1 - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NO. 1-13726 CHESAPEAKE ENERGY CORPORATION (Exact name of registrant as specified in its charter) OKLAHOMA 73-1395733 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6100 NORTH WESTERN AVENUE OKLAHOMA CITY, OKLAHOMA 73118 (Address of principal executive offices) (Zip Code) (405) 848-8000 (Registrant's telephone number, including area code) --------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] At April 30, 1998, there were 105,105,580 shares of the registrant's $.01 par value Common Stock outstanding. - --------------------------------------------------------------------------------
2 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES INDEX TO FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 1998 PART I. FINANCIAL INFORMATION <TABLE> <CAPTION> PAGE ---- <S> <C> <C> Item 1. Consolidated Financial Statements (Unaudited): Consolidated Balance Sheets at March 31, 1998 and December 31, 1997 3 Consolidated Statements of Operations for the Three Months Ended March 31, 1998 and 1997 4 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 1998 and 1997 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 PART II. OTHER INFORMATION Item 1. Legal Proceedings 21 Item 2. Changes in Securities 21 Item 3. Defaults Upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 22 Item 5. Other Information 22 Item 6. Exhibits and Reports on Form 8-K 23 </TABLE> 2
3 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED) <TABLE> <CAPTION> ASSETS MARCH 31, DECEMBER 31, 1998 1997 ----------- ------------ ($ IN THOUSANDS) <S> <C> <C> CURRENT ASSETS: Cash and cash equivalents ............................ $ 31,945 $ 123,860 Restricted cash ...................................... 2,001 -- Short-term investments ............................... 5,876 12,570 Accounts receivable: Oil and gas sales ................................... 11,553 10,654 Oil and gas marketing sales ......................... 16,592 20,493 Joint interest and other, net of allowance for doubtful accounts of $961,000 and $691,000 .... 26,773 38,781 Related parties ..................................... 5,502 4,246 Inventory ............................................ 5,217 5,493 Other ................................................ 5,053 1,624 ----------- ----------- Total Current Assets .............................. 110,512 217,721 ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties, at cost based on full cost accounting: Evaluated oil and gas properties .................... 1,564,941 1,095,363 Unevaluated properties .............................. 144,403 125,155 Less: accumulated depreciation, depletion and amortization ...................................... (883,734) (602,391) ----------- ----------- 825,610 618,127 Other property and equipment ......................... 78,068 67,633 Less: accumulated depreciation and amortization ...... (7,528) (6,573) ----------- ----------- Total Property and Equipment ...................... 896,150 679,187 ----------- ----------- OTHER ASSETS ........................................... 58,673 55,876 ----------- ----------- TOTAL ASSETS ...................................... $ 1,065,335 $ 952,784 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable ..................................... $ 100,135 $ 81,775 Accrued liabilities and other ........................ 53,519 42,733 Revenues and royalties due others .................... 26,020 28,972 ----------- ----------- Total Current Liabilities ......................... 179,674 153,480 ----------- ----------- LONG-TERM DEBT, NET .................................... 654,013 508,992 ----------- ----------- REVENUES AND ROYALTIES DUE OTHERS ...................... 10,551 10,106 ----------- ----------- DEFERRED INCOME TAXES .................................. -- -- ----------- ----------- STOCKHOLDERS' EQUITY: Preferred Stock, $.01 par value, 10,000,000 shares authorized; none issued ............................ -- -- Common Stock, 250,000,000 shares authorized; $.01 par value; 100,102,270 and 74,298,061 shares issued and outstanding at March 31, 1998, and December 31, 1997, respectively .......... 1,001 743 Paid-in capital ...................................... 659,868 460,733 Accumulated deficit .................................. (439,772) (181,270) ----------- ----------- Total Stockholders' Equity ........................ 221,097 280,206 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ............. $ 1,065,335 $ 952,784 =========== =========== </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 3
4 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA) <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, ----------------------- 1998 1997 --------- -------- REVENUES: <S> <C> <C> Oil and gas sales ........................................ $ 50,241 $ 57,399 Oil and gas marketing sales .............................. 26,524 22,410 Interest and other ....................................... 224 3,277 --------- -------- Total revenues ....................................... 76,989 83,086 --------- -------- COSTS AND EXPENSES: Production expenses ...................................... 7,894 3,158 Production taxes ......................................... 1,544 1,150 Oil and gas marketing expenses ........................... 26,261 21,747 Impairment of oil and gas properties ..................... 250,000 -- Oil and gas depreciation, depletion and amortization ..... 31,342 24,663 Depreciation and amortization of other assets ............ 1,380 873 General and administrative ............................... 4,380 2,481 Interest ................................................. 10,688 3,654 --------- -------- Total costs and expenses ............................. 333,489 57,726 --------- -------- INCOME (LOSS) BEFORE INCOME TAX AND EXTRAORDINARY ITEM .... (256,500) 25,360 --------- -------- INCOME TAX EXPENSE: Current .................................................. -- -- Deferred ................................................. -- 9,255 --------- -------- Total income tax expense ............................. -- 9,255 --------- -------- INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ................... (256,500) 16,105 EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax of $101 ................................... -- (177) --------- -------- NET INCOME (LOSS) .................................... $(256,500) $ 15,928 ========= ======== EARNINGS PER COMMON SHARE (BASIC) Income (loss) before extraordinary item .................. $ (3.19) $ .23 Extraordinary item ....................................... -- -- --------- -------- Net income (loss) ........................................ $ (3.19) $ .23 ========= ======== EARNINGS PER COMMON SHARE (ASSUMING DILUTION) Income (loss) before extraordinary item .................. $ (3.19) $ .22 Extraordinary item ....................................... -- -- --------- -------- Net income (loss) ........................................ $ (3.19) $ .22 ========= ======== WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING Basic .................................................... 80,330 69,534 ========= ======== Assuming dilution ........................................ 80,330 73,493 ========= ======== </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 4
5 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, ------------------------ 1998 1997 --------- --------- ($ IN THOUSANDS) <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) ...................................... $(256,500) $ 15,928 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation, depletion and amortization .............. 32,326 25,236 Impairment of oil and gas assets ...................... 250,000 -- Deferred taxes ........................................ -- 9,154 Investments in securities, net ........................ -- 34,777 Amortization of loan costs ............................ 396 300 Amortization of bond discount ......................... 21 5 Loss on sale of fixed assets and other ................ 368 18 Extraordinary loss before income tax benefit .......... -- 278 Equity in (earnings) losses of equity investees ....... 22 (91) Bad debt expense ...................................... 604 88 Changes in current assets and liabilities ............. 21,948 (46,007) --------- --------- Cash provided by operating activities ............... 49,185 39,686 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Exploration, development and acquisition of oil and gas properties .................................. (149,002) (158,245) Proceeds from sale of assets ........................... 220 2,850 Repayment of long-term loan ............................ 2,000 -- Additions to other property and equipment .............. (19,684) (4,712) --------- --------- Cash used in investing activities ................... (166,466) (160,107) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings ..................... 145,000 292,626 Payments on long-term borrowings ....................... (120,000) (12,664) Cash received from exercise of stock options ........... 61 625 Other financing ........................................ 305 (95) --------- --------- Cash provided by financing activities ............... 25,366 280,492 --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ..... (91,915) 160,071 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ........... 123,860 140,739 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD ................. $ 31,945 $ 300,810 ========= ========= </TABLE> <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, --------------------- 1998 1997 --------- ------ ($ IN THOUSANDS) <S> <C> <C> DETAILS OF ACQUISITION OF HUGOTON ENERGY CORPORATION: Fair value of assets acquired .......................... $ 336,517 $ -- Liabilities acquired ................................... $(128,146) $ -- Stock issued ........................................... $(206,321) $ -- Fair value of Hugoton stock options converted into Chesapeake stock options ........................ $ (2,050) $ -- </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 5
