Carl Icahn and The Chesapeake Conundrum

Those not living in a cave by now know that legendary corporate raider Carl Icahn has shelled out about $785 million to buy 50.1 million shares, or 7.6% of downtrodden Chesapeake Energy CHK, the second-largest U.S. natural gas producer. This is Icahn's second tryst with Chesapeake. The first one was quite profitable. Taking a stake of almost 6% in December 2010 when the stock was in low to mid-$20s, Icahn was out by February after the stock peaked at over $35. Back then, Icahn was looking to force now embattled Chesapeake CEO Aubrey McClendon to sell assets to reduce the company's debt load. McClendon obliged, selling $4.75 billion in Fayetteville Shale assets to BHP Billiton BHP, the world's largest mining company as one example. In other words, Icahn did he what does best and that is take an activist approach, forcing management to acquiesce to his demands. The sequel to the Icahn/Chesapeake dalliance could be different. Arguably, it has to be. Even though it really wasn't that long ago the Icahn was last involved with the Oklahoma-based energy company, things have changed and changed for the worse since Icahn last took this car for a spin. Ensconced in controversy following the revelation that McClendon borrowed as much as $1.1 billion over the last three years against his holdings in thousands of Chesapeake wells and didn't tell analysts and investors about it, Chesapeake desperately needs change. As we previously noted, it would appear the loans are legal, but the ethics of a company executive borrowing funds to take stakes in company projects and then use the stakes as collateral walks a fine line of what shareholders would be willing to tolerate. And Chesapeake investors have had to tolerate a lot with McClendon, namely epic destruction of shareholder value. This was a $70 stock before the commodities bubble burst in 2008. It closed at $16.44 Wednesday, but hey, Icahn's probably already in the green. Needing More Beleaguered Chesapeake shareholders need more than near-term pops on the back of noteworthy investors taking stakes. Icahn's latest stake makes him Chesapeake's second-largest shareholder and while there is certainly room for him to acquire more shares, there's no guarantee he will. For all anyone knows, this could be another hookup of less than 90 days, not a marriage, between Icahn and Chesapeake. If his profit resembles anything close to what it did the last time he was involved with the stock, why would Icahn hang around for more than 60, 70 or 80 days? This time around, Icahn doesn't need to excoriate McClendon into selling assets. The asset sales are already underway because Chesapeake has no choice but to sell, sell, sell to keep itself afloat. Earlier this year, the company also sold its Appalachia Midstream Services LLC division to its MLP unit, Chesapeake Midstream Partners CHKM. France's Total TOT also agreed to pay $2.32 billion for access to Chesapeake's 619,000 acres in the oil-rich Utica Shale formation in Ohio. On Wednesday, Chesapeake said it's selling 57,000 net acres of leaseholds and producing wells in the Woodbine Sand play in East Texas. The company called those assets "non-essential." The point is Chesapeake is looking to slash its debt load by $9.5 billion this year, so asset sales are going to be part of the game. Icahn doesn't need to tell McClendon that, but maybe the financier can get Chesapeake to cut its meager dividend and pull its name off the arena where the Oklahoma City Thunder play. It may sound trite, but this company needs to save money. Period. A Good Record, But No One Is Perfect Of course, Icahn's involvement gets investors salivating over the prospects of a proxy fight. Such a scenario with Chesapeake would be far from Icahn's first rodeo of this nature. Proxy fights are where his legend was made and he's not only prolific at proxy battles, but proficient at them as well. And proxy fights get shareholders thinking a takeover might be around the corner, but at this juncture, it's not even clear that Icahn wants a prolonged proxy tussle at Chesapeake. Not to mention the fact he has been known to take stakes in companies with the hopes of forcing them to sell and fails. Amylin Pharmaceuticals AMLN and Clorox CLX being two examples. The "x factor" with forcing McClendon to sell Chesapeake is that he founded the company and has molded it in his maverick image for more than two decades. In other words, McClendon may not be amenable to a sale, no matter who's doing the cajoling. The other issue to consider is a sale of Chesapeake doesn't benefit McClendon as much as it does Icahn and other investors with substantial stakes in the company because following those now infamous margin calls, McClendon's stake in his own company is relatively small. Icahn's current Chesapeake stake is believed to be 10 times as large as McClendon's. The bottom line is proxy fights are sexy for a minute, but tedious the longer they drag on and there are no guarantees Icahn even wants to wait around long enough to wage and win a proxy battle with McClendon and then try to sell a company with over $13 billion in debt and a financing shortfall of up to $10 billion. The Allure Earlier this year, it was reported that plunging natural gas prices could make Chesapeake takeover bait. Now with natural gas prices perking up a bit, and Chesapeake's share price depressed, the prospects of a takeover have become more intriguing. Well, what's really intriguing is the Utica Shale, which is believed to hold 5.5 billion barrels of crude and almost 16 trillion cubic feet of gas. Chesapeake's equity and net debt was valued yesterday at $9.19 for each barrel of oil equivalent, the lowest among U.S. oil and gas explorers with market capitalizations greater than $5 billion, according to Bloomberg data. So Chesapeake has the benefit of compelling assets and a compelling valuation, but what companies really might make an offer to McClendon? The consensus among many analysts seems to be Chevron CVX, the second-largest U.S. oil company. The Bloomberg story mentions Exxon Mobil XOM, Chevron and Royal Dutch Shell RDS, the largest European oil company. One, two, three strikes you're out. Those companies can afford to buy Chesapeake and even absorb its putrid balance sheet, but they won't. Over the past five years, shares of Exxon have lost 4.2% while Chevron is up more than 20%. The primary reason for that performance gap is Exxon's gas exposure. It's already the largest U.S. natural gas producer. Investors and Wall Street will not condone Exxon acquiring more gas assets. Chevron is the oilier company, but it has plenty of natural gas exposure as well. The company is the primary operator of the $45 billion Gorgon field project in Australia. Shell also has a stake in Gorgon and said that plans to spend $50 billion over the next decade developing assets in Australia, many of which will be gassy in nature. Like almost every other major integrated oil company, Chevron and Shell do not need more gas assets. Even if they wanted them, it's not likely either company would be willing to pay lofty premium for Chesapeake. The list of companies that can afford Chesapeake is fairly long, but the list of legitimate acquirers is short. Acknowledging that it would be tough to rule Total out of the equation, we reiterate the view that BHP Billiton BHP is the best bet to make a move on Chesapeake. The mining giant is also the world's seventh-largest independent energy producer, has shown a desire for and willingness to acquire shale assets and has the balance sheet to get a big deal done. Plus, CEO Marius Kloppers, several times bitten but never shy, still may want to do a mega deal to cement his legacy. Carl, meet Marius. And for the sake of Chesapeake shareholders, convince Marius this company is a steal at $21-$24 a share.