Linn Energy (LINE) is an independent oil and natural gas company structured as a Master Limited Partnership [MLP]. The Company's properties are in the United States, primarily in The Granite Wash: the Texas Panhandle, Oklahoma and Kansas. They also have properties in the Permian Basin, Michigan, California and the Williston Basin of North Dakota. Linn is currently working on an acquisition of Berry Petroleum (BRY) which will add significant acreage in California, the Permian and a few other places. This transaction will be a centerpiece of Linn's growth strategy. Linn's greatest draw to retail investors is its high distribution yield. It currently yields 8.74%.
Linn is under attack. Of all the upstream MLPs, Linn now has the highest short interest. Its short ratio of 4.9 is much higher than its peers. Rumors abound about the shorts using Barron's magazine as a platform to knock the stock down and cause Berry to walk away from this stock-based transaction.
The patient investor should fully expect this transaction to go forward. Everything we've seen thus far says it will. This is just short term noise. There's no doubt, however, that long-term, income-oriented retail investors are rattled by the volatility in Linn. Especially because many just aren't sure how to value upstream MLPs.
This article will attempt to put forward some ways in which to value Linn Energy and other MLPs, particularly those involved in production of oil and gas. We may then get a handle on just how low Linn Energy will ultimately go.
Method 1: Price/Distributable Cash Flow [DCF]
Though DCF is a non-GAAP number, price/DCF would be the most obvious choice for a valuation metric. DCF is seen as a sort of "real earnings" for MLPs, especially because it is a more accurate reflection of what these partnerships can distribute to shareholders. How DCF is measured can vary slightly between partnerships. For Linn, it is the following: Adjusted EBITDA (including effects of hedge positions) less interest expense and maintenance capex. Linn's "Growth Capex" is not included.
How low can it go?
Linn trades at 10.67 times next year's expected DCF. At first blush, that seems cheap, but there's one problem: Most upstream corporations are cyclical, meaning that low P/Es are often a sign of high earnings, and hence peak price. Would this be right for Linn? Or does Linn's thorough, long-term hedging make it more of a secular stock? In that case, 10.6 times would be cheap, and at a more "normal" Price/DCF of 16, LINE could be as high as $52.50.
Secular or cyclical, which one is it? Because these upstream MLPs are less than ten years old, at this point it's hard to say. In four to five years we should have a better picture.
Method 2: Economic Value Added [EVA]
Economic Value Added, or EVA, is not quite as widely used as P/E ratio equivalents. But I believe EVA to be particularly valuable for upstream MLPs due to their leverage and acquisitive nature.
In its most basic form, EVA reflects the value a company can bring by measuring its own profitability vs. the rate of debt it has taken out. Here, it is the earnings yield (100/price to DCF ratio) less the cost of debt. So, let's do the math: 100/10.67 comes out to 9.37. Linn's approximate cost of debt is 6.75% on average. That gives us about 2.6 percentage points of EVA. That's about the same as a major competitor, BreitBurn (BBEP).
EVA metrics also shed light on the interest rate dynamic, which is important to the leveraged MLP. Higher rates will squeeze EVA metrics, particularly for new acquisitions, which upstream MLPs need to frequently do. When the earnings yield cannot overcome a higher cost of debt for an acquisition, the upstream MLP can get caught in a nasty trap of depleting assets and no way to replenish them. Given Linn's advantage of a lower capital cost than its peers, they would be the last to fall victim to this contingency.
So, how long can it go?
If the 10-Year Treasury eventually hits four percent, which is 1.5 percentage points, or 150 basis points above the current rate, Linn's cost of new debt would rise perhaps by the same 150 basis points. To compensate, their earnings yield would have to rise to about 10.75 to keep the same EVA number. Assuming DCF stayed the same, we would need a stock price of $30.60, a drop of 7.8%. Obviously, there are many variables here. Perhaps rates go up more. Maybe less. Perhaps DCF grows. For the sake of simplicity, I think $30.60 could be a good floor.
Here are some other interesting things to note. At 16 times DCF, the EVA number is negative. Also, with an EVA of 2, a slight, and arguably deserved premium to competitors like BreitBurn, Linn's stock price would be $37.60 all other things being equal. This represents an upside of 13%.
Method 3: NPV 10 Per Share
NPV 10, or projected cash flows from hydrocarbon assets discounted at 10% per year, is another common way to value upstream companies. As of the last report, Linn's PV 10 sits at $6.07 billion on the 65% of their reserves which are proven. If we include all of their unproven reserves, PV 10 would be $9.33 billion. It's interesting that Linn's market cap is now $7.8 billion, near the middle of those two numbers. Assuming the company is worth only $6.07 billion, we would be looking at $25.82 per share, a massive drop of 22.2%. The maximum would be $39.69, and increase of 19% from here. We're now right in the middle.
I've gone over three plausible valuations for Linn Energy today, which I believe can also be applied to other upstream MLPs. For Linn, price/DCF is inconclusive. EVA valuations show a little more upside than down, and NPV 10 numbers are just about even. While all of these estimations are rough ones, they do point to a fair valuation right here.
With this in mind, I may have been too bullish in previous articles. I do believe that Linn will ultimately complete this acquisition, thereby banishing the short sellers to whence they came. I also believe there will be growth in both DCF and distributions in the future. Linn Energy may not be the screaming buy that I thought it was earlier, but their story is a compelling one. They will reward patient, brave shareholders.