Alternative Ways to Invest in Chesapeake Energy

Chesapeake Energy Corporation (CHK), the embattled U.S. oil and natural gas producer, has had a tough year. It has lost more than 30% of its market value due to historic low natural gas prices and Aubrey McClendon’s potential conflict of interest between his role as CEO/Chairman, and his personal stake in some of its assets. Although, McClendon’s conflicts have been cleared up, the low natural gas prices have caused a cash crunch.   

However, in every crisis, there is some opportunity. Carl Icahn, the legendary investor, has amassed a stake of over 50 million shares (over 7% of outstanding shares). He believes the assets of the company are worth far more than what the stock price belies. He is betting that cutting expenses, liquidating assets, and rising natural gas prices will lift the company.

At HypeZero, it is hard for us to follow Icahn’s lead and make a heavy bet on Chesapeake shares. We cannot be sure that natural gas prices will rise or that the assets of the company are as valuable as Icahn believes them to be. However, Chesapeake does offer some interesting alternatives to the common stock that allows investors to make money without as much risk. Let’s take a look.

Senior Notes

Coupon

CUSIP

Maturity

Callable

Current Price

7.625%

165167BY2

7/15/2013

Yes

$104

9.50%

165167CD7

2/15/2015

Yes

$113

6.25%

027393390

1/15/2017

Yes

6.50%

165167BS5

8/15/2017

Yes

$107

6.875%

165167CE5

8/15/2018

Yes

$106.5

7.25%

165167CC9

12/15/2018

Yes

$109

6.775%

165167CH8

3/15/2019

Yes

$101.375

6.625%

165167CF2

8/15/2020

Yes

$106.125

6.875%

165167BU0

11/15/2020

Yes

$107

6.125%

165167CG0

2/15/2021

Yes

$103

During the pinnacle of the crisis, there was money to be made on these bonds. However, Chesapeake has stabilized and the bond prices reflect that. As you can see, all of them trading above the par value and none of them are offering a yield to maturity above 6%. Right now, none of them are suitable investments.

Senior Contingent Convertible Notes 

Coupon

CUSIP

Maturity

Callable

Conversion

Current Price

2.75%

165167CG0

11/15/2035

Yes

$38.8108

$103

2.50%

165167BZ9

5/15/2037

Yes

$51.1429

$92

2.25%

165167CB1

12/15/2038

Yes

$85.8142

$83

The convertible notes rank equally with the senior notes. Investors looking for safety with some upside might want to examine these securities. Out of the three, only 2.75% note has a realistic conversion price. But, at the current price of $103 and the stock being almost 50% below the conversion price, even this is not worth investing in.

Cumulative Convertible Preferred (CHK-PD) 

Coupon

Symbol

Maturity

Conversion

Current Price

4.5%

CHK-PD

N/A

$43.9142

$82.00 

Out of the all the alternatives, the cumulative convertible preferred is the most attractive.

  • At the current price, it offers a 5.5% yield. This yield is taxed at the 15% rate and it is cumulative. So if they ever miss a payment, they have to make it up in the future.
  • At the current price, the conversion price really becomes around $36/share instead of $43.9142.
  • It is junior to the senior notes, but still senior to the common stock.
  • As long as Chesapeake is not in any serious trouble, the coupon should provide a floor to the price. For example, a price drop from $82 to $60 would make the yield a very attractive at 7.5%.

If investors are very confident that natural prices are going to rise and Chesapeake is going to turn it around, then the common shares are the way to go. However, for investors that want the upside of the shares, but still want current income and more safety, the preferred is the way to go.

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Disclosure: I do not own shares of CHK or CHK-PD and I do not plan to initiate a position within the next week.

Avoid Sears Spinoff

Sears Holdings Corporation (SHLD), a HypeZero recommendation, in order to raise capital and focus on its main business is spinning of yet an another business, Sears Hometown and Outlet (SHOS). (Read our article on its last spinoff, Orchard Supply Hardware (OSH)).

