That Was Fast

Chesapeake Caves To Shareholder Pressure Ahead of Its Annual Meeting

Chesapeake Energy (CHK) announced today that the company has pretty much completely caved in to pressure being applied by Southeastern Asset Management and Carl Icahn, who collectively own more than 20% of the company.  As I detailed in my last post (http://lifeinvestmentseverything.blogspot.com/2012/05/chk-little-help-from-your-friends.html), CHK has been subject to a great deal of criticism due to its apallingly poor corporate governance.  Against a background of extremely low natural gas prices, this criticism has helped push the company toward a crisis and the share price has plunged as a result.  There is still one major unresolved issue with respect to the company's Board structure, but the increased clarity in governance allows an investor to begin to make an informed decision about the company and formulate an investment thesis.

The company will replace 4 of its current 9 directors with 3 chosen by Southeastern and 1 chosen by Mr. Icahn.  That leaves 4 legacy directors in place (including CEO Aubrey McClendon), and a vacancy for Chairman of the Board.  CHK's announcement indicated that the new (as-yet unidentified) Chairman would be acceptable to the shareholder-designated directors.  If this turns out to be true, it appears that the activist shareholders have succeeded in largely wresting control of the company from a complacent, do-nothing Board and management which still acts like the US' second largest natural gas producer is a tiny wildcat operation.

We now know that the corporate governance problem has largely been solved, courtesy of the actions of CHK's two largest shareholders.  The question now facing investors is where will the company go from here?  First and foremost, it is clear that the activists will push CHK to rein in its capital spending and transition from a "land grab" play to a more mature development and production company.  There is probably a lot of fat that can be cut from CHK's current operations and all of that excess spending will fall to the bottom line over time.  Second, the activists will likely push CHK to liquidate some of its a very large and diverse collection of assets, many of which are not core to the company's business and are largely underemployed.  Expect to see the sale of acreage/drilling opportunities, possibly the midstream/pipeline company, and perhaps even such diverse odds and ends like CHK's stakes in FracTech and CLNE.  The proceeds of these sales will be used to right-size CHK's debt load and fill the cashflow shortfall occasioned by low natural gas prices and the company's efforts to increase liquids production.  Finally, it is possible that the activists will force the Board to consider a sale of the entire company.  CHK would make an attractive target for a number of oil majors, all of whom have the ability to pay cash for the outstanding shares if they so desire.

So will CHK be sold?  The activists clearly have the ability to push for a sale and a relatively frequent trader like Mr. Icahn would have motivation to do so if the price were right.  However, the activists will undoubtedly want to maximize their profits so they will only push for a sale if the price is higher than what CHK might be able to achieve as an independent company.  As such, expect to see CHK continue to move on actions which will close its cashflow gap and reduce leverage regardless of whether a sale materializes, as this will give the company a credible alternative to a sale.  Potential investors in this name will need to be prepared for a possibly long holding period, since the lack of a sale implies a longer path to higher valuation as the CHK gradually cures what ails it.  That said, the investment opportunity is fairly attractive.  CHK clearly has scads of untapped (and in some cases largely unexplored) drilling opportunities for natural gas, oil, and everything in between.  It has a collection of other assets which could be monetized, such as a large midstream/pipeline operation and a sizable oilfield service business.  All of these assets provide more than sufficient asset value to underpin everything in the capital structure from the bonds to the common equity, the entirety of which trade at a significant discount to peers.

The equity should provide upside if CHK simply cleans up its mess and begins to look like the kind of company that is headed toward investment grade bond ratings and conservative operation (like DVN, for example).  Greater upside would occur if natural gas prices recover from their present very low levels.  It is unclear when or how much natural gas prices might rise, so unless you have a strong feeling about a potential natural gas recovery it would be wise to heavily discount this possibility as a major reason to invest in CHK.  Also available are the company's senior unsecured bonds trading at a roughly 7% yield, and at least one issue of exchange traded preferred stock.  The preferred (http://finance.yahoo.com/q?s=chk-pd&ql=1) is potentially interesting as it has a 4% and change coupon, presently trades at about 78% of par, and is convertible (albeit at a high price - over $30 a share).  As a preferred stock, CHK-PD is senior to the listed equity owned by the two large activist shareholders and could offer the potential for capital gain should CHK's fortunes improve.  In the meantime, the preferred offers greater cash yield and higher priority than the common equity.

As always, this is not intended as investment advice.  Do your own due diligence, consult your advisors, take your own risks, and be careful.

Disclosure: I am long CHK equity and options.