Chesapeake Energy Corporation (NYSE:CHK) is emblematic of a stock type — less an investment and more of a deep value/asymmetrical risk-return trade. That’s as opposed to stocks trading at the lower end of a range, and that I’ve been watching for some time, affording me some sense of how they behave. In a trade like CHK stock, I see shares that are struggling through some hard times.
CHK has been beaten down by the market into the sub-$5 range, but the prospects for actual bankruptcy seem unlikely in the near term. Oftentimes, this means there is probably a floor for the stock that will limit any potential losses, but that there may be excessive upside — 50% or more.
When it comes to swing trading, such as the type I utilize in my stock advisory newsletter — The Liberty Portfolio — one of my last big hits was with EZCORP Inc (NASDAQ:EZPW), a pawn shop operator that had several years of misfired diversification. The stock sunk to $1.59 in early 2016. I knew the intrinsic value of the pawn business alone was $9, so I bought in and sold out for a four-bagger before year-end.
I don’t know if a CHK stock trade will yield that much, but signs point to a possible significant upside trade.
CHK stock has lost 90% of its value since the oil price crash in 2014, and trades at $3.87. Things were looking very grim for CHK stock and bankruptcy — under the burden of very low oil prices and some $21 billion in debt — seemed likely.
For the near future, or at least until the next debt maturity rolls around in 2020, Chesapeake Energy just needs to hold its own. That’s all. Part of the reason is that the energy producer was able to cut its debt load by almost 60%. Plus, there are operating earnings — about $495 million in the last quarter — and that was with oil prices down about 7% YOY.
Unlike most shale producers, CHK also has a natural gas business. That diversification probably saved it, because the pure-play shale companies are in big trouble. For example, while First Trust ISE Revere Natural Gas (ETF) (NYSEARCA:FCG), a natural gas-focused exchange-trade fund (ETF), is down 18.7% in the last six months, the closest thing to a pure-play shale ETF — PowerShares S&P SllCp Egy Ptflio (NASDAQ:PSCE) — lost almost 32% in the same period.
The renegotiation of debt maturities has also helped. Creditors aren’t just going to demand money that isn’t there, and as long as CHK can at least come close to being cash-flow positive, it has time to wait for a significant recovery in the oil patch. In addition, CHK has hedges which will, when unwound, add to its cash pile.
It has more than $3 billion in cash and a $3.8 billion revolver. Bankruptcy in the next 2-3 years is not going to happen.
Management has said that break-even cash flow comes at $50 oil and $3 gas. We’re close to that now.
CHK stock has been hit by Hurricane Harvey because it had to suspend operations in affected areas. No production means no sales, and these areas account for a significant part of Chesapeake’s production. Still, the company will ramp up again so the stock seems to be getting hit for this short-term weather reason, not because of any organic issue.
With CHK stock at $3.87, I see any good news as lifting the stock. Even neutral news may do so. There is limited downside based on the unlikely possibility of bankruptcy. Sure, CHK stock could get hit with more near-term bad news that pushes shares lower. But the stock hit $1.59 when things looked far worse than today.
Traders might open at least a half position here, or a full one, and look to scale out beginning at $5 and drop out more as CHK stock rises.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
