Chesapeake Bankruptcy Analysis
Disclaimer: I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand!
This article will be split up into four sections: background, findings, methodology, and vocabulary. The findings section will highlight my results from a recovery analysis, valuation exercise, as well as a comparable analysis. The methodology section will explain in a step by step process how I got to each finding. Also check out the vocabulary section at the bottom. Any terms you are not familiar with I have likely defined below!
Background
I’m sure you all remember Chesapeake Energy, not too long ago it was the most traded oil and gas stock on Invstr, however due to its delisting from the NYSE, it has been taken down. Similar to Hertz, it had a shocking rally in late June. I will point out the same message I did in my article on Hertz, buying a stock of a company going into bankruptcy is a likely a bad idea, since it will likely be worthless. In this article I will provide an analysis of a post-bankrupt Chesapeake, the debt recovery in bankruptcy, and an insight into some basic valuation as well as cash flow projections.
Before going into bankruptcy Chesapeake had over $9 billion in debt, combined with years of net losses, and it is not surprising that is where the company ended up. As seen in the pre-bankruptcy capital structure, the company had a $1.9 billion revolving credit line, a term loan of $1.4 billion, $3.2 billion of second lien notes, and $3 billion in unsecured bonds. Before bankruptcy, Chesapeake had an enterprise value of $10.7 billion. Debt makes up $9.1 billion, preferred equity makes up $1.6 billion, equity (from the close on 7/2) makes up $45 million; by subtracting $82 million of cash and $21 million of non-controlling interests you get the enterprise value.
Findings
In this bankruptcy, the two most senior classes of creditors- “other secured claims and other priority claims”, will get a full recovery. The revolving credit facility holders will be impaired and thus every creditor junior will be also. Revolving credit facility holders will receive a proportional amount of the new revolving credit facility and or (at their choice) a proportional amount of the new term loan. The pre-petition term loan holders will receive a pro rata share of 76% of the new common stock. The second lien note holders will receive a pro rata share of 12 % of the new common stock, the New Class A and New Class B Warrants, as well as 50% of the New Class C Warrants. Unsecured bond holders will get 50% of the New Class C Warrants. Any general unsecured claims, or unsecured bonds will get a proportional amount of 12% of the new common stock. And as part of the bankruptcy plan, Chesapeake will cancel all previous equity claims on the business. That means if you own any common stock or preferred equity in Chesapeake it will be worthless after this process. If this restructuring plan is approved Chesapeake will create new shares, which will be distributed to the creditors mentioned above. In the case of Hertz, I highlighted a potentially worthless stock, but in this case, management is proposing a cancellation of the old common stock. The strange thing is that as of this Friday, Chesapeake was trading at about $4 per share.
Now that we have gone over and defined what creditors will receive, we can value these claims as well as develop approximate recovery values for each class of creditor. To get the simple ones out of the way, any equity claim recovers 0% of their initial investment. Also claims more senior than the pre-petition revolving credit line recover 100%. The revolving credit line recovers 88.5%, the term loan holders recover 34.12%, the second lien holders recover 11.17%, and the unsecured creditors recover 3.19%. These figures are in line with what the bond market is projecting, the unsecured bonds are trading at around 3 cents on the dollar, and the second lien bonds are trading at about 12 cents on the dollar.
The next item to address is managements predicted enterprise value, specifically the equity value portion. In order to deliver a concise article, I will not use more granular oil and gas valuation methods. Instead I have created a discounted cash flow (DCF) of management’s cash flow projections as well as used comparable ratios to project a quick and simple valuation. Using the projections management gave in a DCF produced an enterprise value of between $3.1 billion and $3.6 billion, similar to management’s $3.25 billion projected enterprise value projection. Using comparable companies as a reference for valuation, Chesapeake should have a valuation of between $2.9 billion and $4 billion (see “comparable analysis” in the methodology section to see how I got to these figures). The range is quite wide on both of these, however since I have not created my own projections, I could not accurately tighten this range.
One thing to note, is that all of this assumes management’s projections are accurate. In practice this cannot be done. Historically management of companies in bankruptcy have overpromised. Because of this I would ask certain questions like, how can Chesapeake downsize yet spend a similar or lower percentage of projected revenue on capex? I would also ask about the EBITDA margin. Pre-petition Chesapeake had an EBITDA margin between 15% and 25%, after 2020, however the company projects above a 38% EBITDA margin every year after. More questions I have for the management based on my analysis can be found under the “Management’s Projections” in the methodology section. For the process and rational behind my analyses please see the methodology as well.
Methodology
As explained previously, any findings or claims, I will explain in this section.
Rights offering
As part of their bankruptcy plan Chesapeake will create new common stock. This will be issued in a rights offering. As part of the rights offering, 63.75% of the new stock will go to the term loan holders, 11.25% of the new stock will go to the second lien claims, and 25% will be reserved for backstopping parties (see vocab). All of these parties will be part of the rights offering where the minimum subscription price is $600 million. This is according to management, equity value at a 35% discount to management’s plan of $3.25 billion enterprise value. After the rights offering, Chesapeake will issue three classes of warrants. All the warrants expire after 5 years or due to a liquidation event. Class A warrants give the holders the option to buy 10% of the common stock at an enterprise value of $4 billion. Class B warrants give the holders the option to buy 10% of the common stock at an enterprise value of $4.5 billion. Class C warrants give the holders the option to buy 10% of the common stock at an enterprise value of $5 billion.
