There are some investments you should stay away from no matter how attractive they look. Chesapeake Energy
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:
ROA in 2008
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:
- 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?
- 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."
- 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!"
- 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.
- 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.