We are moving Chesapeake Energy (CHK) to a Sell. While the company reiterated their full-year production growth guidance of 10% for 2019, and is making progress on improving its operational efficiency, the company appears to be in triage mode - taking increasingly aggressive steps to avoid defaulting on its vast debt, which would lead to a bankruptcy. In a bankruptcy, shareholders would likely have zero recovery. We believe these triage steps carry a very slim chance of achieving their goal, and an even less likely chance of restoring any measure of prosperity to Chesapeake’s shares.
In its 10Q filing, the company essentially admitted this, warning about its ability to continue as a going concern.
The company slashed its 2020 capital spending plans by 30%, essentially eliminating any chance of production growth. Given the unpredictability of drilling success rates and follow-on production volumes, along with the possibility that current well production tapers faster than anticipated, Chesapeake could find itself with production declines next year and almost certain declines in 2021.
Chesapeake is also resorting to trading equity for debt reduction. While its debt outstanding declined by $500 million compared to the second quarter, it issued 319 million shares to achieve this, increasing shares outstanding by 20%. Shares outstanding have more than doubled from a year ago, while debt has actually increased modestly. Part of this higher debt and share count was due to the WildHorse acquisition earlier this year, but output, net of acquisitions and divestitures, has increased only 3% so it appears that this dilution was marginally productive.
While asset sales in the past have provided critical cash inflows, prices for oil and gas assets have fallen, limiting the net benefit of this route for Chesapeake.
Even with its capital spending reduction, the company’s cash flow margin for error in 2020 is slim. We estimate that it will have about $50 million in free cash flow next year. For a company with $4 billion in revenues that sells into a volatile commodity market, with a wide range of other cost and operational variables, this slim margin could disappear and turn negative very easily.
There remains a remote possibility that the company will be rescued by a sharp and sustained increase in prices for oil (now comprising about 60% of revenues), natural gas (35%) and natural gas liquids (5%), but this possibility is too low to merit a continued position in Chesapeake Energy.
We move shares of Chesapeake Energy (CHK) to a Sell.
Disclosure Note: One or more employees of the Publisher own shares of all Turnaround Letter recommended stocks including CHK shares.