Windfall premiums, massive yields — Elliott Gue

By Travis Johnson, Stock Gumshoe, March 11, 2009

“When Wall Street giants took a tumble, some of our picks’ payouts actually jumped 17% on average.

“They’re still standing tall.

“And right now, you can grab these high-yield gems—some with windfall potential—at ridiculously bargain rates.

“If anything’s better than a monster-size yield, it’s a monster-size windfall. And why settle for just one when you can have both?”

That’s how the ad launches for Elliott Gue’s Energy Strategist newsletter — and he’s got some teasers to get our mouths watering, too.

As you might expect, these stocks are all in the energy sector … but unlike some, they’ve all got high dividend yields.

The first one is a convertible preferred stock — Gue tells us that these were mostly held by hedge funds, and that …

“… the retreat of these once-vaulted fund managers leaves the “preferred” gates wide open for the rest of us. And these premium investments are just sitting there ripe for the taking.

“You see, with corporate bonds and preferreds, you get to have your cake and eat it, too.

“Because right away, you get great, steady yields up to 12% and more.

“And, because you’re buying them on the cheap, you also get the great, long-term upside from these choice, growth investments. Talk about playing both sides of the Street.”

Convertible bonds and preferred stock aren’t new to these pages, of course — several high profile “teaser” ad campaigns have pushed them in recent months, and they’ve been all over the financial press, too. Convertibles are widely seen to be a way to dip your toe into the water without buying somewhat riskier common stock, and still get a nice income stream that’s often just slightly lower than similar corporate bonds. If you want to learn more about these, you can check out my earlier articles on them here.

But this isn’t a teaser for a bunch of convertibles, or for a closed-end fund, as those previous ones were … this focuses on just one company’s convertible preferred stock. So what is it?

Clues, please!

“Right now, one of my favorite picks is just such a potential triple play. This company has in abundance what two cash-heavy corporate suitors have in short supply—and are desperate to get.

The company is a US oil & gas producer sitting on tons and tons of prime natural gas reserves. Over 12 TRILLION cubic feet of it. So much, in fact, that at least two of Europe’s oil and gas majors are salivating over the prospect of a takeover bid for this plum.

“The reasons are simple: while the price of natural gas is off the charts in Europe, it’s abundant and dirt cheap here in the US.

“And, European majors have another reason for scrambling after US natural gas—mistrust of Russia. No doubt you’ve heard that Russia yanked Europe’s natural gas supply in the cold dead of winter—yet again.”

There are some more good clues for this one … their credit line doesn’t expire until 2012, and …

“They’ve also built the best oil and gas reserve asset base in America, bar none. They shrewdly snapped up stakes in every prime US oil and gas basin and some really outstanding unconventional plays, as well.

“So, I’m suggesting that my readers scoop up this company’s preferred convertible shares.”

Who are we dealing with here? Well, we throw those details into the Thinkolator — 2012 expiration, big reserves of 12 trillion cubic feet of natural gas, including unconventional plays, and we find that this is almost certainly …

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Chesapeake Energy. Probably the biggest natural gas company in the US, and a huge lightning rod over the last couple years — thanks, in part, to Aubrey McClendon, their high profile CEO who has been collaborating with T. Boone Pickens on his natural gas-focused “Pickens Plan,” and who has been so enthusiastic about his own stock in recent years that he borrowed tons of money to buy shares … and got a massive margin call back in October and had to sell close to 30 million shares. He still owns a little bit, but his holdings as of January are down to about two million shares. Ouch. Tough times when natural gas goes from the teens down to below $4.

But we’re not looking for CHK, the common stock (which has recovered a bit from last fall’s debacle) — remember, we need the preferred shares.

Chesapeake does have a credit facility that ends in 2012, and a debt expiration in 2013, and they just issued new notes that they’re going to use to repay some of their current revolving line of credit (those new notes take them out to 2015, and they’re costing CHK 10% a year).

And yes, they do have preferred shares. There are several different convertible preferreds outstanding for Chesapeake (and other notes, too — you can see them all here if you’re interested). The details of the preferred shares are listed here (PDF file).