Recovery rates
The revolving credit line recovers 88.5%. The lenders of the $1.9 billion revolving credit line are the same lenders that provided the $925 million debtor-in-possession financing or DIP financing. Because DIP financing has super priority, it has a recovery of 100%, however the pre-petition debt was rolled-up into the DIP financing. This means that part of the revolving credit line was converted into DIP financing. This class of creditor is being compensated with a total of $2.5 billion in exit financing, which breaks down into $1.75 billion of revolving credit facilities and a $750 million term loan. This class of creditor loaned the $925 million which has a 100% recovery, but then there is only an 82.9% recovery on $1.9 billion of principal, $1.575 billion (2.5-.950) given for a $1.9 billion principal.
The first lien term loan has a 34.12% recovery. After taking into account where backstopping parties sit in the capital structure, the first lien is entitled to 76% of the $600 million rights offering equity value. Including 77% of the backstopping fee (first lien is backstopping 77% of the 25% of the equity value), the first lien recovers $502 million out of the initial $1.47 billion loan.
The second lien has a 11.17% recovery. After taking into account where backstopping parties sit in the capital structure, the second lien is entitled to 12% of the $600 million rights offering equity value. The second lien is also entitled to 23% of the backstopping free. In addition, the second lien is entitled to Class A Warrants worth $159 million, Class B Warrants worth $88 million, and half of the Class C Warrants which add $24 million in value. In total the second lien recovers $408 million out of its $3.2 billion investment.
Unsecured claims recover 3.19%. The $97 million recovery comes from half of the Class C Warrants worth $24 million and a proportional share of 12% of the $600 million rights offering equity value.
Lastly as mentioned previously, equity does not have any recovery. Management proposed the old shares be canceled.
Valuation of equity warrants
To value the equity warrants, I used the Black-Scholes option pricing model. I of course had to make the assumptions that Black-Scholes requires like that the option is European, that standard deviation represents volatility, ect. A note- I took volatility from 5 years of Chesapeake stock data. I used 810 to be the current equity value, derived from the $3.25 billion enterprise value by subtracting the $2.5 billion in debt as well as $101 million of non-controlling interests and cash. There is a slight discrepancy between the enterprise value I use and the one Chesapeake uses, this is likely due to lack of updated financials as well as differences in valuation of the warrants- Black-Scholes is just an approximation. The equity value strike price I used for Classes A, B, and C respectively are $1.5 billion, $2 billion, 2.5 billion (Equity value here is enterprise value minus $2.6 billion, as shown previously). The value of each class warrants is shown in a table below. The value of each is multiplied by 65% to take into account the dilution of the equity.
Discounted cash flow (DCF)
In this DCF, I used management’s projected unlevered free cash flow for the next five years. This does not mean I will accept management’s projections as fact, I use these figures as a baseline to keep the article shorter, I will discuss the validity of the projections in the last “methodology” section. I discount management’s projected unlevered free cash flow at their pre-petition weighted average cost of capital (wacc). I use the pre-petition capital structure due to the lack of details about the new capital structure like interest rates on post-petition debt. The 8.14% after tax cost of debt was derived from taking the weighted average interest rate Chesapeake paid pre-petition and adjusting for taxes. The 16.12% cost of equity was determined by using the capital asset pricing model, I used the firm’s pre-petition beta of 1.72, and a risk-free rate of 1.5%. Since the capital structure has changed drastically, I used the proposed post-petition capital structure. Thus, the wacc of Chesapeake, I project to be 10.25%. I discounted 5 years of management projected cash flows. I then took the terminal value of the firm by using the average EV/EBITDAX multiple of 4 times across comparable firms. I discounted this terminal value and added the sum of the present value of future cash flows to get an enterprise value of $3.6 billion as well as an equity value of $1.1 billion. Looking at the sensitivity of wacc and EBITDAX exit multiple, at the low end of both the enterprise value would be $2.6 billion, the high end would have an enterprise value of $4.7 billion. Using the perpetuity method Chesapeake had an enterprise value of 3.2 billion and an equity value of $726 million.
Comparable analysis
To maintain simplicity, I left out many traditional oil and gas valuation ratios and instead used: EV/EBITDA, EV/EBITDAX, and EV/Sales. I was also unable to use ratios like price/cashflow per share, EV/debt adjusted cashflow, in addition to others due to the lack of information on post-petition interest rates on debt and on shares outstanding. I looked for companies who had more natural gas revenue than oil, also companies with similar revenue numbers and similar indebtedness. Antero Resources and Range Resources were not included in averages of the first two ratios because their values were negative. The average EV/EBITDA was 5.66, the average EV/EBITDAX was 4.02, and the average EV/Sales was 1.5. In order to develop a valuation range that would be in line with Chesapeake’s competitors, I multiplied management’s projections by the average comparable ratio. For example, I multiplied Chesapeake’s expected EBITDA by the average EV/EBITDA. I also used projections from 2021 to value Chesapeake when the company is earning a more typical amount of revenue. Based on EV/EBITDA, EV/EBITDAX, EV/Sales respectively, Chesapeake should have a valuation of $3.9 billion, $2.95 billion, and $3 billion.
