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The CHK Equity Offering

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By RedneckRoleModel
December 8, 2006

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Those of you who follow CHK saw the announcement of a major equity offering today, representing about 6% new shares. For those who don't, the company is offering these shares to pay down debt. Since I anticipate getting asked a question about this offering sometime soon, I thought I'd post my thoughts here and ask for thoughts and opinions from other knowledgeable shareholders.

In my opinion, this offering stinks. The company is selling equity priced at 7.5X trailing earnings and less than 10X forward estimates in order to pay down a bank credit facility that's priced around 6%. They say they're doing this to (i) get an investment grade credit rating by 2009, (ii) have a "balanced" financing strategy, and (iii) continue their aggressive drilling program.

All of these reasons make zero sense to me. Credit spreads are so tight right now that the company would get very little benefit from having a higher credit rating. What's more, the company is in excellent financial health, with very high interest coverage and a falling debt to equity ratio. And speaking to their "balanced" financing strategy, they've issued plenty of equity already this year for acquisitions.

So that brings us to drilling. McClendon has been telling us since the Q2 earnings call that the company was preparing to shift from a "buy and drill" mode to a "drill drill drill" mode (my words). So that's no surprise. What does surprise me, is that the company feels like they need more liquidity to fund this strategy. I always anticipated that they would simply fund their drilling out of cash flows, since their cash flows are now so much higher than they were a few years ago. If need be, they had ample borrowing power at attractive rates to use, which is a good proposition considering the IRR of their drilling programs. This is certainly how most of their well-funded competitors are financing their drilling programs these days.

What, then is going on? I see two alternatives. One -- the company is preparing for a major acquisition. This is not likely, though, given what McClendon told investors in the last two quarterly calls. So this brings me to another hypothesis, one that dawned on me this afternoon over lunch. My idea is that the common stock of CHK is not the most junior security in the capital structure, and that this problem creates a mis-alignment between the interests of management and the interests of outside shareholders.

What do I mean by this? Think of how we, as investors, judge management teams. Among other things, we want them to use the balance sheet -- and in particular, to manage the issuance and redemption of classes of senior securities like bank debt and bonds -- to provide maximum value for shareholders. Bond managers, subject to constant call risk, have always bemoaned this mandate from common shareholders, but no one cares about bond managers whining that they got their money back too early and now don't have anywhere else to put it, so this side effect of good management is tolerated by the markets.

But what if the common stock wasn't the most junior security -- how would common shareholders feel if the issuance and redemption of common stock was planned in order to maximize the wealth of another class of security holders? As that great investment philosopher Dr. Peter Venkman* might say, the markets would react with "human sacrifice, dogs and cats living together, mass hysteria!"

I can think of only one scenario that allows me to make sense of today's equity offering, and that's that issuing equity benefits the founders' well participation plan, which is a unique co-investment/compensation agreement that allows McClendon to invest side by side with Chesapeake directly in CHK-operated wells. The FWPP is no secret -- we've discussed it on Liquid Lounge before -- and I've always viewed it as a distasteful aspect of CHK, but one that I was willing to tolerate. Partly, I was willing to tolerate it because of McClendon's large interest in CHK shares, and his ongoing purchases of CHK stock. At today's prices, McClendon owns over $880 million of CHK common stock, according to his most recent Form 4.

So how would an equity offering benefit the FWPP? My idea is that as CHK begins ramping up its drilling program in the next few years, his investment in the FWPP could potentially have more upside than his $880M stake in CHK common. And if that were the case, he could manage the issuance of equity to benefit the FWPP, just as a good manager does with debt to benefit equity holders. By reducing the company's bank debt, and/or lowering the company's borrowing costs, the company could invest more of its cash flows into drilling, creating more opportunities for McClendon to invest in CHK wells. In this kind of scenario, McClendon could potentially make more money from his FWPP investment than he could make in capital appreciation in CHK stock, even if he wasn't diluting it all the time.

Again, this is just a thought, but it's the only one I can come up with to explain today's equity offering and reconcile with all that I know about the company, and all that they've told us in the last year. As my posting history on CHK makes clear, I think the company's history of issuing equity and debt to fund acquisitions over the last 5 years has been nothing short of brilliant. There's no question that it's created tons of value for shareholders. But for six months now, McClendon has been telling us that the land grab is over, and I think it was only natural for me, as a shareholder, to expect and end to the dilution. So today's news was truly mystifying.

I would love to hear anyone else's thoughts on this. I'll be calling IR at the company tomorrow to vent my frustration and ask for an explanation. If I can't come up with a good explanation for the way they're allocating capital today, I will have to rethink my investment thesis in CHK -- and potentially walk away with my excellent gains in search of another energy company with capital allocation decisions that I can be comfortable with. Tiddman -- we discussed precisely this issue when we were contrasting CHK and BAM, and it appears from today's news that CHK just doesn't get these kinds of shareholder issues in the way that BAM does. Or if they do, the FWPP creates incorrectly aligned incentives.

Best,
Redneck

* http://www.imdb.com/title/tt0087332/quotes


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