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Chesapeake (CHK) May Breach Covenants As Liquidity Concerns Swell

 May 15, 2012 05:52 PM

(By Manikandan) Shares of Chesapeake Energy Corp. (NYSE:CHK) fell as much as 6 percent after S&P downgraded its credit rating of the company to "BB-" from "BB," reflecting shortcomings in Chesapeake's corporate governance practices and covenant concerns.

S&P's action comes after Fitch recently cut the company's outlook to "negative" from "stable," implying that there is more than a 50 percent probability Chesapeake's rating will be cut over the next 12 months.

Fitch expects the company to be sharply free cash flow negative over the next three years. S&P also expressed similar concerns stating that the U.S. natural gas producer's liquidity as less than adequate and warned that the company could breach a financial covenant under its $4.0 billion corporate credit facility.

"Chesapeake will face an even wider gap between its operating cash flow and planned capital expenditures than we had previously anticipated," said S&P credit analyst Scott Sprinzen, who expects Chesapeake's negative free cash flow to total over $16 billion during 2012 and 2013.

Meanwhile, Chesapeake has reportedly raised the size of a bridge loan to $4 billion from $3 billion. On May 11, the company said it entered into a 5-year $3 billion unsecured loan from Goldman and Jefferies. The debt costs a minimum of Libor +7 percent (8.5 percent currently) and can be paid back at par if repaid by year-end 2012.

Importantly, the loan does not have the less than 4 times debt/EBITDA maintenance covenant, and will be used to pay down the $2.46 billion outstanding under its $4 billion credit facility.

However, the loan would become costlier next year as the interest rate would increase to 11.5 percent in 2013. Chesapeake would pay interest of $255 million on the new debt, more than thrice the $83 million it has been paying on the revolver debt.

On the positive note, the new loan gives Chesapeake more time and flexibility to execute the remaining $9 billion to $10.5 billion in planned asset sales, which could be used to repay debt. At the end of the first quarter, Chesapeake had about $13.1 billion of long-term debt.

Chesapeake Energy is the second-largest producer of natural gas and owns leading positions in the Barnett, Haynesville, Bossier, Marcellus and Pearsall natural gas shale plays. The company also owns substantial marketing, midstream and oilfield services businesses directly and indirectly through its subsidiaries Chesapeake Energy Marketing, Inc., Chesapeake Midstream Development, L.P. and Chesapeake Oilfield Services, L.L.C. and its affiliate Chesapeake Midstream Partners, L.P. (NYSE:CHKM).

The company's corporate governance practices took a hit after a Reuters report in mid-April said that CEO Aubrey McClendon, who received 2.5 percent stake in the company wells under the Founder Well Participation Program (FWPP), used it to secure a $1.2 billion personal loan. The Securities and Exchange Commission is conducting an inquiry in to the matter.

After heavy investor backlash, the company said it would split the roles of the chairman and CEO and appoint a new independent, non-executive chairman. Current chairman and CEO Aubrey McClendon will resign from chairman position but continue as CEO.

These developments, coupled with depressed natural gas prices, could hurt Chesapeake's ability to meet its huge external funding needs, which is further aggravated by a weak operating cash flow and aggressive, ongoing capital spending. Operating cash flow before changes in working capital was just $910 million as of the first quarter.

"With <$3 bn in operating cash flow, one would assume CHK slashes its $12 billion capex budget to avoid liquidity concerns. But it would be operationally difficult to reduce activity before 4Q and CHK's long list of JVs, preferred stock financing vehicles, and volumetric production payment (VPPs) have it committed to fairly high activity levels," UBS analyst William Featherston wrote in a note to clients.

Thus, the successful execution on its remaining $9 billion to $10.5 billion in divestitures is a prerequisite to improving its liquidity, while the loans from Goldman and Jefferies just buys it more time and flexibility.

Shares of Chesapeake Energy have fallen 19 percent since the April 17th Reuters report. They have lost 48 percent in the last one year and 34 percent year-to-date.


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