Netflix and Tesla: Early Signs of Froth in a Bull Market

It is quite common for a bull market to last far longer than many would have thought, and even more so after the brutal economic downturn we had in 2008-2009. Only just recently did U.S. stocks surpass the previous market top reached in 2007. Although it does not mean that a correction is definitely imminent, the current stock market rally is the longest the U.S. has ever seen without a 5% correction. Ever. Dig deeper and we can begin to see some froth in many high-flying market darlings. Fortunately, we are not anywhere near the bubble conditions of the late 1990's, when companies would see their share prices double within days just by announcing that they were launching an e-commerce web site. However, some of these charts have really taken off in recent weeks and I think it is worth mentioning, as U.S. stocks are getting quite overbought. Here are some examples:

TESLA MOTORS - TSLA - $30 to $90 in 4 months:

NETFLIX - NFLX - $50 to $250 in 8 months:

GOOGLE - GOOG - $550 to $920 in 10 months: 

You can even find some overly bullish trading activity in slow-growing, boring companies that do not have "new economy" secular trends at their backs, or those that were left for dead not too long ago:

BEST BUY - BBY - $12 to $27 in 4 months:

CLOROX - CLX - $67 to $90 in 1 year:

WALGREEN - WAG - $32 to $50 in 6 months: 

Ladies and gentlemen, we have bull market lift-off. My advice would be to pay extra-close attention to valuation in stocks you are buying and/or holding at this point in the cycle. While the P/E ratio for the broad market (16x) is not excessive (it peaked at 18x at the top of the housing/credit bubble in 2007), we are only 15-20% away from those kinds of levels. Food for thought. I remain unalarmed, but definitely cautious to some degree nonetheless, and a few more months of continued market action like this may change my mind.

Full Disclosure: No positions in any of the stocks shown in the charts above, but positions may change at any time

First Carl Icahn, Now Former Warren Buffett Co-Manager Lou Simpson Invests in Chesapeake Energy

Corporate activist investor Carl Icahn timed his 6% investment in natural gas driller Chesapeake Energy (CHK) almost perfectly earlier in 2011, buying in the low 20's and selling in the mid 30's a few months later after extracting a publicly announced debt reduction plan out of management. Now, with the stock back down to prices even lower than where Icahn originally bought, Lou Simpson (former GEICO executive and Warren Buffett number two investment manager at Berkshire Hathaway (BRK)) has bought 200,000 shares in the energy producer.

Simpson, long considered to be a possible Buffett successor despite only a small age difference, retired from Berkshire in 2010 but remains active as a director on three public company boards of directors. Chesapeake is one of the three and the latest. Interestingly, in recent months Simpson has sunk more than $5 million of his own money into Chesapeake stock, at prices in the high 20's. This is a rare move for Simpson, who typically does not make moves in the public eye like this. As a director though, he must update his holdings in Chesapeake whenever changes are made. I find this move especially telling because in the case of the other two public companies he is involved with, he has largely been given stock options in return for his service, whereas direct open market purchases are rare for him. Often times new directors make small investments (say, a few thousand shares) to show public support, but Simpson has made two separate purchases of 100,000 shares each, for more than $5 million in total.

Now, some may point out that Simpson is worth a heck of a lot of money, so $5 million to him may be peanuts relatively speaking. And I can't argue that point, but given Simpson's investment savvy, coupled with the fact that he has not done this with the other companies he serves, I think it is worth noting and is likely due to his belief that the stock is actually quite attractive.

CHK shares, as mentioned previously, are down a lot in recent weeks, as natural gas prices have sunk to $3 and the company continues to spend more on exploration and production than it brings in (to the detriment of equity holders), but it is now even cheaper than it has been previously. And given that Icahn was very successful with his first investment in CHK, I would not be surprised if he got back in, now that the stock price has given back all of the gains he booked, and more. Chesapeake investors, myself included, have been frustrated a lot in recent years, but these recent buys by Lou Simpson strengthen the case that giving up now might be a mistake.

