With Chesapeake's McClendon, It's Not Just Personal

| About: Chesapeake Energy (CHK)

The tattered reputation of Chesapeake Energy (NYSE:CHK) CEO Aubrey McClendon took another hit this week when Reuters reported that McClendon had traded e-mails with executives at rival Encana Corp. (NYSE:ECA), correspondence that appeared to show a bid-rigging scheme for purchasing land in Michigan's Collingwood Shale formation.

Monday's report was the latest embarrassing disclosure for McClendon and Chesapeake; earlier this year Reuters detailed previously unreported borrowing by McClendon against his personal stake in Chesapeake wells. In a series of articles focusing on the Chesapeake CEO, the news agency also reported on McClendon's use of company assets and employees for a personal hedge fund and family vacations.

As I argued in April, McClendon's behavior wasn't all that surprising. In 2008, 94 percent of McClendon's stake in Chesapeake was liquidated due to margin calls on stock the CEO purchased for his personal account, helping drive CHK down 40 percent in a single week in October of that year. In response, McClendon took a $112 million pay package for the year, but still needed to sell his collection of antique maps to the company for an additional $12 million. (That sale was later reversed after a shareholder lawsuit.)

Reaction to McClendon's behavior has been mixed. Private investor Richard Finger wrote a guest post on Forbes.com titled "Aubrey McClendon Must Be Stopped," a sentiment echoed elsewhere (including in many comments here on Seeking Alpha); but Chesapeake itself has only removed McClendon's chairman title. Four directors have resigned, a move in part instigated by major shareholder Carl Icahn; but the company's largest shareholder, Southeastern Asset Management, appears to have thrown its continued support behind McClendon. Southeastern head Mason Hawkins went as far to say last week that the company was worth $50 per share, and headed to $100. Given that CHK closed Tuesday at $17.05, Hawkins is clearly standing by the company -- and, by extension, McClendon.

Personally, I find McClendon's behavior distasteful; even offensive, if I'm feeling self-righteous enough. Personally, I feel that McClendon's aggressive lifestyle has impacted shareholders too many times for investors to grant his company their hard-earned money. Others disagree. McClendon's tolerance for risk has resulted in a series of failings over the past few years; but, as his defenders note, he has also built an $11 billion company that employs over 10,000 people using the same full-bore aggression. Indeed, it appears the market as a whole remains split. CHK has seen a number of sharp one-day drops in response to the Reuters pieces; but the stock still sits 28% above its lows from mid-May, as many analysts and investors see value in the company's wide-ranging portfolio and are bullish on the company's upcoming asset sales. CHK remains down 23% year-to-date, but it's hard to blame the entire drop on McClendon's public troubles; multi-year lows for natural gas have affected the entire sector. Competitors like Devon Energy (NYSE:DVN) and SandRidge Energy (NYSE:SD) are down 11% and 27% YTD, respectively, without the drama surrounding Chesapeake's 2012.

But lost in the criticism of McClendon's personal dealings is the fact that his professional strategy of late has not fared much better. The asset sales -- which may reach $14 billion in total -- result from Chesapeake's need to raise capital simply to cover its operating expenses. (The company is expected to have a shortfall that could reach $22 billion by the end of 2013.) Those asset sales are a direct result of the company's strategy, led by McClendon, to amass as much acreage, as many wells, and as many reserves as possible. Chesapeake's 2011 letter to investors details the many "bold" steps the company took in its aggressive expansion, even noting that the company's "investment opportunities over the past few years have exceeded our cash flow from operations." (It's worth pointing out that it's not just "the past few years"; CHK has outspent its cash flow in 19 out of the past 21 years.)

Chesapeake has spun the asset sales as an attempt to re-define the company as a leaner, more focused operation. According to The Oklahoman, McClendon told the company's recent annual meeting:

"We now move into a phase of asset harvest from seven years of asset identification and capture...It will become a completely different company to invest in."

The paper also quoted McClendon telling analysts in early May, "The payoff for this corporate transition we have under way should be increasingly clear."

But there is no evidence that Chesapeake's strategy is anything but a desperate bid to recover from the aggressive acquisitions of the past few years, as lower natural gas prices and a retreat of the natural gas "land rush" have lowered the value of the assets acquired during Chesapeake's spree. McClendon himself clearly had no intention of decelerating, as evidenced by this quote from the 2011 shareholder letter: "We believe U.S. natural gas is the most under-valued asset in the world, and it represents a once-in-a-generation investment opportunity."

Yet now, Chesapeake is selling some $14 billion of its stakes in this "once-in-a-generation" opportunity. Not by choice; not by plan; but because it has to. Because the bill for McClendon's strategy over the past decade has literally come due, and it amounts to something in the range of $22 billion.

Chesapeake must now sell its assets under pressure, into a natural gas market that still remains at its weakest point in years, with its negotiating position hampered by the public knowledge that it simply must sell to maintain its existence. Yes, its diversified asset base will allow the company some flexibility; but Chesapeake only carries about $40 billion worth of plant, property, and equipment on its balance sheet (including depreciation). The idea that Chesapeake will be able to cherry-pick its non-essential or less-desirable properties and still raise $14 billion is absurd. The company must sell at least 35% of its existing net asset base; there is no doubt that some coveted acreage will have to be a part of the company's streamlining process.

Even shareholders who can look past McClendon's personal failings, and excuse his nine-figure pay packages, now-suspended well participation program, and potential conflicts of interest must realize that McClendon's supposed "visionary" status must be called into question. The acquisition spree of the last few years has simply failed, as evidenced back the stock's return to 2005 levels, and the cash crunch facing the company. Yes, CHK is trading below its book value; but what kind of price can a publicly flailing company get for its assets? How much will book value deteriorate as assets are sold and the cash immediately goes out the door to keep the lights on? And how many more assets will have to be sold if natural gas stays below $3 (with crude well below $100), or if natural gas prices fall back towards their lows earlier this year?

There is more risk for Chesapeake investors than just another negative disclosure about its CEO's personal life -- a risk that on its own calls the Chesapeake bull case into question. Indeed, Aubrey McClendon's highly leveraged personal life has now cost Chesapeake shareholders dearly twice in the last five years. The cost of his extending that same strategy to his company has yet to be paid.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.