Why I’m Exiting Chesapeake Energy After Earnings – Chesapeake Energy Corporation (NYSE:CHK)

Yesterday’s earnings release by Chesapeake Energy (NYSE:CHK) was met with a morning surge followed by a quick selloff to below the previous days close.

Why did the stock price sell off on a top and bottom line earnings beat?

The simple answer is share dilution and balance sheet issues. While the company posted a net gain of $.18 cents a share beating the street investors saw some issues that need to be addressed. Outstanding shares have ballooned from 724M shares outstanding too 1.14B.

Here is a clip from the earnings report:

In my investment world, that scenario is a nightmare, on top of that the company has a total of $13M in cash and a $3.1B credit line. Sorry folks, but that is not impressive to this trader, I see a possibility for more dilution in the near future. How can you have $9.7B in debt and $13M cash on hand and not have the need to raise more capital?

Credit line

Chesapeake has a huge pile of debt hat they are not paying down fast enough. Any way you look at it, the balance sheet is still in trouble and $50 oil is not going to get it done for this business model. CEO Doug Lawler says the company can be cash flow neutral at $50 oil, which is a good ,sign but it is not enough to pay down this amount of debt anytime soon.

Imagine yourself as a homeowner with 100K in credit card debt and $1,500 in the bank. You then tell yourself you have $100k in liquidity? In my view, that type of mentality is not a successful way to run a business.

Dilution destroying shareholder value

Any way you look at it, going from 724M outstanding shares to 1.14B is a sell sign or at the least an avoid. In my previous article I mentioned that investors will want to see the share count stabilized, but this was not even mentioned, not one comment addressing this alarming issue on the conference call.

How is it on the Q&A that not one analyst brings this dilution up and asks the tough questions about what the company intends to do about lowering the share count? Where are the questions about future dilution and how the company plans to handle $9.7B in debt with $13M cash on hand?

Why I sold most of my position pre-market and at the open yesterday

A simple answer as to the above: dilution and lack of cash. I am still holding a couple thousand shares waiting for an opportunity to sell a short squeeze pop, but until I see some kind of substantial improvement, I am not interested. Two days ago I wrote an article stating why I took a position in Chesapeake before earnings, where I mentioned investors would be watching for dilution and balance repair. Interested investors can read that article here.

I have to admit I am disappointed in the company’s ability to retire debt, and extremely disappointed in the lack of capital on the balance sheet. The nearly $500M in settlements really hurt the company’s cash position.

Where does Chesapeake trade from here?

That will depend largely on the price of crude going forward. I have written many articles on this company and from a technical standpoint the stock will need to hold the $4.38 level to avoid a slide to $3.92. It traded to that level nearly a year ago where it bottomed; I might take a little bite at that level. Anything can happen in a stock with a 23% short interest, so investors may be wise to sit back and watch from the sidelines.

In my opinion, the share price will be range bound with a possible low of $3.62 in a big market sell-off and a high of $5.50 until traders see substantial improvement in cash flow.

Here is a weekly chart for a little more guidance:

The red line drawn around the lows of $3.50 would be ideal for a risk reward trade. That leaves room for a 20% downside target, I am not saying the stock will trade there, but it is a possibility. The CEO needs to convince the Wall Street that the company can go forward without further dilution. In my view, that is going to be a stretch with the balance sheet at current levels.

Buyout?

In the past, I have written about the possibility of a large player such as TOTAL SA (NYSE:TOT) buying out the company for a large natural gas footprint in the U.S. This event has failed to materialize at present, however with the trend in oil prices starting to show signs of market equalization, this is still a remote possibility of a buyer to emerge with deep pockets who could change the debt structure and quickly turn things around through restructuring debt.

Deals happen when some least expect it, so in my view that is one catalyst that could fry the shorts at any time. I expect volatility with Chesapeake Energy to continue, so my advice is be nimble and pick your spots wisely if you choose to invest in this company.

Conclusion

Chesapeake energy is diluting shareholders but has has pulled back from the brink of bankruptcy rumors of 16 months ago. The company’s balance sheet is in clear and present danger with $13M in cash and $9.7B in debt. I am no longer a buyer at this level, even though it may be bottoming right now.

Chesapeake needs oil to rise into the mid-$50s and beyond to have a real chance at cleaning up the balance sheet. I see more sales of assets and possible near-term dilution on the horizon. That gives me serious pause to look elsewhere for better stocks paying dividends, like my favorite oil major BP (NYSE:BP).

As always, do your own homework and have an exit strategy in place before making any trade.

Disclosure: I am/we are long BP, LYG,CHK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may sell the rest of my position in CHK on any short squeeze rally at any time.

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