Business

Sears Hometown and Outlet operates two segments: Sears Hometown and Hardware and Sears Outlet. Sears Hometown and Hardware, the larger of the two with 1,105 stores, sells “national brands of home appliances, tools, lawn and garden equipment, sporting goods, consumer electronics and household goods, depending on the particular store.” The Outlet segment with 123 stores sells “new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked and scratched and dented products, including home appliances, lawn and garden equipment, apparel, mattresses, televisions, sporting goods and tools at prices that are significantly lower than manufacturers’ suggested retail prices.”

Spinoff

For each Sears share held, investors received a subscription right (SHOSR) that would allow them to purchase 0.218091 of a share of SHOS common stock at $15/share. So you would need ~4.59 (1/.218091) subscription rights and $15 to purchase 1 share of SHOS. Currently, SHOSR is trading at $2.33. So, you would expect SHOS to start trading at 4.59*$2.33 + $15 = $25.7/share.

Holders of SHOSR have until October 8 to exercise the subscription right. If the offering is fully subscribed, Sears expects to raise $446.5 million (23.1 million shares*$15/share + $100 million SHOS will pay to Sears).

Valuation

Sears provided the latest quarterly report for SHOS. A cursory read of the report point to a great deal for investors:

  • For the 26 weeks ended July 28, 2012, revenues are up over 4% and net income is up over 100% to $41.66 million or $1.80/share. If SHOS earns $3.60 for this fiscal year, it would trade a P/E of a little over 7 at the current subscription rights price.
  • Other valuations measures such as sales per share ($100+/share) seems to indicate that SHOS is cheap compared to its peers. 
  • ESL Investments (Eddie Lampert), Sears biggest shareholder, has said that it fully intends to exercise its subscription rights. “In addition, ESL has indicated to Sears Holdings that it intends to exercise its over-subscription privilege in full, such that it will purchase the maximum number of shares allocated to it under the oversubscription privilege.”
Lipstick On A Pig
 
However, a closer look reveals that:
 
  • From 2007 to 2011, comparable store sales have been down every year.
  • From 2007 to 2011, total store sales have been flat to slightly up due to an increasing store count.
  • From 2009 to 2011, the gross profit margin rate and net income have been down every year.   

So, what happened in the first 2 quarters of 2012? Why the triple digit increase in net income?  The simple answer is that the increase in net income came from substantial improvements in the gross profit margin rate. The margin rate increased in 2012 to 25.2% from 21.6%. 

Sears explains the dramatic margin improvements: “The 360 basis point increase in gross margin rate was primarily driven by lower occupancy expenses from the conversion of company-operated stores to franchisee-operated stores, initial franchise fees, lower free-delivery promotional expense, better inventory management, and a higher balance of sales in higher margin categories”. 

It is interesting that the first few reasons for the significant margin improvements are from converting company-operated stores to franchisee-operated stores. It is not a coincidence that they waited until they were spinning off the company to do this conversion and thus, improve profitability. 

Another reason that profitability improved is the $15 million charge it took in 2011 to close 84 under performing stores. This has two effects:

  • The net income in 2011 is lower. Thus, the 2012 net income will look better.
  • As it closed underperforming stores, the profit margin rates, and comparable store sales improved in 2012.  

It seems Sears is trying to fool investors into thinking the underlying fundamentals of the company are improving when they clearly are not. In addition, the following costs have not been taken into account in the income statement:

  • There will be an “additional annual operating charges are estimated to be approximately $8.0 million to $9.0 million” from being a public company.
  • “One-time information technology costs related to the separation to be approximately $6.0 million to $7.0 million.”
  • Interest expense from the $100 million borrowed from the Senior ABL Facility in order to pay Sears.
If you add to the fact that $167 million of SHOS’s equity is not tangible, it operates in one of most competitive industries, and it is heavily dependant on Sears, you have a multitude of reasons to avoid the spinoff of Sears Hometown and Outlet.

Disclosure: I do not own shares of SHLD or SHOSR and I do not plan to initiate a position within the next week. 

