Linn Energy (LINE) is not a Ponzi scheme. It's just another MLP. But like too many MLPs, Linn has systematically implemented Ponzi-like strategies that are designed to capitalize on investor desperation for yield in a zero-interest rate environment.
In my previous article entitled, "Linn Energy: Many Ponzi-Like Blow-Ups To Follow", a few readers vehemently objected to my use of the term "Ponzi-like" to describe various aspects of LINE's business strategy. In that article, I discussed several aspects of LINE's Ponzi-like business strategy; in this article, I will focus on only one: Unsustainable distributions.
First, let me define exactly what I mean by a "Ponzi-like" strategy. In my view, any company that claims to only pay cash distributions to investors out of "distributable cash flow" and then systematically distributes more cash to its investors than it actually earns from its operating activities is engaging in a Ponzi-like business strategy. Furthermore, it is my view that any company that utilizes unsound accounting techniques and systematically employs misleading communications to materially misrepresent its ability to support and maintain its distributions is employing Ponzi-like tactics.
In this article, I will demonstrate beyond any doubt that since its IPO, LINE has systematically pursued a strategy of distributing far more to unit holders than the company has earned from its operating activities, according to the company's own statements of cash flows. Furthermore, I will demonstrate beyond any doubt that LINE management has engaged in obfuscation of this essential fact through systematic implementation of fundamentally unsound accounting techniques combined with misleading communications.
Robbing Peter To Pay Peter: The Proof Is In LINE's Own Financials
LINE management has claimed in several of its investor presentations and filings that it earns sufficient amounts of cash flow from operations to cover distributions. In at least one presentation, LINE management even claimed that the company actually earns "excess" cash flow, even after paying for distributions, that enables it to fund growth. However, according to LINE's financial statements, for most years and for the entire period since the company's IPO, this has not been the case.
Below is a consolidated statement of LINE's cash flows since its IPO in 2006. Immediately below that is a table of all of LINE's distributions to unit holders since inception. These figures are all taken directly from LINE's consolidated statements of cash flows in its annual 10K filings:
What this table shows unequivocally is that between 2006 and 2012, LINE claims to have earned $1,695 million in cash from operating activities, but has paid $2,209 million in distributions to unit holders. Not only does this data prove that LINE has systematically paid out more in distributions than it has earned from its operating activities (according to LINE's own accounting), it proves that LINE has done so by a very large margin in five out of seven years since its IPO. (Please note that the approximately $1.7 billion in cash flows from operating activities cited above include $1.3 billion in realized net gains from derivative transactions and -$1.4 billion in premiums paid for derivatives).
Therefore, it is clear from Linn Energy's own statements of cash flows that any claim that LINE has paid its distributions to unit holders entirely out of the company's cash flow from operations is fundamentally inaccurate. Since its IPO, LINE has paid at least $514 million or about 30% more in distributions than it has earned in cash from its operating activities. Thus, as a simple matter of cash accounting, in order to pay the distributions that have exceeded its operating cash flow, Linn has had to raise debt, sell equity and/or sell assets -- all of which are ultimately dilutive to unit holder value.
I say that LINE financed at least $514 million in distributions with equity and debt issues because, for reasons discussed in a separate report, it is quite possible that at least some capital expenditures that LINE has booked as "cash flows used in investing activities" have been misclassified and that they should have been booked as "cash flows used in operating activities." The upshot is that LINE classifies "maintenance capex" as an operating activity and expenses these outlays as incurred, while it capitalizes "growth capex" and books it as an "investing activity." If LINE has indeed classified outlays as "growth capex" that are more properly classified as "maintenance" capex," then cash flows from operations are even lower than the $1.7 billion that the company has reported in its statements of cash flows. Furthermore, non-GAAP "distributable cash flow" would have been correspondingly lower since "maintenance capex" is by definition deducted from DCF. All of this, of course, would mean that LINE's distributions have historically been even less supported by underlying cash flows from operations than the shortfall already indicated by the company's statements of cash flows. This also would necessarily mean that LINE's distributions have been financed by equity and debt issues to an even greater extent than the $514 million implied by simply taking LINE's cash flow reporting at face value.
Please note that this is not a case of "robbing Peter to pay Paul." This is case of robbing Peter to pay... Peter. It's a case of LINE feeding its unit holders with the company's "seed corn," thereby impoverishing unit holders in the long run. That might have been acceptable if the company admitted that it was doing this. But this is not the case. LINE management has systematically pursued a misleading communications policy of assuring its investors that it is only feeding unit holders with surplus corn from the harvest.
