You Couldn't Pay Me to Invest in Chesapeake Energy

There are some investments you should stay away from no matter how attractive they look. Chesapeake Energy (NYSE: CHK  ) is one for me. I wouldn't touch this natural gas driller with a 30-foot pole and I don't think you should, either.

Reason No. 1: CEO Aubrey McClendon
Probably the most important job a CEO has is capital allocation. How should the company use its profits? In the case of Chesapeake, answers probably include signing leases for drilling rights, buying rigs and drilling wells, returning money to shareholders, and, apparently, persuading the board to make sweet deals with the CEO (see below).

So how would you judge CEO Aubrey McClendon as a capital allocator? Well, one way is to look at return on assets (ROA) over time and compare it to several competitors. If the purchase of assets (such as drilling rights and rigs) generates a high return (net income), then that was a good use of the company's resources. Here's how Chesapeake and several competitors stack up:

Company

ROA in 2008

2009

2010

2011

Chesapeake Energy 7.7% 4.1% 5.0% 4.0%
Apache (NYSE: APA  ) 13.8% 7.4% 9.9% 11.0%
Devon Energy (NYSE: DVN  ) 10.2% 4.6% 8.0% 7.8%
Newfield Exploration (NYSE: NFX  ) 12.0% 4.9% 8.6% 7.1%
Southwestern Energy (NYSE: SWN  ) 13.2% 11.4% 11.8% 9.7%

Source: S&P Capital IQ.

While nearly all these companies have seen lower ROA recently, thanks to lower natural gas prices (and thus lower profits), Chesapeake's ROA is consistently at the bottom.

But investors interested in Chesapeake have an extra source for judging: McClendon himself. And he doesn't come up smelling like roses.

A few years ago, he borrowed money using his Chesapeake shares as collateral. When the stock market fell in the fall of 2008, McClendon got the dreaded margin call. He had to sell 94% of his Chesapeake shares -- about $552 million worth -- to cover his obligation.

It gets better (or worse). Last week, Reuters reported that McClendon has borrowed more than $1 billion. The collateral is the 2.5% ownership stake that McClendon has in wells the company drills. The money is letting him invest in even more wells.

Gee, this sounds familiar. At some point, he'll have to pay that billion dollars back. Maybe he'll end up selling his stake in the wells, just like he had to sell his shares previously to cover an earlier ill-conceived loan. Worse, what if one of the lenders decides to call the loan? What kind of pressure could they exert on Chesapeake?

If McClendon's so willing to take big risks with his own money, what's he doing with shareholder money at Chesapeake?

Reason No. 2: The board of directors
Turning to the board of directors, this group is supposed to be the shareholders' direct representative with the company, making sure management is working in the best interests of the company and shareholders. Here's part of how the board's been accomplishing that:

  1. Paying $12.1 million to buy a collection of historical maps from McClendon in December 2008, which appeared to be part of a bailout for his margin call. The maps had been hanging on the walls around corporate headquarters for years and all it was costing was some insurance coverage. Why did the company all of a sudden have to buy the maps that month?
  2. Approving an extra bonus of $75 million to him. It was called a "well cost incentive award" in 2008, but it appeared to be part of a bailout for his margin call. "You got into financing trouble? Here's an extra $75 million for showing up each morning."
  3. Reducing McClendon's share ownership requirement in his contract at the end of 2008 after he had to sell 94% of his shares to cover that margin call. "Oh, you violated the terms of your employment contract? Let's change the terms!"
  4. Letting McClendon buy a 2.5% ownership stake in every well the company drills. This is a rare perquisite, according to The Wall Street Journal.
  5. Letting a company that's been a "big financier to Chesapeake" be the biggest lender to McClendon on this newly revealed loan.

Are these the actions of a board looking out for shareholders?

Those are my two major reasons: I trust neither McClendon nor the board to run the company for shareholders' benefit. However, I could also mention:

  • The really low price of natural gas hurting revenue and profit.
  • The fact that the company is spending more obtaining and extracting natural gas than it receives for selling it ("a practice it says is necessary to take advantage of newly discovered shale formations," writes the Journal, which leads me to ask if the company plans to make up for it on volume).
  • The off-balance sheet arrangements that, according to Moody's, come close to doubling the company's reported debt level.

All of these are yellow, if not red, flags for me.

Now tell us what you really think
I don't care how much money you think you can make in this company when natural gas prices go back up -- which won't happen as long as supply outstrips demand. In my opinion, there's too much risk from letting McClendon manage your ownership stake when he can't seem to manage his own private investments, too much risk from the board apparently treating the CEO better than the shareholders it nominally works for, and too much risk from the way Chesapeake is running its business.

I'm staying away from buying Chesapeake Energy shares and I suggest you do the same.

So what energy company should you invest in? In this special free report, we reveal the name of a well-positioned energy stock that should do well for your portfolio. Click here to read further.

Fool analyst Jim Mueller doesn't own shares of any company mentioned. He's an analyst for the Motley Fool Stock Advisor newsletter service. The Motley Fool owns shares of Devon Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy, Moody's, and Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed-up.


