Big mergers always come with the promise of supercharging future returns. However, the stock market is littered with the worthless paper of mergers that went bust. Synergies never happened, sales' growth never materialized or something beyond management's control made profits evaporate. While any of these risks could doom a future buyer of Chesapeake Energy (NYSE:CHK), the company's closet full of secrets are what should really worry any future acquirer.
Massive risks can be hiding in the unlikeliest of places
Over the years a number of notable mergers ended up costing the acquirer billions of dollars years later when an unknown risk came back to bite. For example, in 2000 Chevron (NYSE:CVX) paid $36 billion to buy Texaco only to discover that there was a $19 billion future contamination judgment hiding in an Ecuadorian rainforest. That judgment has been sliced in half to $9.51 billion and more recently a U.S. judge ruled that the original judgment was acquired through corrupt means. However, there is still a risk that Chevron will one day have to pay billions of dollars thanks to its acquisition of Texaco.
Anadarko Petroleum (NYSE:APC) is another company that was hurt by a hidden liability. It will now have to pay out a multi-billion dollar settlement relating to an acquisition it made years ago. Anadarko spent $18 billion to buy Kerr-McGee in 2006, however, a few short years later a $25 billion lawsuit emerged due to the toxic past of a former Kerr-McGee unit. That payout was eventually reduced to a range of $5.15 billion to more than $14 billion before Anadarko settled last week for $5.15 billion.
The skeletons in Chesapeake Energy's closet
Most of these were unknown risks at the time of the acquisition. That's really worrisome as Chesapeake Energy has a number of already known risks that could one day come back to haunt a would-be acquirer. For example, one skeleton in its closet involves possible collusion with Encana (NYSE:ECA) to bring down the price of leases in Michigan. Just recently the state of Michigan charged both Chesapeake Energy and Encana with collusion. If found guilty Chesapeake would be forced to pay a fine of up to a million dollars.
However, beyond that Chesapeake Energy could also face federal charges under the Sherman Antitrust Act. Criminal penalties can be up to $100 million or in some cases up to twice the amount lost by the victims of the crime. Needless to say given the billions in leases signed during the land rush, Chesapeake Energy and anyone that acquires the company could face very stiff penalties in the future.
Another skeleton also began to recently emerge from Chesapeake Energy's closet. In this case the state of Pennsylvania is looking into whether Chesapeake is aggressively charging landowners for "post-production costs" so that it doesn't have to pay as much in royalties to the landowners. In one case the Wall Street Journal found that Chesapeake Energy deducted 37% of the royalty payment for expenses relating to shipping the gas on pipelines. However, Anadarko Petroleum, which was a partner in the well only deducted 18% from its share of the royalty payment while another partner didn't deduct any costs. Again, if Chesapeake Energy is found to have been aggressive, it and a future acquirer could face stiff penalties.
Beyond that there is no telling what other secrets could still be hiding. Chesapeake was one of the most aggressive companies pursing the land-grab and subsequent drilling boom. It entered into a number of transactions that included off balance sheet arrangements. An article by Pro Publica, for example, noted that the company had as much as $36 billion worth of these arrangements, including $17 billion in long-term gathering agreements. The company, for example, has a number of volumetric production payments, or VPPs that could come back to bite the company, or again, the company that someday buys Chesapeake.
None of this is to say that Chesapeake Energy is actually guilty of any of the accusations, nor that its off balance sheet arrangements are a problem. However, there is the risk that these emerging risks, or something yet unknown, could one-day represent a massive liability. That's why I'd be careful not to over allocate an investment in Chesapeake Energy, which is just what a would-be acquirer would be doing as any one of Chesapeake Energy's past dealings could come back to bite.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Chevron. 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 has a disclosure policy.