6 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 (UNAUDITED) 1. ACCOUNTING PRINCIPLES The accompanying unaudited consolidated financial statements of Chesapeake Energy Corporation and Subsidiaries (the "Company") have been prepared in accordance with the instructions to Form 10-Q as prescribed by the Securities and Exchange Commission. All material adjustments (consisting solely of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods have been reflected. The results for the three months ended March 31, 1998 are not necessarily indicative of the results to be expected for the full fiscal year. The Company has changed its fiscal year end from June 30 to December 31. This Form 10-Q relates to the three months ended March 31, 1998 (the "Current Quarter") and March 31, 1997 (the "Prior Quarter"). 2. RECENT ACQUISITIONS On December 16, 1997, the Company acquired AnSon Production Corporation ("AnSon"), a privately owned oil and gas producer based in Oklahoma City. Consideration for the acquisition was approximately $43 million, which included the issuance of 3,792,724 shares of Chesapeake's common stock and the payment of $24.8 million on May 7, 1998, pursuant to a make-whole provision. On January 30, 1998, the Company entered into a 40/60 alliance with Ranger Oil Limited to jointly develop a 3.2 million acre area of mutual interest in the Helmet area of northeastern British Columbia. As part of the transaction, the Company paid approximately $48 million for proved oil and gas reserves, undeveloped leasehold and a 40% interest in Ranger's infrastructure in the area. On February 6, 1998, the Company purchased the Mid-Continent properties of EnerVest Management Company, L.L.C. for $38 million. On March 10, 1998, the Company acquired Hugoton Energy Corporation ("Hugoton") pursuant to a merger by issuing approximately 25.8 million shares of the Company's common stock in exchange for 100% of Hugoton's common stock. See Consolidated Statements of Cash Flows. On April 22, 1998, the Company issued $230 million (4.6 million shares) of its 7% Cumulative Convertible Preferred Stock, $50 per share liquidation preference, and $500 million of its 9.625% Series A Senior Notes due 2005. Net proceeds from these offerings were approximately $712 million. On April 27, 1998, the Company acquired from Gothic Energy Corporation certain proved oil and gas reserves for $20 million, purchased $50 million of Gothic 12% preferred stock, acquired ten-year warrants to purchase 15% of Gothic's currently outstanding common stock for $0.01 per share, acquired a 50% interest in Gothic's undeveloped leasehold acreage and entered into a five-year drilling and acquisitions participation agreement. On April 27, 1998, Chesapeake acquired the British Columbia properties of Sunoma Energy Corporation for $33 million. On April 28, 1998 the Company acquired by merger the Mid-Continent operations of DLB Oil & Gas, Inc. for $17.5 million in cash, 5,000,000 shares of the Company's common stock, and the assumption of $90 million in outstanding debt and working capital obligations. On April 30, 1998, the Company acquired 100% of the stock of MC Panhandle Corp., a wholly-owned subsidiary of Occidental Petroleum Corporation, by paying approximately $95 million, net of working capital adjustments. Effective April 30, 1998, the Company purchased all of its outstanding 10.5% Senior Notes due 2002. Of the $90,000,000 aggregate principal amount, $89,830,000 was acquired pursuant to the Company's offer to purchase, which commenced April 1, 1998, and the remaining $170,000 was acquired on the same terms after the tender period. The cost to acquire the 10.5% Senior Notes was approximately $99,000,000. The early retirement of these notes will result in an extraordinary charge of approximately $12 million during the quarter ended June 30, 1998. 6
7 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 (UNAUDITED) 3. LEGAL PROCEEDINGS The Company and certain of its officers and directors are defendants in a consolidated class action suit alleging violations of the Securities Exchange Act of 1934. The plaintiffs assert that the defendants made material misrepresentations and failed to disclose material facts about the success of the Company's exploration efforts in the Louisiana Trend. As a result, the complaint alleges the price of the Company's common stock was artificially inflated from January 25, 1996 until June 27, 1997, when the Company issued a press release announcing disappointing drilling results in the Louisiana Trend and a full-cost ceiling writedown to be reflected in its June 30, 1997 financial statements. The plaintiffs further allege that certain of the named individual defendants sold common stock during the class period when they knew or should have known adverse nonpublic information. The plaintiffs seek a determination that the suit is a proper class action and damages in an unspecified amount, together with interest and costs of litigation, including attorneys' fees. The Company and the individual defendants believe that these claims are without merit, and intend to defend against them vigorously. No estimate of loss or range of estimate of loss, if any, can be made at this time. Various purported class actions alleging violations of the Securities Act of 1933 and the Oklahoma Securities Act have been filed against the Company and others on behalf of investors who purchased common stock of Bayard Drilling Technologies, Inc. ("Bayard") in its initial public offering in November 1997. In May 1998, the plaintiffs in the two cases pursuing state claims dismissed their state court suits and became co-lead plaintiffs in the remaining federal case. Total proceeds of the offering were $254 million, of which the Company received net proceeds of $90.2 million. Plaintiffs allege that the Company, a major customer of Bayard's drilling services and the owner of 30.1% of Bayard's common stock outstanding prior to the offering, was a controlling person of Bayard. Plaintiffs assert that the Bayard prospectus contained material omissions and misstatements relating to (i) the Company's financial "hardships" and their significance on Bayard's business, (ii) increased costs associated with Bayard's growth strategy, and (iii) undisclosed pending related-party transactions between Bayard and third parties other than the Company. The alleged defective disclosures are claimed to have resulted in a decline in Bayard's share price following the public offering. The plaintiffs seek a determination that the suit is a proper class action and damages in an unspecified amount or rescission, together with interest and costs of litigation, including attorney's fees. The Company believes that the claims are without merit and intends to defend against them vigorously. No estimate of loss or range of estimate of loss, if any, can be made at this time. In October 1996, Union Pacific Resources Company ("UPRC") sued the Company alleging infringement of a patent for a drilling method, tortious interference with confidentiality contracts between UPRC and certain of its former employees and misappropriation of proprietary information of UPRC. UPRC's claims against the Company are based on services provided to the Company by a third party vendor controlled by former UPRC employees. UPRC is seeking injunctive relief, damages of an unspecified amount, including actual, enhanced, consequential and punitive damages, interest, costs and attorneys' fees. The Company believes that it has meritorious defenses to UPRC's allegations and has requested the court to declare the UPRC patent invalid. The Company has also filed a motion to construe UPRC's patent claims and various motions for summary judgment. No estimate of loss or range of estimate of loss, if any, can be made at this time; however, in reports filed in the proceeding, experts for UPRC 7
