After the close on July 1, 2013, Linn Energy (LINE) and LinnCo (LNCO) issued a press release announcing an informal SEC inquiry regarding its use of non-GAAP financial measures, a hedging strategy and Linn Energy's proposed merger with Berry Petroleum (BRY). This has led some to say Linn Energy is a Ponzi-like scheme, and within the Master Limited Partnerships [MLPs] space, more would also blow out. I think this is a serious accusation and way out of line, at least regarding Linn Energy. The inquiry by the SEC was private and non-public, and Linn Energy decided to disclose it was ongoing. The SEC stated that the inquiry does not indicate that it has a negative view of the partnership.
First, I think it's important to understand what is a Ponzi scheme and its implications. According to Wikipedia:
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going.
Linn Energy does have a higher than average yield, but this by itself does not mean it is a Ponzi-like scheme. There are other companies that have higher yields, and investors don't question if they have a Ponzi-like nature. For instance, consider Frontier Communications (FTR), which yields about 10%. This is even higher than Linn Energy's yield before the recent sell-off, but obviously Frontier's business model isn't questioned just because it has a high dividend yield. One could question its sustainability and how the company is financing this dividend, but to question its business model just because of its high-yield I think is overstated.
Another argument is that Linn Energy's distributions are growing over time, therefore it must be a Ponzi-like scheme. Again, this is clearly misleading, as the partnership maintained distributions unchanged for several quarters from 2008 to 2010, showing it is not immune to crisis. Other companies also maintained or even increased their dividends during this period, so does that mean they are also Ponzi-like schemes? For example, McDonald's (MCD) increased its dividend in the last quarter of 2008 when the financial crisis was at its peak, so McDonald's should also be questioned if it is a Ponzi-like scheme?
For Linn Energy to be a Ponzi-like scheme its distributions are necessarily funded by equity or debt capital raised from investors, rather than cash flow generated from its operations. The partnership says its debt and equity issues history is justified by its growth through acquisition strategy. Indeed, since its inception in 2003, the partnership has spent about $14 billion in 58 acquisitions, and raised $6.4 billion of equity and $5.4 billion of bonds. Therefore, there is a funding gap of $2.2 billion that was funded by the partnership's cash. For Linn Energy to be a Ponzi-like scheme, the money spent on acquisitions should be equal to the capital raised through equity and debt, and it isn't. Remember, in a Ponzi scheme "perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going," something that did not happen in Linn Energy's case throughout its history.
Another argument is that Linn Energy's declining reserve base should be a red flag. Exploration and Production [E&P] assets are declining assets, and in order to grow the distribution E&P, MLPs must bring on new production or acquire assets to more than offset the decline curve. However, growth through acquisitions is risky, because while acquisitions are a necessity, the pace and speed of Linn Energy's acquisition program accentuates the risk related to successful execution and integration. Also, for valuation purposes, this implies that one cannot treat the partnership as a going-concern. If for instance one is using a net present value model through discounted distributable cash flows [DCF], this means one should use a forecast period of 15-20 years with no terminal value, with the assumption the company does not perform acquisitions in the future. I don't see any reason here to think that Linn Energy is a Ponzi-like scheme.
Regarding its valuation, given the yield focus and lack of taxes at MLPs, the implied EBITDA multiples for MLPs look rather high in comparison to other companies. This probably means that MLPs are not bargains, but to suggest they may be a Ponzi-like scheme seems stretched. Upstream MLPs trade primarily on a yield basis, with a yield discount applied to traditional, midstream MLPs due to the commodity price exposure inherent in the revenues and depleting asset base. Historically, Linn Energy traded at a premium to its upstream peers, due to the 100% hedged cash flows and track record of strong distribution growth. Therefore, its higher yield than some of its peers and E&P C-Corps seem to be justified.
For all the above reasons, I don't think Linn Energy is a Ponzi-like scheme. Its business model is sound but risky, and that is why it offers a high yield. Given the uncertainty the SEC's inquiry brings to the Berry Petroleum transaction, a lot of volatility should be expected over the next few months. Currently, Linn Energy's yield is above 11%, which is naturally attractive, but may also signal a distribution cut may lay ahead. Therefore, income investors should be aware that until the inquiry is resolved, Linn Energy is a high-risk bet.