Read/Post Comments (19) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 24, 2012, at 5:18 PM, TMFPennyWise wrote:

    So if we are long on CHK would you recommend selling now?

  • Report this Comment On April 24, 2012, at 5:46 PM, markstevewalker wrote:

    I guess you must have had a bad experience with CHK, but why try and make your subscribers(Me), who own their stock, pay for the idea of you not getting paid to invest with CHK. The pen can be a powerful tool, if its held by a responsible or irresponsible operator. Thank you for ALL of your help Fool.

  • Report this Comment On April 24, 2012, at 6:25 PM, schnappsicle wrote:

    Somebody once said "Buy when everyone else is selling, and sell when everyone else is buying." CHK is a prime example of that winning philosophy. What's not to love about a $30 stock selling for just over half that amount? I'm all in.

  • Report this Comment On April 24, 2012, at 6:54 PM, car1020 wrote:

    Wish i knew who was really right on this. I have some shares and will take a small loss but have not read anything good about this man ( second article in less than a week) and THAT makes me mad! Why did the FOOL who recommended CHK in the first place not know about this ceo!

  • Report this Comment On April 24, 2012, at 6:57 PM, 102971 wrote:

    I believe that TMF recommended CHK last Spring at a considerably higher price but I don't recall any "sell" recommendation. When did you last recommend selling this stock?

    I actually bailed out earlier this week (taking a loss based upon your earlier buy recommendation) and I'm glad to be out of it.

  • Report this Comment On April 24, 2012, at 8:06 PM, wmtworker wrote:

    I bought chk at 35 should i sell?

    At least i only have 15 shares ,still a big loss for me.

    I.m better at buying low now.

  • Report this Comment On April 24, 2012, at 8:13 PM, wmtworker wrote:

    Another cramer and motley fool recomendation i bough at the time was alcoa.

    I have much more faith in it eventualy recovering and making money.I own more of it.I'm scared to buy more though.Any advice?

  • Report this Comment On April 25, 2012, at 12:00 AM, TMFGebinr wrote:

    Thanks, everyone, for your comments and reading my article.

    No, I did not have a bad experience with the stock. I'm not trying to make you do anything, except think more about the risks of investing in this company. If you're fine with the risks I've outlined, I wish you the best of results. But I think the risks outweigh the potential gain and I gave arguments in support of that.

    Yes, buying when everyone is fearful can be a successful strategy, but I don't think so in this case. Sometimes stocks drop for a real and valid reason.

    I'm studying for the CFA Program Level II exam right now and going through what due diligence should be done for fixed income investments. Interestingly enough (though probably not if you think about it), a lot of that is what equity investors should be thinking about, too.

    For instance, one characteristic that bond investors often worry about is the character of the company. After all, they want to the return of the money loaned to the company, so making sure that they're loaning to the best of people is advantageous. Is the board of directors and management working for the shareholder and other stakehoders (which tends to lead to growing company value and the ability to pay off the loan) or are they working for themselves (which tends to destroying company value and a distinct lack of paying off loans)?

    The agency problem (management works for shareholders, not themselves, though they are often motivated to work for themselves to the detriment of shareholders) should always be a concern for equity investors. Too often, however, this issue is overlooked as people often intend to be owners of the company only for the short term. Yet even for that short period, poor management and board decisions can negatively affect the value of the company and your investment.

    My argument is that for Chesapeake, the agency problem has become so large that it should scare you away from investing in this company. There are other, better run companies out there to make money on in natural gas or oil.

    Jim

  • Report this Comment On April 25, 2012, at 8:55 AM, Minow wrote:

    CHK ,

    is only one-in approximately 14k listed and OTC stocks traded in the markets, so for the lack of a better analogy, or put another way its the equivalent or a tree in a forest or trees, and some people can't see the forest because of the trees! Your money would probably be better invested in Master Limited Partnerships (MLPS) that trade in oil and gas, or what ever your interest maybe that's out performing its index and the S&P500. If CHK is really that bad, and I have no reason to doubt this article, why throw good money down a rabbit hole? I been there and done it, that's partly the reason I'm here now. If it were me, I would re-evaluate the situation if I were long and scale out of CHK if it were possible on a up swing in the market and cut my losses--cash for the coming correction or fire-side-sale, (but that's me) in the end you're the one that has to make that decision---live to trade or invest another day!

  • Report this Comment On April 25, 2012, at 10:30 AM, Fooginidjit wrote:

    Hmmmm. No answer to the comments about CHK being an MF recommendation and no sell rec. Interesting.

  • Report this Comment On April 25, 2012, at 1:18 PM, okla323264 wrote:

    Where in the heck do you get your facts?

    please show me where CHK loaned him a dime?

    These are his loans, with his assests. This has nothing to do with the company.