8 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 (UNAUDITED) claim that damages could be as much as $18 million while Company experts state that the amount should not exceed $25,000, in each case based on a reasonable royalty. The Company is currently involved in various other routine disputes incidental to its business operations. While it is not possible to determine the ultimate disposition of these matters, management, after consultation with legal counsel, is of the opinion that the final resolution of all such currently pending or threatened litigation is not likely to have a material adverse effect on the consolidated financial position or results of operations of the Company. 4. IMPAIRMENT OF OIL AND GAS PROPERTIES The Company incurred an impairment of oil and gas properties charge of $250 million in the Current Quarter. This writedown was caused by several factors, including the effects of accounting for the Hugoton acquisition using the purchase accounting method, oil prices declining from $17.62 at December 31, 1997 to $13.92 at March 31, 1998, gas prices declining from $2.29 at December 31, 1997 to $2.01 at March 31, 1998 and higher drilling and completion costs compared to previous estimates. Additionally, lower oil and gas prices at March 31, 1998 and higher drilling costs caused downward revisions in the Company's proved reserves as certain proved undeveloped reserves previously estimated by the Company were rendered uneconomic and therefore excluded by the Company from its proved reserves. The primary reason for the impairment charge was the completion of the acquisition in March 1998 of Hugoton, which was accounted for using the purchase method. The purchase price, which was established in November 1997 when the acquisition was announced (based on a Chesapeake common stock price of $8.00 per share), was allocated almost entirely to Hugoton's evaluated oil and gas properties. Based upon reserve estimates as of March 31, 1998, the portion of the purchase price which was allocated to evaluated oil and gas properties exceeded the associated discounted future net revenues from Hugoton's estimated proved reserves by approximately $150 million. 5. NET INCOME (LOSS) PER SHARE In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, Earnings Per Share ("SFAS 128"). SFAS 128 requires presentation of "basic" and "diluted" earnings per share, as defined, on the face of the statement of operations for all entities with complex capital structures. SFAS 128 is effective for financial statements issued for periods ending after December 15, 1997 and requires restatement of all prior period earnings per share amounts. The Company has adopted SFAS 128 and has restated all prior periods presented. SFAS 128 requires a reconciliation of the numerators and denominators of the basic and diluted EPS computations. For the Current Quarter there was no difference between actual weighted average shares outstanding, which are used in computing basic EPS and diluted weighted average shares, which are used in computing diluted EPS. Options to purchase 10.2 million shares of common stock at a weighted average exercise price of $5.69 were outstanding during the Current Quarter but were not included in the computation of diluted EPS because the effect of these outstanding options would be antidilutive. A reconciliation for the Prior Quarter is as follows: <TABLE> <CAPTION> INCOME SHARES PER-SHARE (NUMERATOR) (DENOMINATOR) AMOUNT ----------- ------------- ------ <S> <C> <C> <C> For the Quarter Ended March 31, 1997: Basic EPS Income available to common stockholders ... $15,928 69,534 $0.23 ===== Effect of Dilutive Securities Employee stock options .................... -- 3,959 ------- ------ Diluted EPS Income available to common stockholders and assumed conversions ..................... $15,928 73,493 $0.22 ======= ====== ===== </TABLE> 8
9 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 (UNAUDITED) 6. SENIOR NOTES 10.5% Notes The Company had outstanding at March 31, 1998, $90 million in aggregate principal amount of 10.5% Senior Notes due 2002. The 10.5% Notes were senior, unsecured obligations of the Company and were fully and unconditionally guaranteed, jointly and severally, by Guarantor Subsidiaries (as defined below). All outstanding 10.5% Notes were acquired by the Company effective April 30, 1998. See Note 2. 9.125% Notes The Company has outstanding $120 million in aggregate principal amount of 9.125% Senior Notes which mature April 15, 2006. The 9.125% Notes bear interest at an annual rate of 9.125%, payable semiannually on each April 15 and October 15. The 9.125% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. 7.875% Notes The Company has outstanding $150 million in aggregate principal amount of 7.875% Senior Notes which mature March 15, 2004. The 7.875% Notes bear interest at the rate of 7.875%, payable semiannually on each March 15 and September 15. The 7.875% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. 8.5% Notes The Company has outstanding $150 million in aggregate principal amount of 8.5% Senior Notes which mature March 15, 2012. The 8.5% Notes bear interest at the rate of 8.5%, payable semiannually on each March 15 and September 15. The 8.5% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. The Company is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. The Company's obligations under its Senior Notes have been fully and unconditionally guaranteed, on a joint and several basis, by each of the Company's "Restricted Subsidiaries" (as defined in the respective indentures governing the Senior Notes) (collectively, the "Guarantor Subsidiaries"). Each of the Guarantor Subsidiaries is a direct or indirect wholly-owned subsidiary of the Company. The Senior Note Indentures contain certain covenants, including covenants limiting the Company and the Guarantor Subsidiaries with respect to asset sales, restricted payments, the incurrence of additional indebtedness and the issuance of preferred stock, liens, sale and leaseback transactions, lines of business, dividend and other payment restrictions affecting Guarantor Subsidiaries, mergers or consolidations, and transactions with affiliates. The Company is obligated to repurchase the 9.125% Senior Notes in the event of a change of control or certain asset sales. 9
10 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 (UNAUDITED) Set forth below are condensed consolidating financial statements of the Guarantor Subsidiaries, the Company's subsidiaries which are not guarantors of the Senior Notes (the "Non-Guarantor Subsidiaries") and the Company. Separate financial statements of each Guarantor Subsidiary have not been provided because management has determined that they are not material to investors. As of and for the three months ended March 31, 1998, the Non-Guarantor Subsidiaries were Chesapeake Energy Marketing, Inc., Chesapeake Acquisition Corporation and subsidiaries of those companies. As of and for the three months ended March 31, 1997, the Non-Guarantor Subsidiaries were Chesapeake Energy Marketing, Inc. and Chesapeake Canada Corporation. For both periods, the remaining subsidiaries of the Company were Guarantor Subsidiaries. 10
11 CONDENSED CONSOLIDATING BALANCE SHEET AS OF MARCH 31, 1998 ($ IN THOUSANDS) <TABLE> <CAPTION> ASSETS GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ----------- --------- ----------- ----------- ------------ <S> <C> <C> <C> <C> <C> CURRENT ASSETS: Cash and cash equivalents ................ $ (15,466) $ 9,148 $ 40,264 $ -- $ 33,946 Short-term investments ................... -- -- 5,876 -- 5,876 Accounts receivable, net ................. 40,931 26,224 2 (6,737) 60,420 Inventory ................................ 5,143 74 -- -- 5,217 Other .................................... 4,771 277 5 -- 5,053 ----------- --------- ----------- ----------- ----------- Total Current Assets .................. 35,379 35,723 46,147 (6,737) 110,512 ----------- --------- ----------- ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties ................... 1,165,645 399,296 -- -- 1,564,941 Unevaluated leasehold .................... 130,106 14,297 -- -- 144,403 Other property and equipment ............. 58,251 3,402 16,415 -- 78,068 Less: accumulated depreciation, Depletion and amortization ............. (703,750) (186,454) (1,058) -- (891,262) ----------- --------- ----------- ----------- ----------- Total Property & Equipment ............ 650,252 230,541 15,357 -- 896,150 ----------- --------- ----------- ----------- ----------- INVESTMENTS IN SUBSIDIARIES AND INTERCOMPANY ADVANCES .................... 