Full Disclosure: Long shares of CHK at the time of writing, but positions may change at any time

Did David Sokol Lie About His Lubrizol Trades on CNBC?

It appears David Sokol picked a bad time to resign from Berkshire Hathaway (BRKA) to start his own "mini Berkshire" investment firm. After appearing on CNBC this morning to try and get out in front of the media blitz regarding his trading in Lubrizol (LZ), Sokol didn't do himself any favors on national television. Oddly, perhaps the most least talked about detail in press reports today was the explanation Sokol gave on CNBC when he was asked why he bought 2,300 shares of Lubrizol on December 14th, sold them a week later, and then bought them again two weeks after that (in early January). On the air Sokol claimed the sale was for "tax planning purposes" and nobody seemed to question that.

Of course, the problem with that explanation is that when you sell a stock at a loss and want to use that loss to cancel out other gains for the year (which is what Sokol was referring to when he said "tax planning"), you must wait 30 days before buying the stock back again. This is a very well known law called the "wash sale rule" and there is no way Sokol (or his tax advisor if he uses one) is unfamiliar with it. It appears that Sokol may been hiding the truth when he used the "tax planning purposes" defense. Either he is lying about his reasons for selling the stock, or he is unaware of the tax rules and routinely deducts losses even when he violates the wash sale rule.

And to think Sokol was considered a leading candidate to take Warren Buffett's place. Berkshire Hathaway shareholders really caught a break there...

Update (6:30pm)

The first commenter below has pointed out that Sokol appears to have earned a profit of about $5 per share from his initial LZ sale. In such a case, wash sale rules would not have applied. It is a shame that Sokol did not provide a crystal clear and more detailed explanation for his actions, as opposed to having others speculate. But in terms of this particular speculation on my part, it does appear that Sokol sold the 2,300 share lot of LZ in order to avoid paying taxes on the gain, as opposed to offsetting gains elsewhere with a loss on the LZ position. Thanks to Michael Kelly for the insight. -CB

Sokol's Lubrizol Trades Sure Look Illegal, And Buffett Needs To Change Berkshire Hathaway's Internal Trading Policies Immediately

I would not go as far as some people have and suggest that Warren Buffett's Berkshire Hathaway has lost its way, but there have certainly been some developments in recent months that should give people pause. First, a young, unknown investor is named as one of Buffett's likely successors, and now we learn that one of the firm's most highly regarded internal candidates has resigned from the company over what appears to possibly be insider trading accusations.

After looking at the timeline of events surrounding Berkshire's discussion to acquire Lubrizol (announced March 14th) and Sokol's trading in the stock while he was serving as the point person for those talks, it is hard to argue that Sokol's trades are not illegal. Not only that, it appears that Berkshire Hathaway has no internal controls regarding how managers trade stocks they may have inside information about, which is also troubling. Although it is reasonable to assume that high level people at the company should know what would fall under insider trading and what would not, given the fact that Berkshire's main source of growth is through acquisitions, the firm should have a specific personal trading policy in place for all of its employees. If anything, to avoid situations like this, where it appears that Sokol made a big mistake and Buffett is pretty much defending him by saying he didn't see anything wrong with the trades.

So why is it most likely insider trading? According to a timeline of the Lubrizol deal compiled by the Wall Street Journal, Sokol met on behalf of Berkshire Hathaway, with their investment bankers (Citigroup), on December 13th. At this meeting the two parties discussed a list of 18 companies that the bankers had put together as a possible deal targets for Berkshire and Sokol told Citigroup that Lubrizol was the only company on the list that he found interesting.  Sokol also told them to contact Lubrizol's management to inform them of Berkshire's interest in exploring a possible deal.

At that point it should be obvious to anyone, including Sokol, that he and the bankers are in possession of material, non-public information. Sokol has decided that Berkshire Hathaway would like to explore the possibility of buying Lubrizol and he has instructed his bankers to inform Lubrizol of their interest. It is painfully clear that a deal could result from these discussions, and only a few people are aware of these private plans. Now remember, this meeting occurred on December 13th.

