There has been a vociferous debate on the merits of Linn Energy (LINE), both on the pages of Seeking Alpha, as well as veteran publications like Barron's. Whether you are long, short, or have no position in the underlying securities, this is a fascinating debate in which investors are learning a lot about the MLP sector, energy stocks, financial analysis, and accounting. I am not going to do a detailed forensic analysis of the accounting issues surrounding LINE; others have attempted to do that at Seeking Alpha and there are plenty of comments debating the issue back-and-forth.
What I want to do in this piece is a Big Picture analysis of where I think Hedgeye Risk Management and other naysayers of Linn Energy and the E&P MLP sector are in error. Hedgeye's objections are here; Leon Cooperman of Omega Advisor's retort to Barron's is here, and the original Barron's article that accelerated the battle is here.
I am not an accountant. I am not able to forensically delve into the arcane corners of the tax code and determine if the financial and tax accounting of publicly-traded corporation are accurate to the nth-degree. But I am a Chartered Financial Analyst who has looked at numerous income statements, balance sheets, and cash flow statements in my 20 years of analyzing companies and managing portfolios. I have seen my share of rock-solid companies with fortress balance sheets. I have seen troubled companies with stretched balance sheets. And I am pretty confident in stating that while some of the valuation questions raised by Hedgeye are worthy of discussion (at least when LINE was $40 a share), some of the most controversial pronouncements are wrong in their most extreme assumptions regarding Linn Energy and Linn Co. (LNCO).
Hedgeye's analysis from their website purports to show that Linn Energy is guilty of financial sleight-of-hand and overly aggressive use of accounting. There is no doubt that LINE has utilized its balance sheet and M&A to grow production, reserves, and market capitalization in recent years. But there is nothing wrong with this practice as large amounts of oil and natural gas properties are being divested by other Master Limited Partnerships (MLPs), Exploration and Production companies (E&Ps), and large integrated oil companies. The question is whether LINE is masking and hiding certain costs through the acquisition process (something Barron's has detailed over the years with other companies, most notably Al Dunlap and Sunbeam).
I believe a fair-minded analysis will show that while you can make a case that Linn Energy is masking some costs and boosting distributable cash flows (DCF) at the margin, the amounts in question are not material. Certainly, they do not warrant a 40% sell-off in the share price of a stock, which was at a mild premium to the peer group of E&P MLPs. This was not some MLP-version of Amazon.com selling at 3x her growth rate and 4x the P/E ratio of her sector peers. I also believe that Linn has been fully compliant with GAAP accounting practices but more importantly, the obsession with GAAP is misplaced when focused on the new brand of E&P master limited partnerships. Finally, I believe some of the more toxic allegations regarding "Enron-like accounting" and "Ponzi" schemes, as well as NAV estimates unworthy of a 1st-year business school student, are completely unworthy of discussion.
Here are 5 major flaws in the Hedgeye analysis, followed by an understanding of the E&P MLP sector that explains the underlying rationale for Linn's business and financial strategies.
First, is Hedgeye's obsession with GAAP accounting. They admit that Linn is fully compliant with GAAP, Generally Accepted Accounting Principles. Note the terminology: GAAP. It is not called SSAP, Super Specific Accounting Principles. "Generally Accepted" means that there is a degree of variance tolerated that is within established norms. Is LINE's accounting within those established norms? I believe they are. Specifically, the issue of the put options that hedge production is one that amounts to about 10% of the purchase price of LINE's previous acquisitions. Because LINE is only willing to do these M&A deals by hedging out close to 100% of future production using swaps (which have no cost) and puts (which do have costs), it seems like a reasonable cost to consider part of the purchase price and which can be capitalized based on GAAP.
As an example, in the case of technology and software companies, often 30% of the purchase price is allocated to questionable R&D, customer lists, patents, goodwill, etc. I never hear the words "Enron" or "Ponzi" used with regards to the hundreds of technology and software deals that have been struck in the last 20 years with such a high overhead cost. Why the fixation on LINE's 10-15% additional capital expense? I would agree that if LINE were tacking on an additional 30% or 50% to the purchase prices then this amount would be material and should be immediately amortized. But 10-15% seems reasonable since Linn's stated policy is to hedge 100% of acquired production. This is the hedge to the growth variable that Linn has chosen to moderate swings in production, revenue and cash flows (you would think a publication with a name like 'Hedgeye" which caters to hedge funds would appreciate a firm that actually hedges).
GAAP earnings are usually but not always confirmed by cash flows. In the case of the cable TV and cell phone industries during their build-outs in the 1980's and 1990's, GAAP earnings were nonexistent while the slow, methodical building of the infrastructure took place. For this reason, a focus on EBITDA and other cash flow measures was considered more relevant. GAAP EPS understated the financial viability of the companies and sectors. If you waited for GAAP financials to turn profitable for John Malone's Telecommunications Inc., you missed out on 3 decades of 32% annual stock gains. If Hedgeye believes that an investment in LINE or MLP stocks must be validated by GAAP accounting, this is not true.
