other BKs, if the 2L were excluded initially, they might still get warrants exercisable at the point where the TL holders have achieved 100% of their debt, which might be a valuable security in this instance.

Many other BKs have involved rights offerings, and if CHK will require more capital to operate within normal parameters for debt ratios, etc., that could definitely impact 2L holders as well. If the rights are offered to the TL holders only, or to 2L holders, investors who own the 2L but don't want to put more $$ in get further diluted; that could be one reason why the 2L trades so low.

[ASB Capital]

@Aleksandar Knezevic it doesn't matter what you think "should" or "shouldn't" happen. Security interests and the absolute priority rule mean a creditor ahead of you has to get 100 cents on the dollar (often including interest and legal fees!) before anyone lower on the totem pole gets a penny.

So in this case, unless someone shows up and offers the first lien lenders 100 cents on the dollar plus interest and fees, 2Ls can't get anything, unsecureds can't get anything, and many counterparties and trade creditors will lose money they're owed as well.

What often happens these days is that instead of forcing a bankruptcy plan over the objections of creditors to exercise their rights to the fullest extent of the law, there are often carve outs for subordinated creditors to get 1, 2 or 3 cents on the dollar of value in exchange for their support for a bankruptcy plan. This is really just a recognition by the senior creditors that life is short and litigation is time-consuming and expensive.

So in an actual bankruptcy, it just doesn't make any difference at all what the liability structure is and who lent how much money. That was yesterday. We start from a valuation supported by either expert evidence or the willingness of third parties to pay money right now.

[Aleksandar Knezevic]

I completely disagree with you that term loan is impaired ,even at today oil and ng prices term loan would get 100% plus interest through chapter 7 process and 2L would get more than 8%. It is just my opinion but at least I have skin in the game , position in USU1450AZ86 at 8,5 (with accrued unterest).

[WorldWideTechGuy]

Question regarding the 2L

I understand they were issued under 144a. I'm trying to understand if I can participate in the rights offering during a restructuring. I'm an accredited investor and foreign national. When reading somethings it looks like I must be a QIB to participate but in other things i'm looking at 4(a)(1½) may apply. I have zero experience on this front can someone provide guidance? Is being an accredited investor sufficient?

[ASB Capital]

Is there a rights offering on the table right now? I'm not aware of one.

It's not uncommon for a bankruptcy plan to include a rights offering. In a case like that, the plan would say, "We're giving holders of the 2L bonds the right to buy up to 10% of the post-reorganization equity for a price of $100 million" and then you'd participate based on your pro-rata ownership of the bonds in question.

I think what's rather likely to happen though is that a group of hedge funds that control half the 2L Bonds might say that *they* and they alone want the chance to do a rights offering and leave the other 2L holders out of it. There are some legal issues around this, but basically if they can show that you're not worse off than you were before they may be able to keep upside for themselves. This kind of thing makes it really tough for "little guys" (by which I mean even wealthy individual investors!) to invest in bankruptcy situations when there are sharks in the water (ie, sophisticated and aggressive hedge funds involved).

It's a bit different when you can identify some collateral value available to pay creditors. I don't have an opinion on it yet, but just as an example for the sake of discussion it looks like there is some value in Hertz bonds and I'm nowhere near as concerned that retail holders of that unsecured debt will be hard done by.

[WorldWideTechGuy]

Thanks for your feedback it's very helpful. I was posing the hypothetical case for a rights offering :D

I have been going over some cases from start to finish to see how things played out. Do you have any good recommendations on cases to look at where majority tried to leave out smaller guys on rights so I can review the filings. I just finished a similar situation with Acosta where it looks like accredited investors were well treated but some simple things like requiring packages to be filled out on their website not mailed to them etc could cause problems.

[ASB Capital]

The details of getting paid are not really obscure, but also not very obvious. If you think you're owed something, you can check with the clerk or the debtor to fund out how to collect it.

I'll look around for examples of dividing a creditor class and leaving out the little guys, but it feels like a common occurrence.