So when did Sokol first buy Lubrizol stock for his personal account? On December 14th. Seriously? Seriously. Sokol bought 2,300 shares of the stock the day after telling Citigroup to call them and express interest in a deal. Interestingly, Sokol sold those shares on December 21st. He didn't wait very long to buy them back though. During the first week of January Sokol bought 96,060 shares of Lubrizol. Lubrizol's board met to discuss the interest from Berkshire Hathaway on January 6th and Sokol met with Lubrizol's CEO face-to-face on January 25. The deal was approved on March 13th and announced March 14th. The purchase price was 30% above where Sokol bought the stock for his own account.

Not only is Sokol going to have trouble on his hands here, but Buffett's reputation is also on the line. Even though Warren didn't know about these trades as they were happening, the very fact that Sokol is allowed to trade in the same companies that he is looking at as possible acquisition targets for Berkshire Hathaway (and at the same time!) screams of lax oversight.

GM Buys Subprime Lender for $3.5B (Some Companies Just Never Learn)

Just when I thought General Motors was on solid footing and heading in the right direction after shedding a large portion of its liabilities in bankruptcy, they seem to have forgotten what has happened over the last several years in the world of credit. One of the big reasons GM's losses were compounded during the recession was because they funded a lot of subprime loans for their vehicles through GMAC. When those loans went sour, the losses not only negated the razor thin margins they had on the vehicle sales themselves, but resulted in a company that lost money on most of their cars. Hence, SUVs (with their fat profit margins) became a focus for the company, even in the face of rising gas prices, which aided their competitors in stealing market share.

Since GM has exited bankruptcy and the economy has stabilized management has stated publicly a desire to once again expand into the subprime auto finance market, but this time GMAC was hesitant (and understandably so). Undoubtedly, the result has been that GM could be selling more vehicles if they were willing to finance customers with bad credit who could not get loans elsewhere. This morning we learn that for $3.5 billion in cash GM is buying AmeriCredit (ACF), one of the larger subprime lenders in the country. They will use this new financing arm to get more cars into the hands of more people, many of whom could not get loans from third party lenders due to bad credit, no job, etc.

While I am sure those in the industry will praise this deal as a way for GM to maximize unit sales, we need not completely forget how cyclical economies work. Subprime lending pays off when the economy is improving but when the business cycle inevitably turns (as every economy does), the loans turn sour, the losses are crushing, and the cycle starts all over again. To me this highlights one of the core problems our domestic economy has developed over the last 10 or 20 years. We continue to follow the path of loose credit when things are going great and at the first sign of a downturn, credit standards increase dramatically. Once things stabilize, we hear that banks are slowly reducing their standards and loan volumes increase again.

For the life of me I cannot figure out why banks and specialty lenders refuse to maintain the same lending standards throughout the entire business cycle. The idea that lending money to people who are likely to default is good business sometimes and bad business other times baffles me. Sure, the few banks that always make smart loans, despite the economic backdrop, make a little less profit during boom times, but they also weather the recessions quite well in return for such prudence.

This kind of cyclical lending activity from the likes of GM (and most others) only contributes to the boom and bust economy the United States has seen become even more pronounced over the last decade. Fortunately, GM is set to go public via an IPO sometime in the next 12 months, at which time the U.S. taxpayer can shed its majority ownership in GM and therefore no longer be in the subprime lending business.

Update (9:15am)

Here is a 15-year chart of AmeriCredit's stock price which puts into graphical form the cyclicality I mentioned above.

Full Disclosure: No position in AmeriCredit at the time of writing, but positions may change at any time.

BP, Goldman Sachs, Google, and FinReg... What a Day!

Today is the kind of day that investment managers such as myself love; lots of resolutions on multiple issues that have been holding back certain companies, stocks, and industries. Let me tackle each one briefly.