GAAP earnings were not confirmed by a focus on EBITDA or cash flows on the negative side, too. A classic example of the latter involved retailer W.T. Grant, which was still showing earnings through the 1974-75 recession even as it hemorrhaged cash before finally declaring bankruptcy in 1976. GAAP EPS is a calculation derived from both cash and non-cash components intended to fully and fairly reflect the economic circumstances of a company. The goal is NOT to most accurately describe the cash flow-generating power of a company, a task reserved for the cash flow statement. This means that when measuring dividend or distribution coverage, the key number is not EPS, but rather cash flow per share. In the case of Linn Energy, the recent cash flows are not 100% sufficient to cover distributions, but they are much closer to full-coverage than a focus on static GAAP accounting. Hedgeye's reliance on GAAP as a substitute for the cash flow statement is wrong.
One firm's estimate of recent DCF coverage ratios for LINE:
Hedgeye says that "… LINN is not a very profitable enterprise on a GAAP basis. But on a non-GAAP basis, it is a DCF machine. We believe that the GAAP financials reflect reality." I disagree and believe that LINN's accounting more accurately reflects both the economic earning power as well as the cash generating ability of the company. Are there certain optimistic or aggressive assumptions baked into their DCF, cash flow, net income, production, or reserve forecasts? ABSOLUTELY! Show me a single company that doesn't have an upbeat forecast on their future results - better yet, show me a single company telling investors to avoid their stock because things are about to get tough. You can't and they won't.
In the case of traditional E&P companies (as opposed to LINN's less-risky business model), some have a success ratio of finding oil and natural gas in the 30% range yet they will tell you they are "optimistic" on virtually 100% of their current wildcat exploration projects. LINN is acquiring proven properties, hedging 100% of the production, and plowing most of the surplus cash flow back to unitholders (shareholders). They are conservatively estimating they can grow production and cash flows mid-to-high single digits, perhaps mid-teens in some years. This is quite modest compared to some E&Ps promising the moon and 20-30% production growth as far as the eye can see. This conservative growth forecast within the conservative MLP structure and the desire for DCF and revenue/cash flow predictability is behind the hedging strategy at the heart of the Linn Energy controversy.
The second problem I have with Hedgeye is that LINE was able to utilize swaps for about 65-70% of the production hedge with puts accounting for about 30-35%. Hedgeye says that this boosts DCF and violates basic accounting principles because the benefit of the put options is used to boost GAAP income and cash flow but no costs are being realized. Again, this is not a black-and-white issue and why it is called GENERALLY ACCEPTED accounting principles. While it is true that LINE is getting the benefit of the put options via revenue, income, and cash flows (because the hedges are above current prices for oil and natural gas), it is also true that the same effect could have been achieved using no-cost swaps or even no-cost collars (see the DCF coverage ratios with and without put options, above).
The expenditure on the put options - reflected in the purchase prices of the acquired properties - is also being reflected in both (1) higher interest expense and (2) a higher share count, which requires a distribution and dilutes current shareholders. So Hedgeye is absolutely wrong when they say that capital raises are being recycled into DCF used to reward shareholders. This would be akin to saying that Mortgage REITS or REITs or traditional MLPs are using equity (or debt) offerings to pay dividends, when it is usually to grow the business (or assets under management). For most executives "bigger is better" (especially as it relates to compensation). If MREITs, REITs, or MLPs did not want to grow then they could engage in persistent stock buybacks. But that is not what their business models were created for. They want to grow their MBS portfolios, buildings, or reserves.
The economic impact of derivatives used to hedge production falls under the cost of additional debt and equity securities used to fund the transaction. Deducting the expenses from cash flows would represent a form of double counting, which is why they were capitalized into the acquisition price. Plus, the put options allow a company to protect downside but maintain some upside from higher commodity prices.
Lastly, the total amount of purchased put options pre-Berry (BRY) was just under $1 billion. The criticism is that this additional cost to the purchase price for acquired properties is not being expensed, that it is being "hidden" in the original purchases made by LINE. But the cash flow statement would not be affected because it is a non-cash charge. And the income statement, which would be affected, would not have an annual weighted cost of capital charge - either higher interest charges (more debt) or more DCF for a higher share count (if equity was raised) - had the puts not been utilized. In fact, if you assume that debt financing was used 100% to finance the put purchase, the annual interest charge is essentially equal to the alleged annual shortfall in DCF, about $60 million annually.
Merrill Lynch ran a 'what if' scenario in which all the put options were replaced by swaps. The impact to DCF was negligible:
Please note that while it looks like Linn is reaping a financial windfall because of the swaps and puts, it was just a combination of fortuitous timing and Linn's policy of hedging out as far as possible at the highest point on the futures curve. This has helped Linn in recent years relative to other MLPs or E&Ps that did not hedge as aggressively. If spot natural gas prices rise the next few years, Linn's big advantage disappears relative to competitors. If spot prices should rise rapidly in the future, Linn Energy will be able to hedge in the future at even higher prices, but immediate production will not be as profitable as that from firms which did not hedge all of their near-term production.
