Linn Energy (NASDAQ:LINE) has been under scrutiny from short-sellers in recent months surrounding its accounting practices. The company responded to criticisms, but its share price continues to gyrate in the high-$30s/low-$40s. Though not the cleanest of companies, we think its dividend still looks attractive.
Structure of the Independent Oil And Gas Industry
The oil and gas business is highly competitive in the exploration, acquisition and production of reserves. Changes in deepwater drilling laws and other regulatory initiatives can add uncertainty to operations. The trajectory of global economic growth, the actions of OPEC, and political and environmental uncertainty are other key factors. A strong balance sheet to manage through the commodity price cycle is necessary for survival. With the group's profitability largely driven by the volatile prices of oil, natural-gas and NGLs, we're not that excited about the structure of this commodity-producing space.
Linn's operations are located in the US, primarily in the Mid-Continent, the Permian Basin, Michigan, California and the Williston Basin. We like its exposure to the Permian and Williston basins, but results are volatile due to commodity price swings.
Return on Invested Capital
Linn Energy's Dividend
Linn Energy's dividend yield is excellent, offering just under a 8% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Linn Energy fits the bill thus far.
We think the safety of Linn Energy's dividend is good (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Linn Energy, this score is 2, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow roughly 2 times.
Now on to the potential growth of Linn Energy's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is not the case for Linn Energy. We have them rated as having good growth potential.
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Linn Energy's case, we currently think the shares are fairly valued (its price falls within our fair value range), so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we like the potential growth and safety of Linn Energy's dividend.