Update May 2nd, 2012 at 2:53pm: Please see an update below for those who are long and a bit spooked by the chain of events, but would like to keep some long exposure in the name in case there is a quick move higher like we saw yesterday.
Original Post May 2, 2012 at 2.27pm: Chesapeake (CHK): A Trader’s Dream, An Investor’s Nightmare
The story of Chesapeake and its founder, CEO, and Chairman, ceases to amaze even the most hardened market watchers. Here’s a story of a plush billionaire running a public company worth tens of billions of dollars, and he still couldn’t seem to focus on his main task of running one of the largest natural gas companies in the world. As far as dramatic character stories go, it doesn’t get much more interesting than this one.
To summarize, Reuters reported 2 weeks ago that McClendon had taken $1.1 billion in personal loans against his stakes in Chesapeake oil and gas wells. That first barrage of news occurred after the stock had already gradually declined from $25 to near $20, likely on general business fears given the continued weakness in natural gas prices, and caused a break down to $17.5 on big volume. The stock seemed to base around that level for a week, and news that McClendon was stripped of his Chairman title seemed to signal that the Board of Directors and management was prepared to clean up the mess and move on.
After yesterday’s close, just when it finally seemed like the buyers had regained control, pushing the stock briefly above $20, and the news flow had turned incrementally positive, Chesapeake not only reported a big miss on earnings but more importantly, Reuters reported this morning that McClendon had been running a personal hedge fund of $200 million on the side, trading commodities similar to what Chesapeake does as a business. It’s one thing to take out a loan against your personal assets, as suspicious as that may be, but to compete in the same market as your company, on a personal basis?!? Our mental alert level just went from cautious to extreme danger.
In this environment of uncertainty, even with the stock at $17, implying a forward P/E of around 8 if the stock can meet next year’s consensus estimates, a naked long stock position seems too risky. Mr. McClendon is not a run-of-the-mill CEO, but rather the founder who infused his freewheeling style into the culture of the company. Whatever your long term view of the stock, the leadership saga is likely to continue until McClendon is eventually forced to leave.
Fortunately, options are surprisingly cheap given the recent headlines and volatility in the name. Our first instinct was to look for a cheap way to play a bounce in the name, but today’s headlines about the personal hedge fund caused us to re-assess that view. Another serious worry came from the commentary from Chesapeake on the conference call today, as Mr. McClendon seems to digging in for a fight with the media, not willingly stepping down. Moreover, weak gas prices does create a funding problem, highlighted here by the FT. Finally, Southeastern, the largest shareholder just came out and indicated its desire to seek talks with Chesapeake management, and the stocks quick 5% pop and then selloff indicates more selling ahead for the next week in CHK. So here’s our short-term play on this headline-heavy story:
TRADE: CHK ($17.25) Bought the May 16 Puts for .48
-Break-even on downside is 15.52, lose up to .48 btwn 15.52 and 16 and max loss of .48 above 16 on May 19th expiration.
I WILL LOOK TO TURN INTO A PUT SPREAD ON ANY SEVERE WEAKNESS AND LOCK IN GAINS.
RATIONALE: Generally we don’t like pressing shorts like this, but this could be the gift that keeps on giving. I wouldn’t short the stock outright, but to risk 2.5% of the underlying that we get another eye opening revelation before May expiration is a bet I am excited to make.
ALTERNATIVELY if you are long and not sure what to do, but you think there is a decent likelihood that the stock makes back some recent losses, but the worry of further declines outweighs the potential positives, you could consider stock replacement.
LONGS could consider selling their stock and buying the May19th 18 calls for .55 (stock ref 17.06), this will give you reltively cheap upside exposure with defined risk.