BP: While it is nice to see the ruptured well capped without any oil spewing out, we have to keep things in perspective. This is a test, this is only a test. The well has been capped for only a couple of hours and leaks could still surface, not to mention the fact that the pressure could further damage the well. Hopefully the relief wells can be paired with this latest cap to finally put a stop to the oil leak, but it is too early to say and the rally in BP shares today (up 3 points) will easily vanish if any issues arise.

Goldman Sachs: News of a $550 million settlement with the SEC is great news for investors. Most were assuming a $1 billion fine to ensure they avoided a fraud charge but it came in at half that amount. Goldman reports earnings Tuesday and the numbers have been ratcheted down a lot due to a weak trading environment early in the second quarter. With the bar set so low, they could surprise on the upside, but the stock is getting a nice bump from the SEC deal, so any further move higher may take some time to develop. I still see GS as the premier firm in the space and earnings should climb back later in the year, which is why I will still be holding the stock for clients.

Google: The stock is down after revenue for the second quarter came in a bit higher than estimates but profits fell short on higher expenses. The company is back in acquisitive mode so free cash flow is on the decline. Without a new, clear growth engine (I am not convinced yet that Android app sales will fit the bill, but they are promising) I would not be willing to pay a premium for the stock. With 2011 earnings estimates around $31-$32, putting a 15 P/E on that gets you to $475 per share, right where the stock is trading after-hours. Color me neutral at these levels.

FinReg: Now that this bill has passed the Senate, we can finally stop hearing about it so much. The banks will see their margins on certain financial products squeezed temporarily (overdraft protection, for instance, is now opt-in, not automatic), but banks will always find ways to recoup the lost income in other ways (free checking accounts, for instance, may become less common in the future). The negative talk today was that the banks and investors are worried because the bill gives regulators a lot of power in forming new rules and this adds to uncertainty. This argument baffles me. Regulators already have the power to make new rules to deal with issues they discover in the marketplace. The bill gives regulators oversight over a few more areas of the financial services industry, but the idea that giving them the power to make rules is a new and overly aggressive idea is simply wrong. That has always been the role of regulators! Now we just need them to do their job, and frankly, that is the part that always seems to let the American people down. I have no reason to think anything will be different this time around.

Full Disclosure: Long shares of BP and GS at the time of writing, but positions may change at any time.

BP Stock Reacts Well as the Obama Administration Helps Craft Framework for Spill Cost Outlays

Once the decline in BP plc (BP) stock reached 20% after the Gulf spill I was in the camp that felt that BP's stock price drop was overdone given the oil giant's financial strength. However, as the oil has continued to gush despite repeated efforts to stem the flow, BP shares have continued to fall, which at its worst levels amounted to a market value loss of 50% or $95 billion. While my initial nibbling in the stock was premature (I, like many people, figured BP would have better success containing the well after 2 months of trying), I still believe the stock market reaction has been excessive.

Thus far on this blog I have resisted providing specific financial projections to back up such an assertion, due mostly to the fact that the oil continues to pour out of the ruptured well, making the potential liability unlimited and unknowable. That said, Wednesday's meeting between the Obama Administration and BP executives was helpful for value investors looking at BP. During the meeting they were able to agree on a timetable for cash outlays to cover the spill's economic damages, which gives us a lot more clarity as to the financial impact on BP in the coming months and years.

As a result, I will run through some of these numbers and show why I still believe that BP can survive this spill somewhat easily, simply due to the size and financial strength of the entire company. We must remember that BP is one of the world's largest and most profitable companies (we are not dealing with accounting games at Enron or 30x leverage at Lehman Brothers).

Let's start with the costs of the containment efforts and the clean-up of the oil. So far BP has spent $1.75 billion in the two months since the Deepwater Horizon rig exploded. Industry experts expect this run-rate of expenses (about $1 billion per month) to drop once the well has been capped (evidently undersea robots drilling with diamond studded saws are pretty costly), but to be extremely conservative I have been assuming that the containment/clean-up costs continue at $1 billion per month through 2011 before the drop. This equates to $12 billion per year in containment and cleanup costs as a conservative estimate.