Linn management has categorically claimed that "LINN does not issue debt and equity securities to pay its distribution." According to LINE's own 10K filings, this statement is simply false. Perhaps LINE management could argue on linguistic grounds that the statement above (and others like it) is not inaccurate in that it is meant to express that it has not been the intent of management to "issue debt and equity securities to pay its distribution." However, based on any common sense understanding, I believe the above statement by LINE management is false and misleading.
In sum, contrary to the disingenuous claims of LINE's management, it is an incontrovertible fact that since its IPO, LINE has systematically utilized cash raised through equity and debt issues to pay distributions. The magnitude of this Ponzi-like maneuver has been at least $514 million (30% of total distributions) since its IPO -- if LINE's statements of cash flows can be taken at face value. The extent of the problem could, in fact, be greater.
How Does LINE Get Away With It? MLP Non-GAAP Accounting
How do MLPs such as LINE get away with systematically paying out high and unsustainable distributions? This is a two-part answer. The first involves what I believe can be characterized as fundamentally misleading accounting and communication practices. The second involves the desire of yield-hungry investors to believe in things that are "too good to be true."
The second factor requires little explanation; psychologists call it "confirmation bias." People tend to see what they want to see and ignore the rest. In particular, in a low interest rate environment, people that strongly desire high yields will search for investments that offer high yields. And in analyzing these high-yielding investments, they will have a strong tendency to see evidence and believe narratives that justify such yields while disregarding the information that might bring the sustainability of those yields into question.
Now, let me address my claim that LINE employs fundamentally misleading accounting and communications practices that prey on the strong desire for high yield.
First of all, it is important to note that all MLPs such as Enbridge Energy Partners (EEP), ONEOK Partners (OKE), Kinder Morgan Energy Partners (KMP), and Kinder Morgan Management (KMR) have to report their financial statements using Generally Accepted Accounting Principles, or GAAP -- just as all publicly listed companies in the US must. However, in addition to providing GAAP accounting, MLPs provide their investors with certain non-GAAP financial accounting information related to "distributable cash flow." This "parallel" accounting by MLPs primarily serves the purpose of justifying the payment of extremely high distributions that are not supported by net earnings under GAAP's exacting standards.
In fact, under the standards of internationally sanctioned Generally Accepted Accounting Principles, LINE has lost money (net loss) in 5 out of 7 years since its IPO for a total accumulated loss of -$523,083,000.
Obviously, in order to be able to justify distributions to shareholders despite this manifest unprofitability, LINE has to employ a different kind of accounting; a type of accounting that is so spectacularly different from generally accepted accounting principles that it can magically transform a loss of over -$500 million into "distributable cash flow" of around $2.5 billion!
This is where non-GAAP MLP-type accounting comes in. In this parallel universe, investors are encouraged to completely ignore net income under international GAAP standards and focus almost exclusively on a non-GAAP construct called Distributable Cash Flow or DCF. This non-GAAP metric is meant to measure the amount of cash that a company can sustainably distribute to shareholders, after accounting for interest expense payable to creditors and the expense of maintaining the company's earning assets (maintenance capex).
In some cases, these non-GAAP adjustments to net income can make economic sense for purposes of measuring the amount of cash that a company can prudently distribute to its owners. For example, for some periods, the depreciation of oil & gas pipeline assets under GAAP accounting can materially exceed the actual deterioration of the asset's cash-generating capacity. In this case, if GAAP net earnings were the only metric employed, the extent of a company's ability to pay sustainable distributions to unit holders would be underestimated. In such select circumstances (which must be analyzed on a case-by-case basis), it may make sense to perform appropriate adjustments to GAAP net earnings in estimating a sustainable level of distributable cash flow.
However, even in the cases where non-GAAP adjustments to net earnings can be justified for purposes of calculating distributable cash flow, the fact of the matter is that in the long term, GAAP earnings and any legitimate estimate of DCF must converge. This is indisputable, since under any legitimate accounting system based on double-entry bookkeeping, all revenues and outlays must eventually be accounted for -- only the timing of recognition can differ. Any accounting technique that fails to properly account for absolutely all revenues and outlays is faulty, if not outright fraudulent.