81,755 274,529 1,214,222 (1,570,506) -- ----------- --------- ----------- ----------- ----------- OTHER ASSETS ............................... 4,418 9,283 44,972 -- 58,673 ----------- --------- ----------- ----------- ----------- TOTAL ASSETS .......................... $ 771,804 $ 550,076 $ 1,320,698 $(1,577,243) $ 1,065,335 =========== ========= =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current maturities of long-term debt ...................... $ -- $ -- $ -- $ -- $ -- Accounts payable and other ............... 119,679 30,677 36,250 (6,932) 179,674 ----------- --------- ----------- ----------- ----------- Total Current Liabilities ............. 119,679 30,677 36,250 (6,932) 179,674 ----------- --------- ----------- ----------- ----------- LONG-TERM DEBT ............................. -- 120,000 534,013 -- 654,013 REVENUES PAYABLE ........................... 10,106 445 -- -- 10,551 DEFERRED INCOME TAXES ...................... -- -- -- -- -- INTERCOMPANY PAYABLES ...................... 911,684 47,175 -- (958,859) -- STOCKHOLDERS' EQUITY: Common Stock ............................. 10 4 991 (4) 1,001 Other .................................... (269,675) 351,775 749,444 (611,448) 220,096 ----------- --------- ----------- ----------- ----------- Total Stockholders' Equity ............ (269,665) 351,779 750,435 (611,452) 221,097 ----------- --------- ----------- ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................ $ 771,804 $ 550,076 $ 1,320,698 $(1,577,243) $ 1,065,335 =========== ========= =========== =========== =========== </TABLE> 11
12 CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 1997 ($ IN THOUSANDS) <TABLE> <CAPTION> ASSETS GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ----------- --------- ----------- ----------- ------------ <S> <C> <C> <C> <C> <C> CURRENT ASSETS: Cash and cash equivalents ................ $ (589) $ 13,999 $ 110,450 $ -- $ 123,860 Short-term investments ................... -- -- 12,570 -- 12,570 Accounts receivable, net ................. 57,476 22,882 1,524 (7,708) 74,174 Inventory ................................ 4,918 575 -- -- 5,493 Other .................................... 1,613 1 10 -- 1,624 ----------- --------- ----------- ----------- ----------- Total Current Assets .................. 63,418 37,457 124,554 (7,708) 217,721 ----------- --------- ----------- ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties ................... 1,056,118 39,245 -- -- 1,095,363 Unevaluated leasehold .................... 125,155 -- -- -- 125,155 Other property and equipment ............. 51,868 343 15,422 -- 67,633 Less: accumulated depreciation, Depletion and amortization ............. (593,359) (14,650) (955) -- (608,964) ----------- --------- ----------- ----------- ----------- Total Property & Equipment ............ 639,782 24,938 14,467 -- 679,187 ----------- --------- ----------- ----------- ----------- INVESTMENTS IN SUBSIDIARIES AND INTERCOMPANY ADVANCES .................... 81,755 49,958 903,713 (1,035,426) -- ----------- --------- ----------- ----------- ----------- OTHER ASSETS ............................... 10,189 6,918 38,769 -- 55,876 ----------- --------- ----------- ----------- ----------- TOTAL ASSETS .......................... $ 795,144 $ 119,271 $ 1,081,503 $(1,043,134) $ 952,784 =========== ========= =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current maturities of long-term debt ...................... $ -- $ -- $ -- $ -- $ -- Accounts payable and other ............... 104,259 29,649 27,280 (7,708) 153,480 ----------- --------- ----------- ----------- ----------- Total Current Liabilities ............. 104,259 29,649 27,280 (7,708) 153,480 ----------- --------- ----------- ----------- ----------- LONG-TERM DEBT ............................. -- -- 508,992 -- 508,992 REVENUES PAYABLE ........................... 10,106 -- -- -- 10,106 DEFERRED INCOME TAXES ...................... -- -- -- -- -- INTERCOMPANY PAYABLES ...................... 853,958 2,959 -- (856,917) -- STOCKHOLDERS' EQUITY: Common Stock ............................. 10 3 733 (3) 743 Other .................................... (173,189) 86,660 544,498 (178,506) 279,463 ----------- --------- ----------- ----------- ----------- Total Stockholders' Equity ............ (173,179) 86,663 545,231 (178,509) 280,206 ----------- --------- ----------- ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................ $ 795,144 $ 119,271 $ 1,081,503 $(1,043,134) $ 952,784 =========== ========= =========== =========== =========== </TABLE> 12
13 CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ------------ ------------ -------- ------------ ------------ <S> <C> <C> <C> <C> <C> FOR THE THREE MONTHS ENDED MARCH 31, 1998 REVENUES: Oil and gas sales .......................... $ 41,803 $ 7,812 $ -- $ 626 $ 50,241 Oil and gas marketing sales ................ -- 47,725 -- (21,201) 26,524 Interest and other ......................... (28) 142 20,035 (19,925) 224 --------- --------- -------- -------- --------- Total Revenues .......................... 41,775 55,679 20,035 (40,500) 76,989 --------- --------- -------- -------- --------- COSTS AND EXPENSES: Production expenses and taxes .............. 6,901 2,537 -- -- 9,438 Oil and gas marketing expenses ............. -- 46,836 -- (20,575) 26,261 Impairment of oil and gas properties ....... 83,500 166,500 -- -- 250,000 Oil and gas depreciation, depletion and amortization ......................... 26,121 5,221 -- -- 31,342 Other depreciation and amortization ........ 806 77 497 -- 1,380 General and administrative ................. 3,755 593 32 -- 4,380 Interest ................................... 17,482 1,741 11,390 (19,925) 10,688 --------- --------- -------- -------- --------- Total Costs & Expenses .................. 138,565 223,505 11,919 (40,500) 333,489 --------- --------- -------- -------- --------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM ..................... (96,790) (167,826) 8,116 -- (256,500) INCOME TAX EXPENSE (BENEFIT) ................. -- -- -- -- -- --------- --------- -------- -------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ......................... (96,790) (167,826) 8,116 -- (256,500) --------- --------- -------- -------- --------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax ............. -- -- -- -- -- --------- --------- -------- -------- --------- NET INCOME (LOSS) ....................... $ (96,790) $(167,826) $ 8,116 $ -- $(256,500) ========= ========= ======== ======== ========= FOR THE THREE MONTHS ENDED MARCH 31, 1997 REVENUES: Oil and gas sales .......................... $ 56,795 $ -- $ -- $ 604 $ 57,399 Gas marketing sales ........................ -- 45,568 -- (23,158) 22,410 Interest and other ......................... 177 197 2,903 -- 3,277 --------- --------- -------- -------- --------- Total revenues .......................... 56,972 45,765 2,903 (22,554) 83,086 --------- --------- -------- -------- --------- COSTS AND EXPENSES: Production expenses and taxes .............. 4,308 -- -- -- 4,308 Gas marketing expenses ..................... -- 44,301 -- (22,554) 21,747 Oil and gas depreciation ................... 24,663 -- -- -- 24,663 Other depreciation and amortization ........ 508 20 345 -- 873 General and administrative ................. 1,757 235 489 -- 2,481 Interest ................................... 172 -- 3,482 -- 3,654 --------- --------- -------- -------- --------- Total Costs & Expenses .................. 31,408 44,556 4,316 (22,554) 57,726 --------- --------- -------- -------- --------- INCOME (LOSS) BEFORE INCOME TAX .............. 25,564 1,209 (1,413) -- 25,360 INCOME TAX EXPENSE ........................... 9,330 441 (516) -- 9,255 --------- --------- -------- -------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM .................... 16,234 768 (897) -- 16,105 --------- --------- -------- -------- --------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax ................. (179) -- 2 -- (177) --------- --------- -------- -------- --------- NET INCOME (LOSS) ....................... $ 16,055 $ 768 $ (895) $ -- $ 15,928 ========= ========= ======== ======== ========= </TABLE> 13
