One of the most important filters or criteria for investing in a stock for Warren Buffett and Charlie Munger is the quality of management. No matter how cheap the stock gets it is always very risky if it is run by a CEO who certainly sees the company as his personal bank account and its board turns a blind eye. Chesapeake Energy Corp (NYSE:CHK) suffers from this problem.
It is understandable that supply and demand dynamics in the natural gas industry has ensured that Natural Gas prices remain at their lowest price point in decades making Mr. Market punish the pure Natural Gas plays like Chesapeake Energy. But company’s CEO irresponsible behavior is not helping the matters.
Yesterday Chesapeake’s stock declined by as much as 10.2% from already depressed levels, Why? Because Chesapeake’s CEO Mr. Aubrey McClendon and the board of the company goofed up again. Reuters uncovered that Chesapeake CEO has borrowed $1.1 billion in personal loans in last three years against his stake in the company’s oil and natural gas wells as collateral to help finance what could be a lucrative perk of his job - the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings. These loans should have been disclosed by the company to its shareholders. These personal loans against company assets surely create a situation where there is a conflict of interest.
Tomorrow if Mr. McClendon gets into a cash crunch or value of assets goes down and he is not able to sustain the loan payments he may force Chesapeake to sell those assets at unfavorable terms to guard his own interests vs. the shareholders.
The worst part is this revelation of McClendon's bout of borrowing comes as he is scrambling to help Chesapeake avert a multi-billion-dollar cash shortfall amid a plunge in natural gas prices.
Per Reuters, a similar approach was used by CEO of WorldCom Bernard Ebbers. The WorldCom scandal in part was driven by $1 billion in loans Bernard Ebbers took secured by his WorldCom stock and we all know what happened with WorldCom after the dot-com bubble burst. Similar risk exists for Chesapeake as Natural Gas prices plunge to new lows posing high risk to its shareholders.
This is not the first time Mr. Aubrey McClendon behaved in his interests vs. the shareholders of the company and its board has supported him.
- In 2008, to buy more Chesapeake stock, McClendon borrowed money from his brokers further what's called "buying on margin." In October 2008, just after the financial crisis erupted with the bankruptcy of Lehman Brothers, he was forced to sell more than 31 million Chesapeake shares for $569 million to cover margin calls from those brokers. The company's stock fell nearly 40 percent the week of McClendon's share sales. McClendon issued an apology but the company's credibility with many shareholders suffered significantly.
- Again in 2008, at the peak of the crisis, the company’s board decided that it was good to spend $12 million to purchase Mr. McClendon’s antique map collection. This decision was reverted after shareholders filed a lawsuit.
- The same year the board paid Mr. McClendon $75 million in one-time bonus when the whole world was reeling from lack of liquidity.
The company’s stock is cheap and is trading at attractive valuations in comparison to the assets it owns but the history of its CEO and board’s actions do not invoke confidence and make it a highly risky bet. I will stay away until the board puts policies in place which will ensure a shareholder friendly attitude from Mr. McClendon. The only hope I have here is that well-known value investor Lou Simpson (ex-CIO of Warren Buffett’s GEICO) has recently joined the board. Hopefully he will drill some sense into the other members of the board.
Disclosure: I don't own any CHK stock in my portfolio.
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