This Just In: Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

A gas leak at Chesapeake?
Everyone knows that natural gas is the future and that the United States is "the Saudi Arabia of natural gas." But if that's the case, why is Argus Research telling investors to sell Chesapeake Energy (NYS: CHK) ?

After all, if we're the "Saudis" of gas, then Chesapeake must be our Jeddah. At 15.4 trillion cubic feet in natural gas reserves, it may not have the most proven gas reserves in the world, but Chesapeake punches far above its weight class in the contest to actually bring product to market. In the U.S., it's second only to ExxonMobil (NYS: XOM) in the volume of nat-gas produced annually. If gas really is the energy form of the future, it stands to reason that Chesapeake seems a good stock to own for the long-term.

Argus raises a stink
Logical, right? Yet Argus begs to differ. In what TheWall Street Journal yesterday called "a scorching critique," this top-10%-ranked analyst blasted Chesapeake's record of continually spending money it doesn't have to buy assets it doesn't need.

Over the past five years, this company has generated positive free cash flow from its business exactly ... never. It burned $1.8 billion in 2007, $12.4 billion in 2008, $3.2 billion in 2009, $8.4 billion in 2010, and $6.8 billion so far this year. Yet in four of these years Chesapeake had the chutzpah to actually claim it was earning a GAAP profit. Result: With a $15.6 billion market cap today, Chesapeake carries an $11.7 billion net debt load. For comparison, that's more debt than either Apache (NYS: APA) or Anadarko (NYS: APC) carries -- despite the fact that these two companies are both more than twice Chesapeake's size.

Perhaps even more dangerous than what it's done in the past, though, Argus argues that you can't even trust Chesapeake to do what it says it will in the future. Last year, the company promised to keep capital spending in check and control its cash burn by leasing no more than $2 billion on new drilling properties. So far this year, it's already exceeded that cap by $1.8 billion -- and Chesapeake is still spending.

In short, Chesapeake is a loose cannon, it's an imminent danger to your portfolio, and it should be sold.

Let's go to the tape
Now, it's worth pointing out that right now, Argus is literally the only analyst on Wall Street saying this -- but that doesn't mean it's wrong. In fact, according to our records here at CAPS, the majority of Argus' recommendations in the oil and gas industry today are outperforming the S&P 500. And the more I look at the numbers, the more I think we could soon see other analysts coming around to Argus' way of thinking.

Consider: Even if you're willing to overlook Chesapeake's total lack of real free cash flow and generously agree to value the company on its reported "GAAP profits," Chesapeake doesn't look too good relative to its rivals. At more than 12 times earnings, Chesapeake stock carries a higher P/E than any of Exxon, BP (NYS: BP) , ConocoPhillips (NYS: COP) , or Chevron (NYS: CVX) -- each of which boasts considerably greater natural gas reserves than even Chesapeake claims.

Foolish takeaway
To make this stock a safer play on the natural gas future, Argus believes Chesapeake must do several things:

  • First and foremost, Chesapeake must reduce its debt load.
  • It should also "slow spending" on the acquisition of new reserves -- at least until it proves itself capable of generating real cash profits from the reserves it already controls.
  • Also helpful would be if the company cut its distressing level of "off-balance-sheet debt" and rationalize an ownership structure that's "becoming more and more convoluted" through Chesapeake's web of partial ownerships of multiple gas-producing properties.

I agree. In fact, I recently terminated my own "outperform" call on Chesapeake for reasons similar to the ones Argus cites. (I earned a tidy profit, too. Thanks for asking.) If you ask me, barring a quick turnaround in cash burn at Chesapeake and a reduction in its debt load, this stock is dead money for the foreseeable future.

Looking for a better way to make money from natural gas? Read the Fool's new -- and free! -- report onOne Stock to Own Before Nat Gas Act 2011 Becomes Law.

At the time this article was published Fool contributorRich Smithdoes not own (or short) shares of any company named above, butMotley Fool newsletter serviceshave recommended buying shares of Chesapeake Energy (and Chevron, too). You can find Rich on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 308 out of more than 180,000 members. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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