The White House and BP agreed Wednesday to a $20 billion escrow account to be used for economic claims from businesses. BP has announced it will pay $5 billion into the fund this year and an additional $1.25 billion each quarter beginning in 2011, until the $20 billion has been fully funded. This comes to $5 billion per year for 2010 through 2013.

It is also important to understand that BP will be subject to additional fines and penalties under the U.S. Clean Water Act, based on how much oil ultimately is determined to have been spilled into the ocean. Because the oil continues to flow from the broken well, this aspect of the cost equation is still unknown, as is the exact daily flow rate. Current estimates are 35,000-60,000 barrels per day. If we assume the oil flow is completely stopped by September 30th (the current expectation is sometime in August) and a penalty of $4,300 per barrel is assessed, these fines could amount to about $30 billion. However, those fines and penalties will likely be fought over in court and therefore the amount will be unclear for a while. Still, because of this unknown liability, I likely will not be buying more BP stock until the well has been capped completely.

The question for investors, obviously, is whether or not BP can afford these projected costs. We are talking about $17 billion per year in containment, clean-up, and damages, plus fines. Let's look at some of their first quarter 2010 financial metrics to get an idea of their financial capacity:

Operating Cash Flow: $7.7B

Capital Expenditures: $4.3B

Free Cash Flow:  $3.4B

Dividends Paid: $2.6B

The dividend has been scrapped for now, so we can expect that BP's ongoing operations will generate about $14 billion per year in free cash flow. However, we must keep in mind that these costs are pre-tax figures. BP paid about $8 billion of income taxes in 2009 and all spill costs will be able to be used to offset operating profits and therefore save the company billions in taxes. On an after-tax basis, $17 billion in annual spill costs comes out to an adjusted figure of about $12 billion of cash outlay. As you can see, BP should be able to handle these clean-up costs without dramatic capital expenditure reductions (they have announced a 10%/$2 billion annual reduction in capex).

Additionally, BP has said they have about $10 billion in available credit facilities and also expect to divest $10 billion of assets over the next 12 months. Undoubtedly that money will be used to help pay the penalties and fines that it will ultimately be forced to pay, as well as serve as a cushion if claims come in higher than $20 billion or the well gets worse rather than better. Unlike some energy firms, BP has a very strong balance sheet, with $8 billion of cash and a debt-to-capital ratio of 20%, at the low end of their 20-30% target range. As a result, the company could take on up to $17 billion in new debt and still be within that range.

Finally, we cannot forget that BP only owns 65% of the ruptured well. They will almost certainly ask Anadarko (APC) and their other partners to foot their portion of the bill, although we can expect the court system to play a major role in that process.

All in all, the financial strength and size of BP makes it possible for the company to use normal business activities and a bit of financial management to pay for the spill. Even using an aggressive estimate $50 billion in total spill-related costs over the next few years should not force BP into dire financial straits. Not only that, but the last Exxon Valdez spill claims were settled quite recently, about 20 years after the accident occurred. Even if costs are higher than current estimates and take longer to resolve, BP should be okay given that the company brings in about $30 billion per year in operating cash flow.

I figured it would be helpful to go through these figures because some people on Wall Street have been talking about BP being forced into bankruptcy due to the Deepwater Horizon disaster. Barring some unforeseen, unexpected, or simply unheard-of developments, it certainly seems that BP's reputation will be hurt far more from this spill than their finances will be. Obviously things can change, but these are the kinds of numbers I have been looking at in recent weeks and I think they are very interesting, even if one has no interest in bottom-fishing in BP stock. Less aggressive investors might want to look at BP bonds, which recently yielded between 8 and 10 percent in the 1 to 5 year maturity range.