14 CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ------------ ------------ -------- ------------ ------------ <S> <C> <C> <C> <C> <C> FOR THE THREE MONTHS ENDED MARCH 31, 1998 CASH FLOWS FROM OPERATING ACTIVITIES: .................................. $(128,409) $ 161,162 $ 16,432 $ -- $ 49,185 CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ....................... (114,698) 4,938 -- -- (109,760) Proceeds from sale of assets ................. 220 -- -- -- 220 Investment in service operations ............. -- (39,242) -- -- (39,242) Other additions .............................. (19,538) 2,313 (459) -- (17,684) --------- --------- --------- --------- --------- (134,016) (31,991) (459) -- (166,466) --------- --------- --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings ..................... -- -- 145,000 -- 145,000 Payments on borrowings ....................... -- -- (120,000) -- (120,000) Cash received from exercise of stock options .................................... -- -- -- -- -- Cash received from issuance of common stock ...................................... -- -- 61 -- 61 Other financing .............................. -- 305 -- -- 305 Intercompany advances, net ................... 245,547 (134,327) (111,220) -- -- --------- --------- --------- --------- --------- 245,547 (134,022) (86,159) -- 25,366 --------- --------- --------- --------- --------- Net increase (decrease) in cash .............. (16,878) (4,851) (70,186) -- (91,915) Cash, beginning of period .................... (589) 13,999 110,450 -- 123,860 --------- --------- --------- --------- --------- Cash, end of period .......................... $ (17,467) $ 9,148 $ 40,264 $ -- $ 31,945 ========= ========= ========= ========= ========= FOR THE THREE MONTHS ENDED MARCH 31, 1997 CASH FLOWS FROM OPERATING ACTIVITIES: .................................. $ 70,762 $ 2,085 $ (33,161) $ -- $ 39,686 CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ....................... (158,280) 35 -- -- (158,245) Proceeds from sales .......................... 2,850 -- -- -- 2,850 Investment in gas marketing company .......... -- -- -- -- -- Other additions .............................. (859) -- (3,853) -- (4,712) --------- --------- --------- --------- --------- (156,289) 35 (3,853) -- (160,107) --------- --------- --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings ........... -- -- 292,626 -- 292,626 Payments on borrowings ....................... (67,569) 1,710 53,195 -- (12,664) Cash received from exercise of stock options .................................... -- -- 625 -- 625 Other financing .............................. -- -- (95) -- (95) Intercompany advances, net ................... 134,385 (3,350) (131,035) -- -- --------- --------- --------- --------- --------- 66,816 (1,640) 215,316 -- 280,492 --------- --------- --------- --------- --------- Net increase (decrease) in cash and cash equivalents ................................ (18,711) 480 178,302 -- 160,071 Cash, beginning of period .................... 4,782 6,182 129,775 -- 140,739 --------- --------- --------- --------- --------- Cash, end of period .......................... $ (13,929) $ 6,662 $ 308,077 $ -- $ 300,810 ========= ========= ========= ========= ========= </TABLE> 14
15 PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT EVENTS On December 16, 1997, the Company acquired AnSon Production Corporation ("AnSon"), a privately owned oil and gas producer based in Oklahoma City. Consideration for the acquisition was approximately $43 million, which included the issuance of 3,792,724 shares of Chesapeake's common stock and the payment of $24.8 million on May 7, 1998, pursuant to a make-whole provision. On January 30, 1998, the Company entered into a 40/60 alliance with Ranger Oil Limited to jointly develop a 3.2 million acre area of mutual interest in the Helmet area of northeastern British Columbia. As part of the transaction, the Company paid approximately $48 million for proved oil and gas reserves, undeveloped leasehold and a 40% interest in Ranger's infrastructure in the area. On February 6, 1998, the Company purchased the Mid-Continent properties of EnerVest Management Company, L.L.C. for $38 million. On March 10, 1998, the Company acquired Hugoton Energy Corporation ("Hugoton") pursuant to a merger by issuing approximately 25.8 million shares of the Company's common stock in exchange for 100% of Hugoton's common stock. See Consolidated Statements of Cash Flows. On April 22, 1998, the Company issued $230 million (4.6 million shares) of its 7% Cumulative Convertible Preferred Stock, $50 per share liquidation preference, and $500 million of its 9.625% Series A Senior Notes due 2005. Net proceeds from these offerings were approximately $712 million. On April 27, 1998, the Company acquired from Gothic Energy Corporation certain proved oil and gas reserves for $20 million, purchased $50 million of Gothic 12% preferred stock, acquired ten-year warrants to purchase 15% of Gothic's currently outstanding common stock for $0.01 per share, acquired a 50% interest in Gothic's undeveloped leasehold acreage and entered into a five-year drilling and acquisitions participation agreement. On April 27, 1998, Chesapeake acquired the British Columbia properties of Sunoma Energy Corporation for $33 million. On April 28, 1998, the Company acquired by merger the Mid-Continent operations of DLB Oil & Gas, Inc. for $17.5 million in cash, 5,000,000 shares of the Company's common stock, and the assumption of $90 million in outstanding debt and working capital obligations. On April 30, 1998, the Company acquired 100% of the stock of MC Panhandle Corp., a wholly-owned subsidiary of Occidental Petroleum Corporation, by paying approximately $95 million, net of working capital adjustments. Effective April 30, 1998, the Company purchased all of its outstanding 10.5% Senior Notes due 2002. Of the $90,000,000 aggregate principal amount, $89,830,000 was acquired pursuant to the Company's offer to purchase, which commenced April 1, 1998, and the remaining $170,000 was acquired on the same terms after the tender period. The cost to acquire the 10.5% Senior Notes was approximately $99,000,000. The early retirement of these notes will result in an extraordinary charge of approximately $12 million during the quarter ended June 30, 1998. 15
16 RESULTS OF OPERATIONS - Three months ended March 31, 1998 vs. March 31, 1997 General. For the three months ended March 31, 1998 (the "Current Quarter"), the Company realized a net loss of $256.5 million, or $3.19 per common share. This compares to net income of $15.9 million, or $0.22 per common share, in the three months ended March 31, 1997 (the "Prior Quarter"). The loss in the Current Quarter was primarily caused by a $250.0 million asset writedown recorded under the full-cost method of accounting and, to a much lesser extent, a $6.5 million loss from recurring operations. The asset writedown was primarily caused by the Hugoton acquisition in March 1998 for consideration in excess of the present value (10% discount) of the future net revenues of the proved reserves acquired as of March 31, 1998 (approximately $150 million of the writedown) and by decreases in oil and gas prices from December 31, 1997 to March 31, 1998. See Impairment of Oil and Gas Properties. No such writedown occurred in the Prior Quarter. Oil and Gas Sales. During the Current Quarter, oil and gas sales decreased 13% to $50.2 million from $57.4 million in the Prior Quarter. The decrease resulted from significantly lower oil and gas prices, partially offset by a 12% increase in production volumes. For the Current Quarter, the Company produced 23.0 billion cubic feet equivalent ("bcfe"), consisting of 1.2 million barrels of oil ("mmbo") and 16 billion cubic feet of natural gas ("bcf"), compared to 0.8 mmbo and 15.7 bcf, or 20.5 bcfe, in the Prior Quarter. Average oil prices realized were $14.84 per barrel of oil ("bo") in the Current Quarter compared to $21.55 in the Prior Quarter, a decrease of 31%. Average gas prices realized were $2.06 per thousand cubic feet ("mcf") in the Current Quarter compared to $2.55 per mcf in the Prior Quarter, a decrease of 19%. For the Current Quarter, the Company realized an average price of $2.19 per thousand cubic feet equivalent ("mcfe"), compared to $2.79 per mcfe in the Prior Quarter. The Company's hedging activities resulted in increased oil and gas revenues of $1.8 million, or $0.08 per mcfe, in the Current Quarter, compared to decreases in oil and gas revenues of $0.2 million, or $0.01 per mcfe, in the Prior Quarter. The following table shows the Company's production by region for the Current Quarter and the Prior Quarter: <TABLE> <CAPTION> FOR THE THREE MONTHS ENDED MARCH 31, ---------------------------------------- 1998 1997 ------------------ ------------------ OPERATING AREAS (MMCFE) PERCENT (MMCFE) PERCENT ------ ------- ------ ------- <S> <C> <C> <C> <C> Mid-Continent ........... 7,646 33% 4,241 21% Austin Chalk Trend ...... 12,054 53 15,017 73 Canada .................. 730 3 -- -- Other Areas ............. 2,533 11 1,290 6 ------ --- ------ --- Total .............. 22,963 100% 20,548 100% ====== === ====== === </TABLE> Natural gas production represented approximately 69% of the Company's total production volume on an equivalent basis in the Current Quarter, compared to 77% in the Prior Quarter. This decrease in natural gas production as a percentage of total production was primarily the result of new production in the Louisiana portion of the Austin Chalk Trend, which tends to produce more oil than gas. The Company anticipates that as a result of its recent acquisitions, increased drilling in the Mid-Continent and Canada and decreased drilling in Louisiana, natural gas will represent 70-75% of anticipated 1998 production. Oil and Gas Marketing Sales. The Company realized $26.5 million in oil and gas marketing sales for third parties in the Current Quarter, with corresponding oil and gas marketing expenses of $26.3 million, for a margin of $0.2 million. This compares to sales of $22.4 million, expenses of $21.7 million, and a margin of $0.7 million in the Prior Quarter. The Company anticipates gross margins will increase during 1998 as a result of the acquisition of certain gas gathering, transportation and marketing assets completed in 1998. Interest and Other. Interest and other revenues for the Current Quarter were $0.2 million compared to $3.3 million in the Prior Quarter. The decrease was primarily caused by the Company maintaining lower invested cash balances resulting in reduced interest income. 16
