Mark Twain once said that the report of his death was an exaggeration, but in the case of Chesapeake Energy (CHK) and its shares, this week's decline has been no exaggeration. Chesapeake shares closed at $1.56 on Monday, capping a nice multi-day rally in what was clearly the expectation of a healthy earnings report. Oops!
You can quote the late Burton Malkiel's "Random Walk Down Wall Street" all you want, but with CHK's shares changing hands at 91 cents on Thursday afternoon trading, you can't convince me that the market was efficient in this case. It simply wasn't.
The cause of CHK's plunge wasn't the earnings press release or accompanying conference call. Cheseapeake's earnings were predictably mediocre in a depressed pricing environment for hydrocarbons, especially natural gas, which represented 74% of CHK's production volume in the quarter.
The fact is, CHK shares are plunging because of management's use of the dreaded "going concern" language in the company's 10-Q filing -- it is mentioned four times.
The legalese around going concern is always predicated by "substantial doubt about our ability to continue as..." and that is the key. It is also why Chesapeake shares are a screaming "buy" here, despite the specter of bankruptcy.
Chesapeake's coverage ratios are fine, and a cock-eyed optimist might even describe them as "healthy." Like many energy companies, Chesapeake uses Adjusted EBITDAX -- Earnings before interest, taxes, depreciation, amortization and exploration -- as a key operating metric. In the first nine months of 2019, Chesapeake generated $1.865 billion in EBITDAX vs. $513 million in interest expense. Cash paid for interest was, as it often is with companies that have a wide array of securities, even lower than accrued figure, and amounted to only $487 million for the first nine months of the year.
Also, as per the 10-Q:
As of September 30, 2019, we were in compliance with all applicable financial covenants under the credit agreement. Our total leverage ratio was approximately 3.88 to 1.00, our first lien secured leverage ratio was approximately 0.74 to 1.00 and our interest coverage ratio was approximately 3.55 to 1.00.
So, how can a company that is generating 3.8 times more operating cash flow than it is paying out in interest charges go bankrupt? Well, near-term debt maturities can be a killer, but through prudent management and a recent debt-to-equity swap, Chesapeake only has $595 million in combined debt maturities in 2020 and 2021.
So, it's really not a matter of whether Chesapeake has too much debt, as I have been reading from the various "Captain Obviouses" in the financial media this week. CHK had $9.52 billion in debt at the end of the third quarter and now the company's equity value is $1.82 billion. Of course, Chesapeake management has saddled this company with excess debt. Duh!
The issue, however, is whether it can service the debt, and with the company's robust hedge book and the recent uptrend in natural gas pricing -- at $2.77 per MMCF today -- CHK can easily pay those interest costs. More importantly, those conditions will allow Chesapeake to maintain compliance with the covenants contained in its credit agreement.
So, I have been buying CHK shares in the past two days, but fully protecting those purchases with call options. It has been a wild ride, but the decline in value of the calls I am short has offset the decline in value of the underlying common. There will come a day to remove those calls, and with brutal cold weather set to hit the Northeast -- a key driver of natural gas pricing -- now may in fact be the time. I will have more on Chesapeake and other energy names soon, but if your risk tolerance is very high, CHK is actually an attractive buy below $1 per share.