Linn Energy (LINE) came under attack again Friday (July 12), dropping nearly 5% after James Kostohryz posted a Seeking Alpha article addressing the company's accounting. The article alleges that LINE "implements a Ponzi-like strategy."
The crux of the argument is this:
Since its IPO, LINE has paid at least $514 million or about 30% more in distributions than it has earned in cash from its operating activities. Thus, as a simple matter of cash accounting, in order to pay the distributions that have exceeded its operating cash flow, Linn has had to raise debt, sell equity and/or sell assets -- all of which are ultimately dilutive to unit holder value.
Here are the cash flow data the article uses ($ amounts in thousands):
In a nutshell, LINE distributed $514 million more than the cash flow it earned from operations. Ouch! As the author correctly notes, cash flow from operations includes premiums paid for derivatives (Put options) as well as realized gains from derivatives. In this cash flow analysis, purchased derivatives are expensed immediately in the year they're bought rather than amortized as LINE likes to do.
So what happened to that $514 million? How in the world did all the analysts (from Merrill Lynch, Wells Fargo, JPMorgan, Raymond James, and others) miss half a billion dollars? The shorts would like you to believe that $514 million was paid out in distributions, or went to line the pockets of greedy executives. Or maybe it just evaporated!
Well, I poked around for about 3 minutes, and found that $514 million just sitting there. Actually, I found a lot more than that. It's right here, on page 91 of LINE's 2012 10K form:
Let me explain. The shorts want you to believe that if you added up all the cash LINE has earned from operations -- including all the money spent on derivatives and all the money gained from them -- and then subtract the distributions, you end up $514 million short. The problem with their analysis is they're omitting the unrealized ending balance of all those derivative transactions, which is a positive number and a heck of lot more than $514 million.
The shorts don't want the derivatives to be counted on the balance sheet as assets that get amortized. They want them to be expensed as they are purchased. Fine. So for this analysis, the net $876 million cash value in the table above shouldn't be counted as an asset, it should be counted as deferred revenue (i.e., cash flow). In other words, if you are taking a snapshot at the end of 2012, analyzing the sum-total historical cash flows of the company, you have to account for the endpoint balance. That is, you need to add any remaining non-amortizable cash-value back in.
In fact, LINE could easily turn this academic exercise into reality by simply liquidating all its Puts and replacing them with swaps. The 2013 cash flow statement would show an extra $600 million or so, and James' $514 million collective shortfall would vanish. (I say $600 million because part of the $876 million net value is in collars and swaps).
The bottom line is that the shorts can't have it both ways: you can't count Put options as a one-time cash expense and leave them on the balance sheet as if they are assets that get amortized. They're either one or the other. If you're counting them as an expense, a fair analysis has to deduct all the money that's been spent, credit all the money that's been gained, AND credit all the cash value that's still on the table.
This is underscored by looking at the actual expenditures for Puts over the years.
|Year||Put Option Expense (1000s)|
The year 2012 should totally jump out at you. LINE made massive acquisitions of nearly $3 billion last year -- and hedged them massively. In fact, LINE spent more on Puts in 2012 than in the previous 4 years! It is this "lumpiness" that allows the shorts to play their deceptive tricks. They want to treat the $583 million as an expense that just vanished into thin air and became a "0" at the end of 2012. So LINE gets dinged for a $583 million expense. But it gets no credit for the five years of future cash flow that "expense" might generate or any current cash value it has at year-end. The $583 million just vanishes! This evinces the problem with expensing Puts.
Now here's the key point of this entire article: for companies with no growth (or very slow growth), the derivative expenses and gains should even out over time. It should all be a wash and James' analysis is totally valid. However, for fast-growing companies like LINE, the expenses repeatedly precede the concomitant gains -- massively so. And that distorts the cash flow picture dramatically. It's particularly dramatic when you have an incredibly outsized expenditure in the most recent year that portends gains that won't be fully realized for five years.