17 Production Expenses and Taxes. Production expenses increased to $7.9 million in the Current Quarter, a $4.7 million increase from the $3.2 million incurred in the Prior Quarter. On a production unit basis, production expenses were $0.34 and $0.16 per mcfe in the Current and Prior Quarters, respectively. The primary reason for the increase in production expenses was the increased lifting costs associated with the Louisiana production, which represented a higher proportion of production in the Current Quarter than the Prior Quarter. Also contributing to the increase was the addition of production obtained in the Hugoton and AnSon acquisitions, which typically has higher production expense per Mcfe of production than the Company's historical production base. The Company anticipates production expenses will continue to rise during 1998 as the result of additional acquisitions closed in April 1998, and expects production expenses to average $0.35 to $0.40 per mcfe for 1998. Production taxes, which consist primarily of wellhead severance taxes, were $1.5 million and $1.2 million in the Current and Prior Quarters, respectively. This increase, from $0.06 per mcfe to $0.07 per mcfe, was the result of the higher tax rates associated with production obtained in the acquisitions as compared to the Company's historical production base. Impairment of Oil and Gas Properties. The Company utilizes the full-cost method to account for its investments in oil and gas properties. Under this method, all costs of acquisition, exploration and development of oil and gas reserves (including such costs as leasehold acquisition costs, geological and geophysical expenditures, certain capitalized internal costs, dry hole costs and tangible and intangible development costs) are capitalized as incurred. These oil and gas property costs, including the estimated future capital expenditures to develop the proved undeveloped reserves, are depleted and charged to operations using the unit-of-production method based on the ratio of current production to proved oil and gas reserves as estimated by the Company's independent engineering consultants and Company engineers. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization computation until it is determined whether or not proved reserves can be assigned to the property or whether impairment has occurred. To the extent that capitalized costs of oil and gas properties, net of accumulated depreciation, depletion and amortization and related deferred income taxes, exceed the discounted future net revenues of proved oil and gas properties, such excess costs are charged to operations. The Company incurred an impairment of oil and gas properties charge of $250 million in the Current Quarter, compared to no impairment in the Prior Quarter. This writedown was caused by several factors, including the Hugoton acquisition, oil prices declining from $17.62 at December 31, 1997 to $13.92 at March 31, 1998, gas prices declining from $2.29 at December 31, 1997 to $2.01 at March 31, 1998 and higher drilling and completion costs compared to previous estimates. Additionally, lower oil and gas prices at March 31, 1998 and higher drilling costs caused downward revisions in the Company's proved reserves as certain proved undeveloped reserves previously estimated by the Company were rendered uneconomic and therefore not included in the Company's evaluation of its proved reserves. The primary reason for the impairment charge was the completion of the acquisition in March 1998 of Hugoton, which was accounted for using the purchase method. The purchase price, which was established in November 1997 when the acquisition was announced (based on a Chesapeake common stock price of $8.00 per share), was allocated almost entirely to Hugoton's evaluated oil and gas properties. Based upon reserve estimates as of March 31, 1998, the portion of the purchase price which was allocated to evaluated oil and gas properties exceeded the associated discounted future net revenues from Hugoton's estimated proved reserves by approximately $150 million. Since March 31, 1998, oil and gas prices have declined further. If prices do not increase from current levels by June 30, 1998, the Company could incur additional impairment charges, reducing earnings and shareholders' equity. Oil and Gas Depreciation, Depletion and Amortization. Depreciation, depletion and amortization of oil and gas properties ("DD&A") for the Current Quarter was $31.3 million, compared to $24.7 million in the Prior Quarter. This increase was caused by increased production and an increase in the DD&A rate per mcfe from $1.20 to $1.36 in the Prior and Current Quarters, respectively. The Company's DD&A rate is expected to decrease to 17
18 approximately $1.10-$1.15 per mcfe for the remainder of 1998 as the result of the impairment charge, the acquisitions completed in April, and reduced drilling in Louisiana. Depreciation and Amortization of Other Assets. Depreciation and amortization of other assets ("D&A") increased to $1.4 million in the Current Quarter compared to $0.9 million in the Prior Quarter. This increase in D&A was caused by increased investments in depreciable buildings and equipment and increased amortization of debt issuance costs as a result of the issuance of Senior Notes in March 1997. The Company anticipates an increase in D&A throughout 1998 as a result of higher building depreciation expense on the Company's corporate offices, additional equipment and depreciable assets added from the acquisitions, and higher amortization caused by the increased offering costs incurred in the Senior Notes issued in April 1998. General and Administrative. General and administrative expenses ("G&A"), which are net of capitalized internal payroll and non-payroll expenses, were $4.4 million in the Current Quarter compared to $2.5 million in the Prior Quarter. This increase was primarily caused by increased employment levels associated with the Company's continuing growth. The increase was also caused by increased accounting, legal, reservoir engineering and other expenses incurred in the Current Quarter as a result of the Company's change to a December 31 fiscal year end reporting period for which there were no comparable expenses in the Prior Quarter. The Company capitalized $2.1 million of internal costs in the Current Quarter directly related to the Company's oil and gas exploration and development efforts, compared to $1.4 million in the Prior Quarter. The Company anticipates that G&A costs for 1998 will continue to increase as the result of industry wage inflation, legal fees associated with litigation, and increases in employment due to the acquisition program. Interest and Other. Interest and other expense increased to $10.7 million in the Current Quarter from $3.7 million in the Prior Quarter. This increase was a result of a full quarter of interest expense in the Current Quarter on the $300 million principal amount of Senior Notes issued at the end of the Prior Quarter. In addition to the interest expense reported, the Company capitalized $2.3 million of interest during the Current Quarter compared to $2.7 million capitalized in the Prior Quarter. Interest expense will increase during the remainder of 1998 as a result of the issuance of $500 million of Senior Notes in April 1998. Provision for Income Taxes. The Company recorded no income tax expense for the Current Quarter, compared to income tax expense of $9.3 million in the Prior Quarter. At March 31, 1998, the Company had a net operating loss carryforward of approximately $383 million for regular federal income taxes which will expire in future years beginning in 2007. Management believes that