Full Disclosure: Peridot Capital had a small long position in BP stock at the time of writing, but positions may change at any time

BP Stock Drop Hits 50%, Market Value Loss Reaches $94B as Panic Ensues

Shares of BP are getting clobbered again today, down to about $30 per share, or 50% since the rig explosion in late April. Today's worries are being attributed to two stories. First, talk of a dividend suspension is not exactly new and even if the company did suspend dividends, or as I have suggested, paid out a BP stock dividend rather than cash it should not have any impact on the stock price (shares are not valued off of dividend yields, only cash flows). Also today the New York Times wrote about a possible pre-packaged bankruptcy for BP:

"But all those numbers don’t account for the greatest possible threat: a jury verdict against BP. Such a verdict might push the cost of the spill into the hundreds of billions. If that happened, even BP might buckle.

This outcome might seem far-fetched right now. But on Wall Street bankers have already coined a term for it: the Texaco scenario. In 1987, Texaco was forced to file for Chapter 11 because it could not afford to pay a jury award worth $1 billion to Pennzoil. That award had been knocked down by a judge from a whopping $10.53 billion."

Talk about instilling fear into the market. The New York Times forgot to mention that shareholders did not get wiped out in the Texaco bankruptcy, as they normally do in Chapter 11 proceedings. It simply was a restructuring move. BP has now lost half its value, a stunning $94 billion, since the oil rig they were leasing exploded on April 20th. The dividend yield now sits at 11%, even though it seems unlikely BP will ignore political pressures and actually continue to pay out cash to shareholders while oil is still flowing into the Gulf.

As is often the case, the stock market has now entered full blown panic mode with BP stock. It is pretty crazy to watch all of this play out. I can understand if people don't want to touch BP stock with a ten foot pole, but I am sitting tight on a small long position in client accounts, as I don't really see how one can argue a $94 billion market value loss is warranted here.

Full Disclosure: Peridot Capital was long BP in select client accounts at the time of writing, but positions may change at any time

Given Its Financial Strength, BP Should Pay Its Dividend in Stock Rather Than Cut It

The main reason value investors may be willing to take a stab at BP plc (BP) stock after a nearly 40% drop since the rig explosion is their financial strength. BP earns about $20 billion per year and has a net debt to capital ratio of less than 20%. Combine very profitable operations and a strong balance sheet with plenty of borrowing capacity and you can see why even an ultimate liability of $15-$25 billion over the next several years could be absorbed by the company.

Given that these situations usually turn out to be buying opportunities, I have begun to accumulate small positions in the stock for some of my clients, even though I admit the ultimate financial impact is unknowable at this point. The company's financial strength coupled with the $70 billion market value loss so far give me enough of a cushion to take a position so long as it is part of an otherwise diversified portfolio.

With the failure of the "top kill" procedure and news that relief wells likely will not be completed until August, there are renewed worries about the sustainability of BP's dividend, which at $3.38 per share ($10.6 billion) annually stands at about 9.25% right now. Given that BP's operations are still throwing off tons of cash and the company has only spent about $1 billion in the first five weeks of this disaster, cutting the dividend does not seem like a necessary step to take from the cash preservation perspective. Still ,with political pressures mounting, BP may not want to pay out billions of cash to shareholders until this spill is under control.

I think that makes sense from a PR perspective but BP should really consider paying out their dividend in stock rather than choosing to cut it for PR purposes. Such a move would succeed in padding the company's cash hoard (which stood at $8 billion as of March 31st) and silence any critics who would be angered if the company paid out cash to shareholders before fixing the hole and paying for the cleanup. After this spill is contained, BP's underlying profitability will be unchanged and any dividend cut would be reversed anyway. Some banks shifted to stock dividends in late 2008 and early 2009 and it worked very well. Such a move would both silence the critics and preserve precious cash, but the shareholders would not be completely left out in the cold. It simply makes more sense to do that rather than take on more debt and pay interest on the additional borrowings or sell certain assets that are the key to BP's future success.