Therefore, while it is plausible that in any given year an MLP will report DCF that is different from GAAP net earnings, the cumulative difference over a long period of time cannot be very large. In the case of LINE, the magnitude of the difference between accumulated GAAP losses for LINE (-500+ million) and its reported positive DCF ($2.5 billion+) is a huge red flag that there is something fishy going on with LINE's DCF accounting. And indeed, in my companion report, I will clearly demonstrate various fundamentally unsound non-GAAP accounting techniques that have enabled LINE to inflate its reported DCF to levels that are spectacularly greater than its net earnings calculated according to generally accepted accounting principles, and greater than the company's cash flows from operating activities as disclosed in the company's consolidated statements of cash flows.
For example, LINE has admitted in various company filings that for purposes of its calculation and reporting of DCF, it counts 100% of all realized net gains from derivatives transactions as revenues, but that it does not deduct any of the cash expenses incurred from the purchase of derivatives contracts. I discuss this issue in great detail in my companion report. However, the upshot is that for purposes of calculating DCF, it is a demonstrable fact that LINE violates the fundamental principle of double entry accounting: It accounts for the cash revenue generated from derivatives transactions, but not for its cash costs. This sort of unsound non-GAAP accounting explains a good deal of the difference between the enormous ($500 million+) losses that LINE has accumulated since its IPO according to generally accepted accounting principles, and the fabulous amounts ($2,500 million+) of "distributable cash flows" that LINE has touted to its investors.
Again, I am not claiming that the DCF estimates of all MLPs are faulty. The problem is that, in too many cases, MLPs such as LINE have exploited the parallel universe created by DCF accounting in order to pay distributions far in excess of what would be justified based on economic fundamentals.
In this essay, my objective has been to prove two things:
1. Since its IPO, Linn Energy has been systematically distributing more cash to unit holders than it has earned from its operating activities. Furthermore, contrary to management's misleading claims to the contrary, LINE has been financing a large portion of these excess distributions through debt and equity offerings. I have proven this beyond any doubt: According to the company's own 10K filings, LINE has paid for at least $514 million worth of cash distributions (30% more than LINE's reported cash flow from operations) to unit holders with cash raised through equity and debt offerings. The amount of distributions paid with cash from equity and debt offerings might actually be even higher if it turns out that LINE is committing certain other irregularities that I describe in my companion report.
2. Since its IPO, Linn Energy has been systematically misrepresenting its ability to support and sustain its distributions to shareholders by employing fundamentally unsound non-GAAP accounting techniques, and by consistently communicating to investors misleading statements to the effect that it pays its distributions from cash flows from operations and that it does not pay its distributions to unit holders with cash raised from equity and debt offerings.
In my view, any company that claims to pay cash distributions to investors out of "distributable cash flow" while it systematically distributes more cash to its investors than it actually earns from its operating activities is engaging in a Ponzi-like business strategy. Furthermore, any company that utilizes economically unsound accounting techniques (that do not respect the fundamental principle of double-entry) as well as a misleading communications strategy employing accounting jargon (e.g., "distributable cash flow") that materially misrepresent its ability to support and maintain distributions to investors, is engaging in Ponzi-like business techniques.
Therefore, by way of the fundamental common-sense standards that I have defined above, I fully stand by and reaffirm my claim that LINE has been engaged in Ponzi-like business practices.
None of this is written in order to encourage readers of this article to short Linn Energy or Linn Co. (LNCO), nor even to sell them if they hold either in their portfolios. At present point in time, trading in these stocks is likely to be highly volatile and speculative as short-sellers attempt to variously push the stock down and simultaneously cover (buy) their positions in order to secure a profit.
At the same time, it is important to note that LINE stock is seriously overvalued, as detailed in my preliminary draft report entitled "Upstream MLP Valuation: Preliminary Draft Valuation Analysis". Furthermore, the ability of LINE to continue to carry forward its "greater fool" strategy of acquisitions premised on its high valuations and good standing in capital markets has suffered a serious and perhaps grievous blow.
Even if the SEC absolves LINN of legal wrongdoing, the indisputable fact will remain that Linn Energy has been systematically paying distributions that are not supported by its operational cash flows, and that a large percentage of distributions have been paid in part, or in whole, through a policy of escalating equity sales and debt increases. Furthermore, it will be difficult for the company to live down the now established fact that it has materially misrepresented its distributable cash flow and therefore its ability to support and maintain its distributions to unit holders.
Finally, greater awareness of the issues that are affecting LINE could have a material impact on the entire MLP sector going forward as short-sellers are actively searching for "the next Linn Energy" in a sector that is full of significantly overvalued companies, and not a few that have been employing very aggressive practices to inflate distributions to unit holders.