Chesapeake Energy vs. Icahn: Round Two

NEW YORK ( TheStreet) -- On a Thursday during which the energy sector was left bleeding, shares of Chesapeake Energy ( CHK) managed to finished the day in positive territory and on elevated trading -- more than 16 million Chesapeake shares changed hands versus an average day of less than 12 million Chesapeake shares traded.

It's the trading of polite punches between Chesapeake and activist investor Carl Icahn, though, that had investors focused on the strategic plan announced by Chesapeake Energy on Thursday. Icahn doubled his stake in Chesapeake Energy in late December, and that led to speculation that Icahn will be seeking quick ways to make some bucks on undervalued Chesapeake.

If Chesapeake is undervalued, it's undervalued for a myriad of reasons related to its balance sheet and aggressive capital spending strategy, and Chesapeake took aim at all the major points of criticism from the Street and investors in the strategic plan unveiled on Thursday.

Controversial Chesapeake Energy CEO Aubrey McClendon remained bold, if singing a different tune, when he called the new strategic plan "a fundamental shift from our aggressive asset accumulation of the past few years to a multi-year period of asset harvest, characterized by a clear focus on capital discipline and maximizing returns."

However, the problem is that the Chesapeake CEO is seen as the boy who cried "fundamental shift" many times in previous years, and then has gone back on his word, continuing to spend and lever up the balance sheet, while engaging in all sorts of complex joint ventures and production royalty payment arrangements to keep rolling the levered balance sheet up the proverbial hill.

Most notably, Chesapeake's new strategic plan includes the goal of reducing debt by 25% over the next two years, including a reduction of lease-hold spending and monetizing assets. This will have the effect of reducing the company's growth production target from 30%-40% to 25%, the other half of the 25/25 plan that Chesapeake unveiled on Thursday.

The expected criticism of Chesapeake's new strategic plan was immediate, even if shares finished the day up a modest 0.6%.

"We've heard this kind of strategic talk from Chesapeake in the past, but this time it could be different because of Carl Icahn," said Scott Hanold, analyst at RBC Capital Markets.

The presence of Icahn looming as a behind-closed-doors and annual shareholder meeting prod to change in the ways of what Argus Research analyst Phil Weiss called the "profligate spender" Chesapeake Energy, is really the only reason why investors were giving more credence to Chesapeake than after past comments about a mischievous boy mending his wayward ways.

Chesapeake Energy, though, says the new strategic plan has nothing to do with Carl Icahn.

Chesapeake manager of investor relations John Kilgallon wrote in an email to TheStreet, "We have had a strategy to significantly reduce debt in place since May 2010 and our '25/25 Plan' is simply an extension of that strategy. We are always engaged in ongoing discussions with shareholders regarding our strategy and financial plans and we believe this updated plan and reaction in our stock price today is evidence of their continued support."

It's not exactly the type of sanitized words that investors would think represents a "fundamental shift" in Chesapeake's operating philosophy as a result of the Icahn double-down investment.

RBC analyst Hanold said, "Typically guys like Icahn look to shake up a company and influence management and that's today's octane, and to that extent we could see a difference in strategy, but the bottom line is, we need to actually see it."

Again, it's going to be words versus deeds with Chesapeake Energy.

Phil Weiss, analyst at Argus Research, who recently downgraded Chesapeake to a sell, agreed, and added, "We've heard things like this before from Chesapeake, only to see them reverse course in the past. Old habits die hard. I need to see execution rather than just comforting words."

One data point that the Argus Research analyst pointed to was the rise in the Chesapeake Energy share count over the past few years.

Chesapeake said in its Thursday release that it doesn't anticipate any common or preferred share offerings as a way to raise capital.

Chesapeake Energy's diluted share count rose from 493 million to 744 million between March 2008 and September 2010, according to Argus Research data.

"Saying they don't intend to issue common or preferred stock sounds encouraging, but there have been several occasions in past where they said they wouldn't issue more stock," Weiss says.

The Argus Research analyst also takes issue with the recent "improvements" made by Chesapeake in its debt reduction plan. Chesapeake lowered its debt to assets ratio in 2010 from 48% to 43%, but the Argus Research analyst says that it was merely a function of Chesapeake offering more preferred shares, which are debt by another name.

"If I take the preferred shares plus long term debt and short term debt, by November 2010 Chesapeake's debt to assets ratio was the highest since September 2008. They haven't reduce it at all," the Argus Research analyst contends.

The "monetization" of assets is inherent in the 25% debt reduction plan, and that's a situation that Chesapeake watchers will monitor closely to see if, in the end, a fundamental shift is really underway.

"Twenty-five percent is a number where it would significantly reduce leverage and it's achievable in a two-year time frame, but it's going to take some asset sales. In the past Chesapeake has done some unique things, like JVs and other unconventional financings, and it hasn't been the cleanest way to monetize assets," notes RBC Capital Markets' Hanold.

The nature of monetization of assets by Chesapeake is bound to be the sticking point again, and circles back around to the hopes fanned by Icahn's sudden interest in unlocking Chesapeake value. Speculation has risen that Icahn would try to bundle together a block of Chesapeake assets and sell them off for a quick shareholder pay day -- and with Chesapeake at a No. 1 or No. 2 position in almost every major U.S. land drilling play it makes sense -- yet that hasn't been the approach of Chesapeake CEO McClendon in the past.

Monetization of assets isn't new for Chesapeake. It's monetized assets through joint ventures with a number of foreign players and entered into volumetric production payments (VPPS).

Critics say that the VPPs are simply debt by another name, and the rating agencies look at VPPs this way. Furthermore, with the joint ventures, Chesapeake loses operational control of assets.

"They don't need to have the No. 1 or No. 2 position in every single drilling play, so let's see them exit some positions," says Argus Research analyst Weiss, who remains skeptical of Chesapeake conceding to Icahn without much reluctance. "I didn't see anything in the wording of the Chesapeake strategic plan to definitively conclude that Icahn is leading them to sell assets as the approach to monetize assets," the analyst adds.

For a fundamental shift to truly be underway, investors will have to see Chesapeake monetize assets through true asset sales as opposed to monetization through joint ventures and off-balance sheet financing.

The Argus analyst noted that Chesapeake's plan to slow production growth to 25% could in the end simply be a function of its monetization of assets, too. If it moves more assets off the balance sheet by signing more VPPs, "it's getting paid today to take revenue and profit out of the future," and it also would lower production growth with any actual asset sales needing to occur.

Even the skeptical Argus Research analyst Weiss said that if Chesapeake achieves its debt reduction goals without additional dilutive offerings and by actually selling off assets, it would no doubt be a good thing to see. However, as has long been the case with Chesapeake Energy, actually seeing is believing, and not before then.

-- Written by Eric Rosenbaum from New York.


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