  • Report this Comment On April 25, 2012, at 2:49 PM, TMFGebinr wrote:

    102971 and Fooqinidjit:

    Chesapeake is indeed an active recommendation of one of TMF's services. What I write about it, however doesn't dictate what that service's advisor decides to do, though I expect he would take the facts I laid out into consideration. Please read http://wiki.fool.com/Motley for why TMF values different opinions.

    okla323264:

    I did not write that Chesapeake was the lender. McClendon got the loans from several other companies, one of which (the one that loaned him the most) has done significant business with Chesapeake. The wells are owned (97.5%, unless the company has sold stakes to others) by the company and I do not consider them to be solely (or even in the majority) McClendon's assets. His 2.5% stake in those wells is what is used as collateral.

    If he has to default on those loans or renegotiate them for some reason, then the lender can lay claim to partial ownership of those wells or potentially influence Chesapeake in other ways. If he had used his house as collateral, something shareholders do not have a majority claim on, fine. It still would have been stupid, in my opinion, but at least he wouldn't have exposed Chesapeake (and therefore shareholders) to the risk that some other company could lay claim to company property or dictate terms favorable to itself.

    Jim

  • Report this Comment On April 25, 2012, at 2:53 PM, Artis301 wrote:

    What's MF's position on UPL these days? They were big on it a few months ago. It's down quite a bit due to low Nat gas prices. Is it well positioned?

  • Report this Comment On April 27, 2012, at 12:58 PM, jtr1939 wrote:

    Sold all shares just an hour ago. Lost some money but I'll sleep better at night. With proceeds picked up shares of Starbucks and a bit of a discount.

    joni

  • Report this Comment On April 28, 2012, at 12:56 PM, Billybobjoebubba wrote:

    Jim, This is a fine and well composed article.

    "It gets better (or worse)..." It gets worser and more worse. It is a veritable flim-flam a la Maryland et The Chesapeake Bay Power Scammers. It took me seventy years to make my money. Unlike Buffett I believe in "Dynastic Wealth." So worry not my children. The word was out on Maryland. Their citizens have the distinction of paying the second highest rates, in the nation, for their Power. Does this then equate to high profits for share-holders in the companies selling the power? Should I buy in? Let's have a look-see. Research; a mere 5% return in MD! Give me 8 in Tenn. and WI. It gets better or worser? One Bay Power Co.makes application to the SEC for another rate increase for their already over-burdened comsumers. The reason given and accepted was that they need added funds to improve their infrastuture. The money not from share holders but from a rate-hike to the consumers. Next quarter still only 5%. Another rate increase, and again only 5%; chicken feed is a much better investment. So Maryland aka The Tidewater Region, is a hold tight, a wait-and-see situation. Due to their geographic location: from great mountains majesty in the west to the ocean blue in the east with the world's largest estuary in the middle; The Chesapeake Bay, they will, in time be blowing in the wind. There is money in this; wind power. The Feds will contribute,The state will pay, and the meager 5% will become 8? To buy or not to buy? It did not fly on The Cape or The Sister Islands off The Cape; "not in my back waters you don't." The dot orgs, the many Chesapeake environmentalists are loving the wind concept. "With your donations we can pay ourselves fatter salaries, build very green offices, and buy a fleet of green automobiles for all employees." Lies and more lies, it gets worser. They call and cry for wind-power, they march on Annapolis. Power companies will harness the wind and the deal is that the consumer will pay a mere $2.50 more a month for "clean-air." Good deal? Buy now? Still a measley 5%. In Maryland; it is, by the way, known as "The Free State." If a crab or fish smells, then we know it is not fresh and we do not buy and consume. Maryland Power Investments are easy to test. Just sniff, Do they pass the "smell-test?" Where are the massive profits going? Not to the share holders, not to the infrastucture, not for rebooting supplies, I smell rotting blue crabs...

  • Report this Comment On April 29, 2012, at 8:07 PM, lowmaple wrote:

    For those invested in CHK I would suggest you at least hedge your bets buy seeling half then IF it pops or you do break even or at least close as well as diversifying.

  • Report this Comment On April 29, 2012, at 8:42 PM, steamoil wrote:

    To begin with, I don't buy any Chinese stocks, or invest in anything that smells Chinese.So for me to even think of buying CHK would make me a hippocrate . CHK was one of the first US companies to sell US land leases to the Chinese with the purpose of Nat gas drilling. That qualifies him a traitor im my book. If you are going to sell US resources, sell them to more deserving buyers.

  • Report this Comment On May 02, 2012, at 8:15 AM, rwchapman wrote:

    I have trouble understanding how Motley Fool could give this stock anything but a "SELL NOW!" recommendation.

    Chesapeake has to liquidate billions of dollars of natural gas assets in the coming year to remain solvent, and they will have to sell these assets at a time when nat gas is at historic lows relative to crude oil. This is a structural problem that won't be changing any time soon

  • Report this Comment On May 11, 2012, at 2:22 PM, goldozone wrote:

    Oil, Gold, Silver, Platinum, Palladium all down as Natural Gas is up. GO $CHK Long and Strong!!

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