Troubling Times at Orchard Supply Hardware

As Sears Holding (SHLD), a HypeZero recommendation, spins off Sears Hometown and Outlet Stores, let’s look at the state of the company that it spun off less than a year ago, Orchard Supply Hardware Stores Corporation (OSH).

Background

Orchard owns and operates 88 home improvement stores in California. The company was spun off Sears on December 30, 2011. For every 22.141777 shares of Sears Holdings, investors received one share of the Class A Common Stock and Preferred Stock. The Class A Common Stock trades under the symbol OSH on NASDAQ. The Preferred Stock trades under the symbol OSHSP on OTCQB.

Competition

Orchard is a small fish in an ocean full of sharks. Its main competitors are Home Depot, Lowe’s, Ace Hardware and True Value. It also competes with discount retailers such as WalMart, Target and Costco in some of their product lines. To get an idea of its size, Orchard’s fiscal 2011 revenue was $660 million and Home Depot’s fiscal 2012 revenue was over $70 billion. Home Depot’s stores are more than twice the size of Orchard’s stores and produce almost four times the revenue. The larger competitor stores give their consumers more variety and better pricing.

Performance

While Home Depot’s revenue, profits and comparable store sales have been increasing since 2009, Orchard’s have been going down year after year. In the first two quarter of this year, all three went down again, and the company is no longer profitable. As a result, there has been liquidity concerns. The company is running low on cash and is struggling to maintain compliance with certain covenants that would allow it to borrow money. Non-compliance could mean that certain debt that is maturing in the future would be due now. And a default in one agreement could mean a default in other agreements.

Because of the deteriorating results, the company would not have been in compliance with the leverage ratio covenant on July 28, 2012 had they not completed a six-store sale and leaseback transaction. The company is pursuing all measures to alleviate the liquidity problems. The next measurement date to see if it meets all its covenants is October 27, 2012. It is a bit of a coincidence that investors have to exercise the subscription rights on Sears Hometown and Outlet Stores offering before October 8, 2012 (right before the measurement date).

It only gets tougher for Orchard from here. The first two quarters are seasonally the best for business.

Insiders

The biggest holder of Orchard, ESL Investments (Eddie Lampert), has been selling its stake in OSH. ESL Investments decreased their holdings by almost 23% in their latest quarterly filing at the end of June. Fairholme Capital Management has also decreased its stake.

One thing to note is that Lampert has been buying up the Preferred Stock at around $1.60/share. The Preferred Stock has no voting power, no conversion rights, and no dividend. However, it has to be redeemed for $4.16 in case of 3 events: before a dividend on the common shares (not going to happen), before any repurchases of the common shares (not going to happen), or in the event of a company liquidation (maybe this will happen). Nobody is sure of Lampert’s motives because in the event of a liquidation, there might not be anything left for the Preferred Stock holders after the debtors take their cut.

Whatever the reason is, the future does not look bright for Orchard. With their poor performance, liquidation problems and their business in a highly competitive industry, it is hard for us to see Orchard turning itself around.

Disclosure: I am short OSH.

Better way to invest in Prospect Capital

In our last article, we mentioned the risks involved in investing in Prospect Capital (PSEC). We also shared that the return over the last 8 years for Prospect has been 39%. However, some investors (especially the ones that have made a good return over the last year) did not agree with our risk assessment and still believed that Prospect was a good investment. If investors still want to invest in Prospect, I suggest they look at Prospect’s bonds.

Prospect has issued many different types of bonds. Some of the bonds are convertible. Convertible bonds pay a fixed interest, but can be converted into shares of Prospect at a certain price. This allows investors to participate in the stock appreciation. Most of, if not all, of the bonds issued are callable by Prospect. This means that Prospect can call the bonds after a certain date before they actually mature.

We are going to focus on one bond issue from Prospect. The main reason is that most individual investors are not familiar investing in bonds. The second reason is that a lot of the issues from Prospect are illiquid.