it cannot be demonstrated at this time that it is more likely than not that the deferred income tax assets, comprised primarily of the net operating loss carryforward, will be realizable in future years, and therefore a valuation allowance of $174 million has been recorded. The Company does not expect to record any book income tax expense for the remainder of 1998 based on information available at this time. RISK MANAGEMENT ACTIVITIES Periodically the Company utilizes hedging strategies to hedge the price of a portion of its future oil and gas production. These strategies include (1) swap arrangements that establish an index-related price above which the Company pays the counterparty and below which the Company is paid by the counterparty, (2) the purchase of index-related puts that provide for a "floor" price below which the counterparty pays the Company the amount by which the price of the commodity is below the contracted floor, (3) the sale of index-related calls that provide for a "ceiling" price above which the Company pays the counterparty the amount by which the price of the commodity is above the contracted ceiling, and (4) basis protection swaps, which are arrangements that guarantee the price differential of oil or gas from a specified delivery point or points. Results from hedging transactions are reflected in oil and gas sales to the extent related to the Company's oil and gas production. The Company only enters into hedging transactions related to the Company's oil and gas production volumes or physical purchase or sale commitments of its oil and gas marketing subsidiaries. 18
19 As of March 31, 1998, the Company had the following natural gas swap arrangements for periods after March 1998: <TABLE> <CAPTION> MONTHLY NYMEX-INDEX VOLUME STRIKE PRICE MONTHS (MMBTU) (PER MMBTU) ------ ------- ------------ <S> <C> <C> <C> May 1998................... 5,270,000 $ 2.310 June 1998.................. 6,300,000 $ 2.356 July 1998.................. 6,510,000 $ 2.356 August 1998................ 6,510,000 $ 2.356 September 1998............. 6,300,000 $ 2.356 October 1998............... 4,030,000 $ 2.317 </TABLE> The Company has closed a transaction for natural gas previously hedged for the period April through November 1999 and received proceeds of $0.9 million, which will be recognized as income during the corresponding months of production. The Company does not currently have any oil hedge transactions in place. Gains or losses on the crude oil and natural gas hedging transactions are recognized as price adjustments in the months of related production. LIQUIDITY AND CAPITAL RESOURCES In April 1998, the Company completed an offering of $230 million of 7% Cumulative Convertible Preferred Stock and $500 million principal amount of 9.625% Senior Notes due 2005. The net proceeds of these offerings were approximately $712 million, of which $170 million was used to retire all of the Company's commercial bank debt, approximately $100 million was used to retire all $90 million principal amount of the Company's 10.5% Senior Notes due 2002, $345 million was used to fund certain of the Company's acquisitions, with the balance of the net proceeds increasing the Company's working capital. As of March 31, 1998, the Company had a working capital deficit of approximately $69 million which has been eliminated with the proceeds from the April 1998 Preferred Stock and Senior Note offerings. The Company estimates that its capital expenditures (excluding acquisitions) for 1998 will be between $225 million and $250 million, including $200-$220 million for drilling and completion expenditures, and the balance for acreage acquisition and maintenance, seismic programs and capitalized general and administrative costs. The capital expenditure budget is largely discretionary, and can be adjusted by the Company based on operating results or other factors. The Company believes it has sufficient capital resources from anticipated cash flow from operations and working capital to fund its drilling program for 1998. The Company is currently negotiating with its commercial bank group to obtain a secured revolving bank loan. It is anticipated that this facility will be completed by the end of May 1998 and will contain terms and conditions similar to the bank facilities the Company has had in the past. It is anticipated that the facility will be documented at $500 million, but will have collateral-based borrowing limitations. The debt incurrence covenants of the Senior Note indentures will also be a limiting factor. The primary purpose of the facility will be to fund potential acquisitions of oil and gas reserves. During April 1998, the Company received a senior debt credit rating decrease from both Moody's Investors Service and Standard & Poor's Rating Services to B1 and B+, respectively. The rating agencies cited, among other factors, the Company's long-term debt to total book capitalization, which, after the recent Senior Notes and Preferred Stock offerings, is approximately 67%. The Company's cash provided by operating activities increased 24% to $49.2 million during the Current Quarter compared to $39.7 million during the Prior Quarter. The increase was due primarily to cash provided from changes in current assets and current liabilities between periods. 19
20 Cash used in investing activities increased to $166.5 million during the Current Quarter from $160.1 million in the Prior Quarter. The Company completed several acquisitions requiring cash in the Current Quarter which totaled $82 million, compared to none in the Prior Quarter, offset by a significant decrease in drilling activity and leasehold acquisitions in the Current Quarter compared to the Prior Quarter. During the Current Quarter the Company expended approximately $62 million to initiate drilling on 52 gross (32.9 net) wells and invested approximately $5 million in leasehold acquisitions. This compares to $129 million to initiate drilling on 35 gross (17.1 net) wells and $30 million to purchase leasehold in the Prior Quarter. Cash provided by financing activities was $25.4 million in the Current Quarter, compared to $280.5 million in the Prior Quarter. During the Current Quarter, the Company retired $120 million in bank debt which it assumed at the completion of the Hugoton acquisition. The Company refinanced the Hugoton debt and obtained additional working capital of $25 million with proceeds from the Company's commercial bank credit facility. During the Prior Quarter, the Company issued $300 million in Senior Notes. The Company is subject to certain routine legal proceedings, none of which are expected to have a material adverse effect upon the Company's financial condition or operations. The Company is also a defendant in other non-routine lawsuits, which are described in Note 3 of the notes to the accompanying financial statements. Also see Part II, Item 1 of this report. An adverse outcome in one or more of such suits could have a material effect on the Company, although management is unable to quantify the Company's exposure to liability. No provision for litigation liability has been recorded in the Company's financial statements. FORWARD LOOKING STATEMENTS This Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements other than statements of historical facts included in this Form 10-Q, including without limitation statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding planned capital expenditures, expected oil and gas production, the Company's financial position, business strategy and other plans and objectives for future operations, capital expenditures plans, and expected future expenses are forward looking statements. Although the Company believes that the expectations reflected in such forward-looking statement are reasonable, it can give no assurance that such expectations will prove to have been correct. Factors that could cause actual results to differ materially from those expected by the Company, including, without limitation, factors discussed under Risk Factors in the Company's Form 10-K for the period ended December 31, 1997 are concentration of unevaluated leasehold in Louisiana, impairment of asset value, need to replace reserves, substantial capital requirements, substantial indebtedness, fluctuations in the prices of oil and gas, uncertainties inherent in estimating quantities of oil and gas reserves and projecting future rates of production and timing of development expenditures, competition, operating risks, acquisition and integration of operation risks, restrictions imposed by lenders, liquidity and capital requirements, the effects of governmental and environmental regulation, patent and securities litigation and adverse changes in the market for the Company's oil and gas production. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof, including, without limitation, changes in the Company's business strategy or planned capital expenditures, or to reflect the occurrence of unanticipated events. 20
