Too Little, Too Late for Chesapeake?

by James Brumley | June 11, 2012 11:28 am

Too Little, Too Late for Chesapeake?

It’s the corporate equivalent to being the coach of the Dallas Cowboys in the 1990s and deciding to not play running back Emmitt Smith. You just don’t bench one of the NFL’s greatest players when you’ve got him on your team (which is why Jimmy Johnson and then Barry Switzer didn’t leave him on the sidelines).

So which company is taking its best player out of the game? Chesapeake Energy (NYSE:CHK[1]).

Oh, sure — on the surface, the sale of a couple of its key properties was just what the doctor ordered. That’s why investors bid up the struggling stock by nearly 18% last week. Before jumping on the bullish bandwagon, though, there are a couple of things to consider:

Details, Details

On the off chance this is unfamiliar news to you, natural gas explorer Chesapeake is selling some fairly significant pieces of itself[2] to raise some much-needed cash. Specifically, it’s going to sell Chesapeake Midstream Partners LP (NYSE:CHKM[3]) — a natural gas pipeline and delivery outfit — to Global Infrastructure Partners to the tune of $2 billion. It’s also going to sell Chesapeake Midstream Development to Global Infrastructure Partners, and also receive $2 billion for the deal. That’s a total of $4 billion in proceeds for $11.8 billion company, which will approximately double the outfit’s current cash hoard.

That’s not the part that stoked investors into a buying mood last week, however. No, patient shareholders are glad to learn the sale also will mean capital expenditures will be reduced by about $3 billion during the next three years. (Why invest in a project you don’t own?) Chesapeake Energy has struggled on this front for years, and an overhaul of the excessive spending plans is a welcome change.

Unfortunately, the maneuver might only be a short-term Band-Aid for a much bigger problem. And it’s not even a very good Band-Aid.

Take a Couple Steps Back and Look at the Bigger Picture

Remember the name John Olson? Probably not. Here’s a reminder: Enron.

Back when Enron was the best thing since sliced bread, Olson was an energy industry analyst with Merrill Lynch, and one of the earliest (and few) voices to suggest the energy trading firm wasn’t anything close to the success it appeared to be on paper. He eventually lost his job for refusing to recommend Enron as a buy, though Olson was vindicated in 2001 when the organization was exposed as a complete farce.

What’s that got to do with Chesapeake? Olson doesn’t think Chesapeake is a carbon copy of Enron. The two companies don’t even have the same business model, and Chesapeake actually has real assets, where Enron didn’t. Yet, given that Olson was right about Enron, one has to at least hear his thoughts about the increasingly questioned natural gas explorer.

In simplest terms, John Olson is understandably concerned about Chesapeake’s perpetual negative cash flow[4], specifically saying “… they have a financial dynamic that only works in the fourth dimension: they need $12 billion when their cash flow is just $2 billion.”

In Chesapeake’s defense, Olson’s numbers don’t quite jive with the ones the company is reporting. He’s not entirely alone in suggesting the math doesn’t work, however. Moody’s recently reported Chesapeake would need to sell $7 billion worth of assets if the gas player was to survive and remain in compliance with terms of a major loan. Moody’s went on to say, though, that $10 billion worth of asset sales[5] might be a sounder target.

But hey, CEO (for now) Aubrey McClendon already has said he’s willing to shed $14 billion worth of property this year, so what’s the problem?

The Problem

The “problem” is a lack of transparency, which wouldn’t be such an enormous red flag if McClendon hadn’t developed earned such a reputation as a reckless spender and a bit of a blowgut[6] … a little too much like Enron’s Ken Lay for the market’s comfort.

As of the last filing[7], Chesapeake reports $39.6 billion worth of property, plants and equipment, which is calculated at “cost based on full cost accounting.” And you know what? Those valuations might be 100% on target. On the other hand, that doesn’t mean McClendon didn’t overpay for them based on some excessive optimism — his eyes have been known to be bigger than the company’s wallet.

And at the extreme other end of the spectrum, there remains the lingering chance those assets are completely misvalued; there’s just little verifiable detail about those assets out there. As John Olson noted of the corporation, “You don’t know what they have. I know that I don’t know.”

Now, back to the original point …

Although we might not have a clear idea of what all the listed property and assets actually are worth, there is some clarity on Chesapeake Midstream Partners and Chesapeake Midstream Partners LP — the two assets the company is selling first.

That value? They might well be the best things the organization has going for it right now; the proverbial superstars on the company’s bench. Both offer real cash flow, and both are quite resilient to natural gas price fluctuations. Yet, rather than play them, McClendon is trading them because he has run into salary cap trouble. It’ll work as a short-term patch, but as is the case with most sports teams, when you let go of your key franchise players, problems can get worse rather than better with the remaining second-tier players.

Sure, there’s always a chance the tactic will solve more problems than it creates. Given that this is a “have to” situation for Chesapeake rather than a “want to” scenario, however (where the buyers have more leverage than the seller), this “shrink our way to success” approach feels a little bit like the beginning of the end of Chesapeake as we know it.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Endnotes:
  1. CHK: http://studio-5.financialcontent.com/investplace/quote?Symbol=CHK
  2. Chesapeake is selling some fairly significant pieces of itself: http://investorplace.com/2012/06/chesapeake-to-sell-4-billion-in-pipeline-assets/
  3. CHKM: http://studio-5.financialcontent.com/investplace/quote?Symbol=CHKM
  4. concerned about Chesapeake’s perpetual negative cash flow: http://www.forbes.com/sites/christopherhelman/2012/06/04/enron-chesapeake-olson/
  5. $10 billion worth of asset sales: http://www.reuters.com/article/2012/05/31/us-chesapeake-loan-assets-idUSBRE84U1CK20120531
  6. reckless spender and a bit of a blowgut: http://investorplace.com/2012/06/how-has-chesapeakes-aubrey-mcclendon-survived/
  7. last filing: http://www.sec.gov/Archives/edgar/data/895126/000119312512228139/d333835d10q.htm

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