The issue that we are going to focus on is the 6.95% Senior Notes due 11/15/2022. The neat thing about these bonds is that they trade like a stock on the NYSE. The principal on the bond is $25 and it pays a quarterly coupon ($.434375). They are callable in 5/15/2015 at $25 by Prospect. Currently, they trade around $25 under the symbol PRYIt is worth a look for investors that want to participate in the strong yield offered by Prospect, but want to take more of the risk out of the investment.

Please note that this issue is getting riskier because prospect is loading up on debt to fund their growth. We personally do not recommend any security offered by Prospect.

Read the prospectus here.

Disclosure: I do not own shares of PRY and do not plan to initiate a position within the next week.

Fooling Some of the People All of the Time

A great book on some of the risks of investing in BDCs is Fooling Some of the People All of the Time, A Long Short by David Einhorn of Greenlight Capital. It details his struggle to out the fraud that was taking place at BDC, Allied Capital.

By no means am I saying there is any fraud taking place at Prospect Capital or any other BDC, but it gives investors insight into the possible risks associated with them.

Be Wary Of Prospect Capital

With interest rates being next to nothing at banks, investors are hurting to find safe places where they could park their cash, and still earn decent interest. One company that has attracted a lot of interest due its 10.50% dividend yield is Prospect Capital (PSEC).

Company Background

Prospect Capital is a business development company that “primarily lends to and invests in middle market privately-held companies”. They “invest primarily in senior and subordinated debt and equity of companies in need of capital for acquisitions, divestitures, growth, development and recapitalization”. As a Registered Investment Company (“RIC”), it has to distribute 90% of their taxable income to their stock holders. It currently distributes this as a monthly dividend. Since their IPO in July 2004 at $15/share, it has paid out over $10 in dividends. So what’s not to like?

Management Incentive

Prospect is managed by Prospect Capital Management. They earn 2% of gross assets and an incentive fee based on the performance of the investment portfolio. Gross assets means their total assets. It is different from net assets which subtracts the liabilities. This incentivizes the management to:

  • Increase total assets regardless of whether it is in the best interest of the share holders in order to get a higher base management fee. Assets have grown every year since inception, and so has the management fee from $1.8 million in 2005 to more  than $46 million in fiscal year 2012.
  • Make speculative investments in order to earn a higher incentive fee.
Leverage

One way to grow the total assets and earn a higher fee is to use leverage. Prospect has been raising more and more capital by selling debt. Their debt/equity ratio has increased from 21.2% in 2008 to around 43.9%. This increases the total assets, and puts more money in management’s pocket. It also creates a better return for share holders when things are going well. However, when they are not, the losses are magnified. It is the same as an individual investors buying a stock on margin. It’s great when the stock goes up, but disastrous when it goes down. Prospect indicated that they will continue to increase their leverage. “We are targeting continued growth in NII per share as we utilize prudent leverage to finance our growth through new originations, given our debt to equity ratio stood at less than 44% (and less than 36% after subtraction of cash and equivalents) as of June 30, 2012”.

Illiquid portfolio

Since Prospect invests in middle market private companies, there is no market to sell their investments. This creates multiple problems:

  • There is no way to value impairments to the portfolio and fair value is determined by the “good faith” of the board of the directors. This is a huge conflict of interest!
  • If a disastrous financial event occurs, then they will not be able to sell their investments at a fair price due to their illiquidity. This disastrous event is more probable due to the fact they are levering up the company. For example, when their debt is expiring, and the company is not doing well, they will have to either sell shares or raise debt at a discount rate.
Prospect’s Performance

All the aforementioned risks are all good points, but the company has returned $10 in dividends since inception on an initial $15 investment. However, at the end of June 2012, the net asset value of the company stood at $10.83. So, an investor’s $15 initial investment is worth $20.83 ($10 in dividend + $10.83 in n.a.v). That is an anemic return of almost 39% over 8 years. That return is definitely not worth the risk!

If investors are still not convinced and wants to invest in Prospect Capital, wait for our next article.

Read Prospect’s latest 10-K.

Disclosure: I do not own shares of PSEC and do not plan to initiate a position within the next week.