21 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is subject to ordinary routine litigation incidental to its business. In addition, the Company and its officers and directors are defendants in certain purported class actions based on federal securities fraud claims. Also the Company is defending claims of patent infringement, tortious interference with confidentiality contracts and misappropriation of proprietary information in another pending action. These matters are described in Item 3 of the Company's Transition Report on Form 10-K for the six-month period ended December 31, 1997. Subsequent developments are as follows: On March 16, 1998, the Company and named officers and directors filed a motion to dismiss in In re Chesapeake Energy Corporation Securities Litigation pending in the U.S. District Court for the Western District of Oklahoma. In May 1998, two purported class actions filed on behalf of investors who purchased common stock of Bayard Drilling Technologies, Inc. in its initial public offering on November 4, 1997 were dismissed without prejudice pursuant to stipulation of all parties. These actions had been filed in the District Court for Oklahoma County, Oklahoma alleging violations by the Company and others of Sections 11 and 12 of the Securities Act of 1933 and Section 408 of the Oklahoma Securities Act. The Company was a selling stockholder in the offering. On May 12, 1998, the plaintiffs in the dismissed cases became co-lead plaintiffs in the remaining federal case: Tom Yuan v. Bayard, et al. filed in the U.S. District Court for the Western District of Oklahoma. ITEM 2. CHANGES IN SECURITIES On April 22, 1998, the Company sold 4,600,000 shares (the "Shares") of 7% Cumulative Convertible Preferred Stock having a liquidation preference of $50 per share in a private placement to Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc. and J.P. Morgan Securities Inc. (the "Initial Purchasers") pursuant to the exemption from registration provided by Section 4 (2) of the Securities Act of 1933 (the "Securities Act"). The Initial Purchasers resold the shares to qualified institutional buyers, as defined in, and in reliance on the exemption from registration provided by, Rule 144A under the Securities Act. The aggregate offering price for the Shares was $230 million, and aggregate discounts and commissions were $6.9 million. Each of the Shares is convertible at the holders' option, exercisable at any time unless previously redeemed, into shares of Company common stock at a conversion price of $6.95 per Share (equivalent to a conversion rate of approximately 7.1942 shares of common stock for each Share), subject to adjustment pursuant to antidilution provisions. The Shares are redeemable, in whole or in part, at the Company's option at any time on or after May 1, 2001, initially at a price of $52.45 per share and thereafter at prices declining to $50 per share on or after May 1, 2008, plus in each case all accrued and unpaid dividends to the redemption date, which redemption price may be paid in cash, by delivery of shares of Company common stock or through a combination thereof. Upon any Change of Control (as defined in the Certificate of Designation for the Shares), each holder of Shares will, in the event that the Market Value (as defined) at such time is less than the Conversion Price, have a one-time option to convert such holder's Shares into common stock at an adjusted Conversion Price equal to the greater of (x) the Market Value for the period ending on the Change of Control date and (y) 66 2/3% of the Market Value for the period ended April 16, 1998. In lieu of issuing shares of common stock for Shares surrendered for conversion upon a Change of Control, the Company may, at its option, make a cash payment equal to the Market Value of the common stock otherwise issuable determined for the period ending on the Change of Control date. ITEM 3. DEFAULTS UPON SENIOR SECURITIES - - Not applicable 21
22 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company held a special meeting of shareholders on March 10, 1998 to approve the merger of Hugoton Energy Corporation into a subsidiary of the Company. The proposal to approve and adopt the Agreement and Plan of Merger between the Company and Hugoton Energy Corporation and the issuance of the Company's Common Stock pursuant to the merger was approved by a vote of 54,018,852 shares for, representing 73% of the outstanding shares of Common Stock; 542,797 shares voted against the proposal; 132,847 shares abstained from voting; and 19,610,315 shares were broker non-votes. ITEM 5. OTHER INFORMATION - - Not applicable 22
23 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are filed as a part of this report: Exhibit No. ----------- 3.1 Registrant's Certificate of Incorporation, as amended 4.3 Indenture dated as of April 1, 1998 among Chesapeake Energy Corporation, its subsidiaries signatory thereto as Subsidiary Guarantors and United States Trust Company of New York, as Trustee, with respect to 9.625% Senior Notes due 2005. 4.11 Registration Rights Agreement dated as of April 22, 1998 by and among Chesapeake Energy Corporation and Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc. and J.P. Morgan Securities, Inc., with respect to 7% Cumulative Convertible Preferred Stock. 4.12 Registration Rights Agreement dated as of April 22, 1998 by and among Chesapeake Energy Corporation, The Named Guarantors and Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc., J.P. Morgan Securities, Inc. and Morgan Stanley & Co., Incorporated, with respect to 9.625% Senior Notes due 2005. 27 Financial Data Schedules (b) Reports on Form 8-K During the quarter ended March 31, 1998, the Company filed the following Current Reports on Form 8-K dated: January 15, 1998 announcing property acquisition in Western Canada and in the Mid-Continent, January 26, 1998 announcing successful negotiation of $500 million credit facility, February 5, 1998 reporting on drilling activities and pending transactions, February 13, 1997 reporting renegotiated terms of the DLB merger agreement, March 5, 1998 announcing the Company and Hugoton Energy Corporation set shareholder meetings seeking approval of merger, March 5, 1998 announcing the Company enhances its position in the Texas Panhandle, and agrees to purchase properties from Occidental Petroleum Corporation, March 5, 1998 announcing preliminary transition period results, March 5, 1998 reporting on activity in Northeast British Columbia, March 20, 1998 announcing that shareholders of the Company and Hugoton Energy Corporation has approved the merger, 23
24 March 23, 1998 announcing cash dividend for shareholders, March 25, 1998 announcing 1997 transition period results, March 31, 1998 announcing senior notes and preferred stock offerings, March 31, 1998 announcing increased reserves in the Helmet Area of Northeast British Columbia, and March 31, 1998 announcing continuation of Mid-Continent Consolidation, and announcing transaction with Gothic Energy Corporation. 24
25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CHESAPEAKE ENERGY CORPORATION ----------------------------- (Registrant) May 15, 1998 /s/ Aubrey K. McClendon - --------------------- ----------------------------- Date Aubrey K. McClendon Chairman and Chief Executive Officer May 15, 1998 /s/ Marcus C. Rowland - --------------------- ----------------------------- Date Marcus C. Rowland Vice President and Chief Financial Officer 25
26 Index to Exhibits Exhibit No. Description Page - ----------- ----------- ---- 3.1 Registrant's Certificate of Incorporation as amended 4.3 Indenture dated as of April 1, 1998 among Chesapeake Energy Corporation, its subsidiaries signatory thereto as Subsidiary Guarantors and United States Trust Company of New York, as Trustee, with respect to 9.625% Senior Notes due 2005. 4.11 Registration Rights Agreement dated as of April 22, 1998 by and among Chesapeake Energy Corporation and Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc. and J.P. Morgan Securities, Inc., with respect to 7% Cumulative Convertible Preferred Stock. 4.12 Registration Rights Agreement dated as of April 22, 1998 by and among Chesapeake Energy Corporation, The Named Guarantors and Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc., J.P. Morgan Securities, Inc. and Morgan Stanley & Co., Incorporated, with respect to 9.625% Senior Notes due 2005. 27.1 Financial Data Schedules 27.2 Financial Data Schedules Restated 27.3 Financial Data Schedules Restated 27.4 Financial Data Schedules Restated 27.5 Financial Data Schedules Restated 27.6 Financial Data Schedules Restated 27.7 Financial Data Schedules Restated 27.8 Financial Data Schedules Restated