[Graham Hart]

buy fear, sell/short greed. I don't short bottoms. In terms of risk/reward I'm willing to risk a certain percentage of my portfolio on CHK and other crushed energy companies during this time. Energy has enormous potential over the next 6-7 years.

[smithcor]

Your reference 165167DD6 unfortunately these are 144a restricted issue. Not for public consumption.

For CHK, Chapter 11 reorganization is an opportunity, just not for the equity stakeholders! Bond holders sit behind the banks in reorganization. The equity disappears and the debt holders get the recovering company and its assets. At best, S&P currently calculates a 15% liquidation value (Chapter 13) for the unsecured bonds. New equity and new bonds will be exchanged for current issuance (calculations estimated 43% recovery in Ch 11 reorganization). In the mean time, the bondholder has an unearning position, no different than a speculative equity.

Bank leverage covenant for 2020 is 4.25x, 2021 4.00x. Unfortunately Q1 2020 financials broke down from (12/19 Q4) 3.98x leverage and 3.38x coverage to 5.58x leverage and 2.65x coverage. They are clearly in violation but earn enough to pay the bonds. In addition, financials reflected a $7.74B impairment on assets. An additional 50% haircut to assets would be reflective of a 15% recovery. Result: there is "value" to the bonds: just what, how and when is the question. If it comes to the courts, estimate 6years for Chapter 13 liquidation for 15%

[MarionPolk2017]

"calculations estimated 43% recovery in Ch 11 reorganization" Why would anybody favor a chapter 13 over a chapter 11?

[ASB Capital]

I haven't tried to buy these 2Ls but I've bought other bonds that were originally issued as 144a and became registered and purchasable by retail later.

Book value or asset value for an oil and gas company are not only backwards-looking (subject to impairments) they also may not reflect the myriad decisions about how to produce the assets. So a creditor today trying to come up with an estimate of value really has to do an asset level analysis. I'll acknowledge that I'm out-sourcing my asset level analysis to debt prices. First lien loans were trading in the 50s the last time I checked with someone who had a Bloomberg.

[Raw Energy]

Yes, that's because of things like unproved acreage value that gets factored out in BK, G&A that gets factored in, and DIP financing for interim ops. DCF is what gets used to establish valuations.

[dcxavier]

"the executives waived their compensation in stock in exchange for a bonus pool of $25 million in cash."

I love capitalism. The same executives that made the common stock worthless are given cash instead. The Board of Directors, which has fiduciary duty to the shareholders, approves it.

[lapas]

At least he is honest that he is talking his book.

[DT Now]

@ASB Capital

How many shares did you short and at what price level? I'd cover right about now if I were you (~$17/sh).

[ASB Capital]

I shorted 300 shares at 15 right after the reverse split, so I've not only paid a high cost to borrow those but also had to endure two short squeezes - inlcuding Monday! So that's not in the black yet.

At the same time however, I've had a really nice run with buying puts in the middle of both short squeezes and those returns have been great.

But like I said, the bankruptcy filing is coming for the reasons I showed above and this little fad of driving up squeezes in bankrupt stocks will come to an end soon too. Just have to be sized appropriately in order to be able to wait it out.

[DT Now]

@ASB Capital

At least you are honest and have skin in the game. However, given that things are looking up (especially since last quarter) and they've taken steps to reduce costs and protect cash flow with hedges through this year, added to the fact that the Fed is going to keep interest rates near zero for the foreseeable future, I just can't see this going lower than $15/sh anytime soon.

The biggest wildcard here, I think, is whether or not a Democrat is elected as the next president. I put country over party and will vote for whoever goes up against Trump, regardless of what they think of shale. IMHO, I think that most politicians think that they have more power than they actually do, including the ability to get rid of frackers.

[solar_master]

A bankrupt company with terrible fundamentals and no future? Buy, buy, buy!!!! Welcome to 2020. Good luck, you're gonna need it...

[KarenP07]

"I trade on Robin Hood platform. Your bankruptcy description means it can only go higher from here....All my friends are loading up using their credit cards"

I found the above online.....Robin Hood folks gonna get lose a pile of money on these things

[Profcc]

Please allow me to ask something...
Why did CHK make the 200:1 reverse split?
Isn´t it possible or why isn´t it possible that they are preparing to issue new shares?
I guess there are many shareholders who would buy new shares instead of losing their whole investment in case of Chapter 11.
Thanks for your answers.