 

Safe 7.7% Yield From AIG

In our last article, we wrote about how AIG shares are significantly undervalued, and the company has shored up its balance sheet by getting rid of risky assets in its portfolio. Buying shares is one way to way to play this lack of love AIG has been feeling from the street. Another way to play it is buying the $25 denominated 7.70% Series A-5 Junior Subordinated Debentures, AVF.

AIG $25 denominated 7.70% Junior Debentures (AVF: NYSE) ($25.77, September 11, 2012)

Basics

  • Symbol: AVF
  • Principal Amount: $25
  • Coupon Rate: 7.7% or $1.925 before December 18, 2047. Three-month LIBOR plus 3.616% thereafter.
  • Call Date: December 18, 2012. AIG can redeem all ($1 billion), but not in part  before if a “tax event” happens or a “rating agency event” occurs anytime before December.
  • Mature Date: December 18, 2062, which can be extended to December 18, 2077
  • Distribution Dates: 3/18, 6/18, 9/18 & 12/18
Risks

  • Company: As mentioned in our last article, AIG is in great shape as they have gotten rid of the risky assets that plagued them during the financial crisis. Even during the financial crisis, this security continued paying a dividend. The company is still critical to the U.S. financial system.
  • Rank: This security is junior to all AIG senior debt. However, this should not be a problem as the company is in great financial shape.
  • Deferral of Interest: The company can defer interest payments up to 40 quarterly payments without giving rise to event of default. The deferred interest does accrue. They have and will probably never defer interest payments.
  • Call Date: The security can be called partially or fully after December 12, 2012. Currently, AIG is spending a lot of money buying its shares back, but if interest rates continue to decline, then it is possible they will at least partially call the security. Thus, it is important to buy it around the the principal amount.
Before September 13, 2012 (ex-dividend date), I would buy AVF at any price under $25.70. After the dividend, I would buy AVF at any price under $25.20 because the $.48 dividend in December is pretty much guaranteed.

Read the full prospectus here.

Disclosure: I do not own shares of AVF, but I may initiate a position within the next week. I am long AIG.

 

Bruce Berkowitz’s Big Bet On AIG

This is part 2 of HypeZero’s 10 best investment ideas from the best hedge fund managers. These 10 ideas are generated by the HypeZero proprietary algorithm. The algorithm has been back tested since 2004 and has returned over 170% cumulatively. Here is the third investment idea:

American International Group, Inc. (AIG: Nasdaq) ($33.30, September 10, 2012)

After what happened to the AIG during the financial crisis, a lot of investors are afraid to touch AIG. However, that can’t be said for Bruce Berkowitz of Fairholme Capital Management. Over 40% of Fairholme’s portfolio consists of AIG and AIG warrants.

Bruce Berkowitz and Whitney Tilson (T2 Partners) believe that AIG trades at a significant discount to its intrinsic value. They believe that investors are undervaluing the fact that:

  • Its main core insurance businesses (Chartis and SunAmerica) are global, well managed leaders.
  • Their balance sheet is no longer risky like in the past.
  • Its stock is trading at almost half its tangible book value. Both believe that it should be worth at least 1x the book value.
  • As the government exits out of its ownership of AIG and as AIG sells its non core assets and buys back shares, the true value will shine through.
Looking into the details, AIG has sold off a lot of their non core assets recently and bought back shares with the proceeds. As of today, AIG has to following non core assets that it would like to get rid of:

  • Holds over a $5 billion stake in AIA Group. It has sold over $8 billion worth of AIA shares already this year.
  • International Lease Finance Corporation (ILFC), which it was trying to IPO for $6 to $8 billion.
  • United Guaranty Corporation (UGC), a mortgage guaranty business, which is valued around $1 to $2 billion.
AIG has bought back $8 billion worth of shares using proceeds from the sale of its non core assets. And in September, they just committed another $5 billion to purchase shares from the government as they are reducing their stake in AIG from 53% to just 20%. It will not be a surprise if, by the end of the year, they spend close to $20 billion in share purchases. This will not only increase earnings per share, but also increase book value per share. In addition to these non core assets, AIG has over $16 billion in deferred tax assets, which means they will not pay taxes for many years to come.