This particular preferred must be one of the two that’s relatively easy to trade publicly — and it is almost certainly the largest one, the one that has more than two million shares outstanding and actually trades with a little bit of volume sometimes. That’s the series D preferred, which is usually listed with the ticker CKH-PD or CHK Pr D or CHK-D. The CUSIP number is 165167842, just so there’s no confusion.

This is a convertible preferred share, it started with a $100 face value and a 4.5% annual dividend, and the dividend is still $4.50 so the current yield, at a share price of $55, is about 8%. The conversion rate is 2.264, so you can turn in your preferred shares whenever you like — right now, the preferred would convert to about $34.50 worth of the common stock, so it’s not worth it today, but that conversion possibility is what helps you to share in any substantial advance in the share price.

The dividend is much nicer and more secure than the common stock dividend (CHK yields about 2% right now), and, at least in theory, helps to keep the preferred shares from falling as hard as the common stock can … but this is not quite as secure as a bond coupon, they could potentially have to stop paying the preferred dividend if they are required to by their debt covenants (there’s a technical coverage ratio for EBITDA that they must meet). On the whole, though the dividend payments on the preferred stock are the least of Chesapeake’s worries — this a tiny entry on their earnings statement.

And if you’re looking for a higher yield, that’s possible, too — Chesapeake’s other NYSE-listed preferred shares, the E series (CHK-PE or the other similar permutations) trade for about $130 and yield about 12% right now. Be extremely careful, though — that one trades in much lower volume and has a mandatory conversion in June of this year (and conversion rate is 7.17 shares of common, so you’d be underwater if you converted today by about twenty dollars), so you’d certainly want to review the details before jumping in. I don’t know if there’s a way to get around the mandatory conversion or not, but if not you’d be betting on the common stock price going up in the next few months just to break even.

The bigger issue for any Chesapeake shares, of course, is natural gas pricing. If natural gas prices fall further, as I suppose is always possible (they’ve certainly been much lower in the past), a lot of Chesapeake’s projects probably stop being profitable — they have a lot of fairly technically demanding projects in the various big shale areas, Fayetteville, Barnett, Marcellus, etc., as well as many “conventional” gas projects, and even conventional gas isn’t necessarily cheap to produce everywhere, especially if properties were acquired when gas was priced in the teens. They’ve hedged for lower prices, but I have no idea to what extent, and they recently shut in 7% of their production recently in just one area because of lower gas prices.

Buying the preferred shares of Chesapeake, whether this widely-available publicly listed one or one of the other series, clearly provides a bit of cushion to the travails of the common shares thanks to the higher dividend and the relatively higher position in the capital structure.

But that doesn’t take away the fact that you’re buying shares in a company that’s producing natural gas at a time when gas prices are at very low levels. It might be a great contrarian “buy low” purchase if you believe, as Chesapeake does, that gas prices will firm up in the near future … but if not, of course, you may well be out of luck. And remember that the “cushion” of preferred shares works both ways — if gas prices go back up sharply or the company otherwise shows remarkable performance, the common shares will go up faster and higher than the preferred stock.

And finally, Gue did note that one possible outcome for these guys is a big buyout from one of the european energy companies, partly because of their fear of Russia and the inconstancy of Russia’s gas supplies to Western Europe. Always possible, I suppose, but I wouldn’t price Chesapeake’s reserves based on European gas prices, or on the pricing of Liquefied Natural Gas in general … Chesapeake’s reserves are all in the U.S., and as far as I know the U.S. does not currently allow or have facilities for (with one Alaskan exception) LNG exports. McClendon has tried to rally folks around the LNG export idea before, but also recently noted that it doesn’t look feasible in the near term (quick article on that here). Oh, and as was reported in the FT a few days ago, we’re looking at a glut of LNG on the world markets anyway.

Incidentally, I should note that I did own these very preferred shares a few years ago, when they were much closer to their par price (I think they were in the $90s, if memory serves) and CHK shares were in the high $30s and climbing … I sold them, also years ago, and no longer own these shares or any other investments mentioned above.

I’ve exhausted this one for the day, but there was more from Elliott Gue — a couple interesting-looking energy partnerships — and I’ll try to have a look at those in the next couple days. If you’ve ever subscribed to his Energy Strategist, please click here to let us know what you thought … and if you’ve got any feelings about natural gas, or Chesapeake, or preferred shares, or, well, whatever, just comment below.