Friday, November 28, 2008 0 comments ++[ CLICK TO COMMENT ]++

Amazing how poorly managed some commodity companies have been

We all know how executives at financial companies, who incidentally were paid gross sums, didn't know what they hell they were doing. Sadly many still don't know what they are doing. Well, at least they have some excuses such as being distracted by the beauty of the ski slopes or by the elegant meal at the finest restaurants while the lending and derivatives businesses they were overseeing were getting out of control ;) But it's amazing how some commodity business executives have poorly run their businesses.

Mike Shedlock refers to a couple of cases of oil&gas companies seemingly facing cash flow problems. The two examples cited, Chesapeake (CHK) and Petrobras (PBR), are not some junior companies with weak balance sheets. Indeed they are not. What we have are two of the largest companies in their field--Petrobras is a supermajor; while Chesapeake is the largest natural gas producer in the US--being mismanaged and running out of cash, at least for the time being. Companies that were and should be minting money are ending up diluting their shareholders, at least Chesapeake is, to the tune of up to 20%, at depressed stock prices.

Being a contrarian, albeit not a very good one, this presents an opportunity for me--and you. I'm adding Chesapeake to my watch list for a potential investment in the future. I'll wait and see if Chesapeake runs into more trouble, which it may if natural gas prices don't recover, and then think of buying its bonds or possibly its convertible preferred shares.

Chesapeake (CHK) is not attractive enough right now IMO. Its bonds have yields ranging from 5% to 12%. That's too low for my taste so I'll wait.

There are also a bunch of exchanged-traded convertible preferred shares (CHK-D, CHK-E; PK-OTC: CHKDL) that one may consider if they think the company will survive and recover. Yields on these range around 8% to 12%.

I favour the bonds right now because of potential bankruptcy risk (not any time soon but in 2 years if natgas prices stay low.) But if one is bullish on the company then the covertible preferreds are worthwhile. All of this is assuming that prices drop a bit more and yields increase. I personally would not buy a bond with a yield of 8% when stocks of large-cap stocks are trading with yields of almost 10% (P/E of 10).

Chesapeake is highly leveraged. Its debt/equity ratio is only 0.9 (not that high) but it has total debt of $14.4 billion versus a market cap of around $10 billion. Its earnings and cash flow look good relative to its debt but you have to keep in mind that this is a cyclical. Natural gas prices are very volatile and there is nothing to say that they won't drop to $5 from the current $6ish price. Chesapeake seems to have hedged most of its production but that means nothing in the long run if prices drop and stay at $5.

The problem a lot of commodity businesses will face, assuming commodities are in a bear market (bear market can imply flat prices rather than a decline,) is that sizeable debt would have been incurred with high cash flow assumptions. If those cash flows don't materialize, these companies will have problems. Chesapeake has been trying to sell assets but that will only go so far.

Companies like Chesapeake have good assets (preliminary impression) so it's ok if the company bankrupt and you, if you are a bondholder, ends up with those assets. As Martin Whitman keeps saying, a huge chunk of the wealth in American capital markets in the last few decades was created by restructuring/spin-off/etc. Recall that Whitman's #1 investment of all time is Nabor industries, an oil&gas service company, which he acquired when it went bankrupt after the oil bust in the 80's.

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