After all the non core assets are sold, AIG will be left with their main core insurance business selling for less than half book value. Once this happens and the government sells its partial stake, Berkowitz and Tilon believe that investors will truly understand the true value of AIG.

Disclosure: I do not own shares of AIG, but I may initiate a position within the next week.

Best Hedge Fund Investment Ideas (Part 1 of 5)

Every quarter, HypeZero offers 10 of the best investment ideas from the best hedge fund managers. These 10 ideas are generated by the HypeZero proprietary algorithm. The algorithm has been back tested since 2004 and has returned over 170% cumulatively. For the third quarter (August 15th to November 15th), Here are the 10 investments:

Apple Inc (AAPL: Nasdaq) ($631.69, August 14, 2012)

It’s no surprise that Apple tops the list of best investments. It is held by many of the best hedge fund managers including David Einhorn (Greenlight Capital), David Tepper (Appaloosa Management) and Julian Robertson (Tiger Management). In fact, over 13% of David Einhorn’s long portfolio is comprised of just Apple shares. Einhorn believes Apple is a business that offers a recurring revenue stream with a huge moat around its business.

“Despite its size, AAPL remains one of the most misunderstood stocks in the market. AAPL is a software company. The value comes from iOS, the App store, iTunes and iCloud. A Motorola RAZR phone was a one-time winner because when someone else made a phone that was just a little better, RAZR sales stopped. In contrast, a consumer with one AAPL product tends to want more AAPL products. Once the user has a second device, AAPL has captured the customer. At that point, a future competitor has to make a product that isn’t just a little better, but a lot better to get people to switch. The high switching cost makes AAPL’s business much more defensible than that of its predecessors.”

“Further, AAPL’s ability to consistently offer innovative features (as opposed to marginal improvements on the current features) encourages users to upgrade every couple of years. This provides a recurring revenue stream. And because AAPL embeds its software into its hardware, it doesn’t face Microsoft’s piracy problem. If the Chinese want AAPL, they have to buy AAPL. Rather than view AAPL as a hardware company, we see it as a software company that monetizes its value through the repeated sales of high margin hardware.”

If you back out the $120 cash and long term investments, even at today’s price $680, the company trades at around 13 times this years earnings estimate of $44/share. So, it is by no means overvalued. A lot of investors are frightened by the high stock price and the large market cap, but Apple is a great business at a fair price.

See below for full comments by David Einhorn in his 2nd Quarter letter to shareholders:

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Sears Holdings (SHLD: Nasdaq) ($55.17, August 14, 2012)

Sears makes it on the list thanks to Eddie Lampert (ESL Investments), who owns over 60% and Bruce Berkowitz (Fairholme Capital Management) who owns over 15% of its outstanding shares. In fact, Lampert just increased his stake by over 100 million on September 4th. The value case for sears has been nicely laid out by Fairholme.

Fairholme argues that if you sum up the different parts of Sears, they far exceed the market capitalization of the company. The major pieces are:

  • Real Estate: Sears holds prime mall based and other freestanding locations across the United States. These properties are either owned or leased long term for below market prices. Of course, the balance sheet does not accurately reflect the value of these assets.
  • Top Brands: Sears holds some of the top brands including: Kenmore, Craftsman, and DieHard. These brands were valued at $5.6 billion in early 2005.
  • Liquidity: Earlier in the year, there was some liquidity fears which made the stock crash to around $30. However, according the Fairholme the company had over $8.7 billion worth of liquid resources including $5.5 billion worth of net inventory.

With a market cap of just $6 billion, it is not hard to see why Lampert and Berkowitz love Sears and why the company has been buying over $1.5 billion worth of its shares over the last couple of years.

See below for Fairholme’s full case on Sears:

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This is part 1 of a part 5 series, please check back for part 2 later this week.

Disclosure: I do not own shares of AAPL or SHLD and do not plan to initiate a position within the next week.