[geeeorge2000]

The reverse split was so they could stay "listed". Too long under $1 a share = delisting from their respective exchange

[DT Now]

They still had time to extend. The fact that they fast-tracked it, and at the highest ratio, should make shorts nervous.

[OptionLover]

The Robinhood users played in a scenario you will be bleeding to death before it goes bankrupt
as it takes months. If you bet it goes bankrupt in a month, your put lasts probably 1 month,
therefore, if it does not go bankrupt in 1 month, your put evaporates.

[ASB Capital]

You're correct, but since they have a debt maturity coming up I feel comfortable buying July puts.

[MarionPolk2017]

The soonest debt maturity is August 15, for $177 million.

[ASB Capital]

The picture of the 2nd lien bond quote says explicitly that the interest payment is due July 1. That's 11.5% interest on $2.2 billion in debt.

[Eugene Investor]

CHK is not run by crooks. Management has done all that they can.They have made a couple of smart moves they are just a part of a poorly priced market.

[longdomgzoomzam]

Do you actually get charged 200 per cent to borrow the shares to short?
I heard interactive brokers can say we want our borrowed shares back and you are forced to buy them back. Ergo a short squeeze

[ASB Capital]

I've had shares called on me once, and that's pretty rare.

But yeah, you pay that high cost to borrow but it's on an annualized basis. So I'm willing to be short here since I think it'll happen pretty quickly.

[rickbkwik]

If you will indulge a rookie, albiet one who used to have a 7, 52, and 63 30 years ago,
Im uncomfortable with naked shorts, but the concept of buying puts on failing companies is on my “educate myself”. list.
If you buy a put, how near to bankruptcy are you comfortable with it being of value with a potential looming bankruptcy, bailing corporate execs, and possible delisting?

The bond recovery angle intrigues me, but I am not an accredited investor and my one foray into distressed bonds (Iridium/Motorola) taught me the little guy buying unsecured bonds is a losing proposition.

[ASB Capital]

@rickbkwik In my experience, bankrupt stocks still trade with at least $25 million market cap and often $50 million. So if I can buy a put:
- When I think a bankruptcy/default, etc. is extremely likely, especially by a certain date
- with a strike price/market cap well above even that $50 million
- and the pay-off ratio makes sense,
then I'll try to do it that way.

So if we're talking about moving from $300m to $150m in a stock like Chesapeake, I would be willing to buy that with a 50% or greater payoff for an option that would be at least one month longer than my expected "event date." For the move from $150m down to $100m or $50m, there's just a much better chance that won't happen, or it'll happen in a way that doesn't let me sell when I want, or something else, so I'd want to see the chance of a 100% or greater.

There's a lot of skullduggery here you can play around with like creating a spread by selling a shorter-dated put or one with a lower strike price, which essentially brings down the price you're paying to get in the position. I've played around with this a lot and I'm not sure it's changed the return profile all that much.

[karondongotbanned]

I am still hopefully that CHK will go back to 200+ dollar range. it went up to 70 dollar 2 days ago.

[andresb13]

Thanks for the analysis. I had reached a similar conclusion on equity. Now, Senior debt (Rev. Credit Facility, Term Loan and Senior Notes) of approx. $5.7bn will have approx. $10.7bn in (Book Value granted) PP&E. Is the latter worth zero?

[ASB Capital]

There are $3.4 billion in term loans that are trading at a big discount and I think that's appropriate. The 2nd lien bonds are trading around 5 cents which reflects the option value of them discovering a diamond mine on company property or something (sarcastic). Lots of unsecured debt is called a "senior" note even though it's not really senior to anything, so don't let that be misleading. (I've thought about calling them "Super Awesome Notes" sometime just to highlight to discrepancy.) If they're not secured, it doesn't matter.

On book value, that can either reflect what the company paid net of depletion and impairments, or it can be adjusted for prices in other ways, but it's just not forward-looking in any meaningful way.