Full Disclosure: Peridot Capital was long BP at the time of writing, but positions may change at any time.

Chesapeake Energy Swaps One Type of Capital for Another, Creating Little Shareholder Value

Last week Chesapeake Energy (CHK) announced a plan to increase shareholder value over the next 24 months by reducing the company's net debt by $3.5 billion over that time. By doing so, the company hopes to attain an investment grade credit rating, something that has been out of the firm's reach as it has accumulated a sizable debt load as a result of growing the company into one of the largest natural gas exploration and production companies in the United States. The plan is being sold to investors as a way to increase CHK's stock price but it appears to me that they are simply issuing one form of capital to repay another.

Chesapeake's plan has two prongs, so to speak. First, the company expects to raise $5 billion from a combination of asset sales and preferred stock issuances in order to repay $3.5 billion of senior debt. This would reduce the company's net debt position from just under $12 billion to about $8.5 billion. The remaining $1.5 billion in funds will be used to expand the company's oil exploration activities, as crude oil prices have rebounded far more quickly than natural gas prices in recent quarters (CHK currently has about 90% of its reserves in natural gas).

On the face of it, this plan does look promising for shareholders. Reducing net debt will boost equity value in the absence of any dilution from the capital raises. Unfortunately, on Tuesday afternoon Chesapeake announced that it has raised a total of $1.7 billion from the sale of new 5.75% convertible preferred shares. Typically convertible preferred is attractive from a corporate standpoint because it tends to carry very low interest rates (in exchange for having equity-like upside from the option to convert into common stock). However, since this new preferred stock is costing CHK 5.75% per year in interest, it hardly looks like a way to boost shareholder value.

In fact, Chesapeake has also announced that it is using most of the proceeds from the new preferreds to redeem $1.334 billion of senior debt. This debt carries interest rates of between 6.875% and 7.5% with maturity dates ranging from 2013 to 2016. As a result, CHK is replacing $1.3 billion of senior debt (average interest rate: 7.2%) with $1.7 billion of convertible preferred stock (interest rate: 5.75%). How is this helping shareholders? The interest on the new preferred will actually cost CHK $98 million per year, more than the annual interest payments ($96 million) paid out on the senior debt they are retiring! Not surprisingly, Wall Street has yet to cheer these announcements with a higher stock price.

Now to be fair, there are some marginal benefits associated with this capital swap, which I am sure the company would point out if asked. First, if Chesapeake does get a credit rating upgrade over the next two years as a result of this plan, it could possibly see a small decrease in the interest rates it needs to pay on future borrowings. Second, CHK is extending the average maturity schedule of its debt by replacing senior notes due to mature over the next six years with convertible preferred shares that come with no maturity date.

These small benefits aside, this type of capital exchange is not likely to help equity holders. Few people are going to be overly impressed by debt reductions accomplished by issuing other forms of capital to replace them (and in this case, raising more new capital than the amount of the senior debt repayments). If Chesapeake really is serious about increasing shareholder value, they are going to have to use free cash flow from operations to reduce their debt load.

A big reason the stock price has lagged, aside from the fact that natural gas prices are in the tank right now, is because the company insists on using all of its profits (and more oftentimes) to continue to grow the company. As borrowings have grown, even increases in production and operating cash flow have not been enough to increase shareholder value. In fact, consider the data below, which I compiled from CHK's 2009 annual report.

Although the company has grown its oil and gas production and operating cash flow, it has taken a lot of new debt and common equity raising to accomplish these growth objectives. Not surprisingly, equity holders have reaped a negative benefit despite CHK being a much larger company today than at the end of 2005. This latest plan to increase shareholder value seems to me to just be more of the same. The company likes to say it is trying to increase shareholder value, but does not go anywhere far enough to actually make it happen.

Full Disclosure: Peridot Capital was frustratingly long shares of CHK at the time of writing, but positions may change at any time