The reality is LINE's $583 million "expense" still had tremendous cash value at year-end. Again, that cash value completely overwhelms everything that was spent (and made) on derivatives in the previous four years. The last 2012 acquisitions weren't closed until the 3rd quarter of the year, so most of those Puts had only aged a few months by year end. As option traders know, longer-term Puts are a lot more expensive than short term. So any puts that were exercised in those few months were immaterial. Worst case, the newly purchased Puts were worth $500 million at year-end. I conservatively estimate the additional Put value from earlier years at $100 million.
Again, if LINE had chosen to hedge its 2012 acquisitions with only swaps and collars, it would have saved $583 million cash in just one year! The supposed $514 million cash flow shortfall would have disappeared and been replaced with a substantial surplus.
A Poker Game with a LINE Short Seller
Suppose you're playing a poker game with a LINE short seller. In the last hand, you have $100 million riding in the pot, and you add another $583 million. That's more than all your money and roughly half the total amount you've bet in all the hands so far. The short seller ends the game in the middle of the hand and declares: "it's time to add up your losses." He notes that all you have in front of you are markers for $514 million. "Looks like you borrowed money and lost!" You protest: "what about my $683 million that's still in the middle of the table." "Well," he says, "you spent that money, so it doesn't count."
In a nutshell, this is what short sellers have done with their analysis of LINE. Again, it's convenient to omit the actual list of derivative expenditures, because the enormously lumpy Put expense in 2012 overwhelms everything that came before it. It's a gargantuan expense for which they allow no current cash value nor any future return.
So let's look at GAAP income. The claims here are similar: "LINE has lost money (net loss) in 5 out of 7 years since its IPO for a total accumulated loss of -$523,083,000." Herewith James' numbers, along with some color that I've added.
Anyone who looks at these income numbers sees the wild swings. That's why I added the other two explanatory rows to the table. Now humor me: before you read below, try to guess what the mystery row is. We'll come back to it in a minute.
Of course, GAAP income has the same problem that we discussed above with regard to cash flow. You have an enormous, lumpy hedge expense at the end of the period in 2012 that overwhelms the earlier years. The problem is the revenue associated with that expense is off in the future and we get no credit for it or for its current cash value.
James maintains that: "in the long term, GAAP earnings and any legitimate estimate of DCF must converge." I agree with this wholeheartedly. But as long as LINE grows at a blazing pace, that won't happen. When you're growing fast and hedging five years in advance, hedging expenses will always precede and outstrip the associated gains.
Now back to the mystery row. Note that the wild swings in GAAP income are "explained" almost entirely by the combination of Put Expenses and the mystery row. For example, 2008 and 2009 had fairly similar Put expenses, but 2009 posted a big loss and 2008 a spectacular gain of nearly $1 billion. The key difference was a very negative mystery number in 2008 and a very positive one in 2009.
If you guessed the mystery row shows the difference between WTI prices on December 31 and January 1 of each year, you were right. You see, LINE's massive hedge portfolio is not considered a cash flow hedge under GAAP rules. So, at the end of each year, the ENTIRE portfolio is marked to market: any UNREALIZED increase in its value since January 1 is counted as income; any unrealized decrease is counted as loss.
Putting it together, annual mark-to-market gains and losses, combined with the hedge expenses, completely overwhelm the actual operating data of the company. The GAAP income numbers give you zero information about what's actually going on in the company. That's why it's pointless to dwell on them and why other metrics like DCF are needed.
LINE is in the unfortunate position of implementing a very profitable business model that most people don't understand. It is far too easy for devious hedge funds and others to capitalize on this and scare naive investors, and then rake in profits on their short positions. Unfortunately, this has even spilled over to other upstream MLPs like Vanguard Natural Resources (VNR), Legacy Reserves (LGCY), QR Energy (QRE).
The hundreds of comments to the "Ponzi-like" scheme articles clearly show this. The errors in the article are fairly obvious to anyone who really understands the business. Yet the bulk of the comments are relatively personal attacks on James from investors who instinctively sense that something's wrong with the analysis, but can't quite identify it. Not one of the hundreds of comments truly fingered the biggest and most palpable errors.
Additional disclosure: I am also short LINE Put options, which I intend to expense rather than amortize.