Management’s projections
As mentioned previously, in this analysis I have used management’s projections. There are issues with doing this as often management overpromises in bankruptcies. Without doing a complete NAV analysis it would be difficult to identify what projections are exaggerated for certain, however we can look for these aggressive projections and ask questions. I personally have few. The most obvious area is that Chesapeake’s EBITDA margin between 2017 and 2019 was between 15% and 25%. After 2020, the company projects above a 38% EBITDA margin every year. Without seeing more detail, it is impossible to know if they have a logic plan to achieve this aggressive improvement, but a smart investor would question how. If Chesapeake is in reality less profitable than management expects, the valuation would suffer, and thus the bondholders who received warrants would get less value also. Another area I question is the company’s capex spending. Chesapeake is clearly down-sizing after this bankruptcy, and with that I would expect costs to increase. Chesapeake is spending around their historical average percentage of revenue on capex, I wonder if this is enough as Chesapeake will likely lose some of the effect of economies of scale. In addition, Chesapeake may lose some of its vendor relationships, as it did have a large accounts payable pre-petition, this could increase costs as well. On the flip side, management’s plan of a $3.25 billion enterprise value is lower on a ratio basis than its peers. This could be to ensure a high subscription rate for the rights offering. This lower enterprise value could be that there are a smaller number of buyers in this rights offering than the open market, however without seeing financials in more detail it is difficult to determine exactly. Regardless, undervalued equity value would lead to a higher recovery for bond holders as Chesapeake’s new stock begins trading on the NYSE.
While it would be incredibly interesting to answer these questions and determine their impact on recovery values, it would have made for an even lengthier article. It is still important to understand this bankruptcy, breakdown expected recovery ratings, and use that information to question Chesapeake’s management. Investors do not have all the answers, it’s all about the questions they ask and what they do to answer them. If you have any questions, I can be reached at Roberto@marketspringpad.com. For more analysis follow my page on Invstr, @robbieb.
Vocab:
Pre-petition: Prior to bankruptcy.
Bankruptcy: In this case Chesapeake is going through Chapter 11. Chapter 11 is where a company will exist after the process, and is just reorganizing, typically negotiating with creditors to ease the debt burden.
Liens: Debt that has a lien on an asset means that if the debtor defaults, the creditor has a claim on that collateral asset. Sometimes there are more than one claim on an asset, and example would be a second lien. The first lien is senior to the second lien.
Term loan: Senior bank debt in this case (secured).
Revolving credit facilities: Similar to a company credit card, companies can draw down revolvers as needed.
Secured debt- Debt that is secured with collateral in case of default.
Unsecured debt- Debt that is not secured with collateral.
Enterprise value: Total value of all the claims on the company.
Non-controlling interests: When a company has less than 50% stake in another company.
Creditors- Party that loans money.
Senior creditor- Has the right to be paid before a junior creditor. Is senior in the capital structure.
Junior creditor- Is junior to the senior creditors and has the right to be paid after them.
Capital structure- The way a company finances its assets and thus operations. Combination of types of debt, hybrid securities, and equity.
Impaired creditors- Creditors who do not get paid in full.
Plan of reorganization- For a class to approve the plan, two thirds of the dollar amount of a claim must approve, and one half of the number of claims must approve the plan. For equity holders, just two thirds of the total amount is needed for approval. If a class in unimpaired, they are assumed to have accepted the plan. If a class gets nothing, they are assumed to have rejected the plan.
Rights offering: In this case, giving stock at a certain valuation to creditors, in exchange for canceling debt.
Warrants: Similar to an option, in this case creditors were given the right to own stock at a certain valuation.
Recovery values: Percentage of initial loan that creditors recovery after bankruptcy. Takes into account total value of thing like warrants.
Backstopping: If the rights offering is undersubscribed the backstopping parties will buy the rest of the shares that no one wanted.
DCF: A discounted cash flow is just what it sounds like, discounting, or taking the present value of future cash flows. Adding them up, and taking a terminal value is the approximate value of a company.
Capex: Spending on property, plant, and equipment.
DIP financing: Financing to get a company through bankruptcy.
Unlevered free cash flow: EBITDA-changes in working capital-capex-taxes
EBITDA: Earnings before interest, taxes, depreciation, and amortization
Weighted average cost of capital: Total cost of capital of the firm, weighted by how it gets capital in debt, equity, preferred equity.
EBITDAX: Earnings before interest, taxes, depreciation, amortization, and exploration expense. Used for oil and gas companies for a more apples to apples comparison.
EV ratios: Looks at how much a company is worth relative to earnings for example.