My third major disagreement with Hedgeye is their fixation on GAAP accounting to value the earnings and NAV of LINE. As mentioned previously, GAAP EPS can overstate a company's profits (W.T. Grant) or understate it (the cable TV industry in the 1970s and 1980s). LINE is paying out approximately 100% of cash flows as distributions. Is Hedgeye aware that oil and gas E&Ps on average spend 140% of cash flows on far riskier drilling prospects that often involved speculative wildcatting with a success ratio as low as 30-40% ? LINE is acquiring established and largely successful properties, with only minor downside risks in production, reserves, and drilling costs.
Without the need to wildcat, the company has elected to plow back the surplus cash back to investors in the form of distributions. In this case, LINE is serving both of its masters: the MLP structure (through a high payout for retail investors) and the E&P growth-oriented business model that LINE has chosen (through acquisitions financed by debt and equity and the use of swaps/puts to hedge production). John Malone and the cable industry invested their cash flows back into their businesses with long lead-times to free cash flow payback for the company and investors. MLPs, including LINE, have elected to use a portion of their present cash flows - sometimes most of them - to reward shareholders in the present. Different strokes for different folks!
E&Ps have traditionally been free cash flow negative, often destroying shareholder value, again with long payback times for investors. Why is LINE being criticized for acquiring low-risk properties, hedging out the commodity and/or basis risk, and then spending most of the surplus cash on her shareholders? Would it be better if LINE followed a pure E&P model and spent the cash flows on future growth, pursuing risky projects around the globe? LINE management is not looking to be the next EOG Resources (EOG) or the next Chesapeake Energy (CHK). They believe in a low interest rate environment that MLPs have a favorable retail constituency and that the E&P model can work well within the MLP framework to produce a low-risk, moderate-growth, retail-friendly yield vehicle. With hundreds of spin-offs, divestitures, and new acreage available in coming years, it seems a reasonable and sustainable business model that does not have any near-term expiration date. Certainly, it is less risky than trying to compete with The Big Boys among the E&Ps or the supermajors.
For this reason, the range estimate for NAV of $5 - $18 is ridiculous. With a recent stock price before the controversy close to $40/share, there is a huge difference between having a downside of 50% and one close to 90%. Amazon.com (AMZN) might be overvalued at $300, but would someone say it is worth anywhere from $30 - $150 a share? Hedgeye and the short-sellers seem to have taken the worst pricing for proven reserves and used this to estimate NAV. It totally leaves out the value of the LINN business model as well as additional potential reserves, which easily measure in the billions of dollars.
Natural gas sold for less than $2/mcf for part of last year and I am not going out on a limb by saying that the next $3 in the price of natural gas is UP and not DOWN. Even if the traditional content parity with oil does not return, the infrastructure buildout in the United States should alleviate the regional gluts that have depressed the price. Increased use of natural gas from homeowners, American businesses, and the relocation and planned "on-shoring" of petrochemical and other energy-intensive industries back to the United States bodes well for natural gas demand going forward. Should prices approach $5/mcf within a few years and hedging prices inch closer to $6/mcf, the economics and reserve estimates for companies like Linn Energy -- even with her recent "oily" additions like the proposed Berry Petroleum -- will be a major positive to earnings, cash flows, production, and reserves. Reserves are volatile even for well-established firms with nearly a century of experience and the best geologists: a decade ago, Royal Dutch Shell (RDS.A) (RDS.B) was forced to write-down nearly 20% of her total global resources.
Merrill Lynch performed an analysis recently and using fair prices for proved and potential reserves came up with a conservative estimate of about $30/share for NAV ($5 higher if you include the hedge book that Hedgeye does give LINE credit for). Numerous other sell-side firms, most with no investment banking relationship to Linn, came up with similar valuations. The write-offs of previous reserves are largely a function of the depressed natural gas price the last few years (another reason to applaud the hedging program). If oil and natural gas prices rise, reserves bounce back. If they remain depressed, then the stronger currency afforded by LINE/LNCO should allow for accretive M&A from struggling E&Ps and/or divested properties. The $18 NAV estimate looks like it was based on worst-case assumptions for every key financial variable. But the $5 NAV estimate looks like it was based on Armageddon-like assumptions, akin to valuing Coca-Cola (KO) in a world where soft drink consumption was limited to a 1/2 can per person per day.
My fourth problem with Hedgeye's analysis and that of the shorts is the criticism of LINE for using "financial engineering" to pursue its growth and distribution strategy. There is no allegation that this is illegal, just that they are being 'aggressive.' But again, many companies have utilized the tax code to minimize payment of cash taxes. Berkshire Hathaway (BRK.A) (BRK.B) and Warren Buffett -- who revels in telling the rest of us we need to pay more in taxes -- is itself involved in numerous tax disputes in excess of $1 billion according to recent 10-K filings. Many companies have relocated to low-tax states within the United States or even overseas to minimize taxes; Apple (AAPL) was recently grilled on this before Congress. The aforementioned John Malone has been very aggressive - and praised by Barron's - for his use of various corporate structures and tracking stocks which have unlocked value for shareholders while minimizing taxes for his corporate vehicles, himself, and fellow shareholders.
The MLP structure eliminates the corporate income tax because all cash flows are taxed at the shareholder level. For this reason, long-lived assets that throw off steady income with minimal volatility were the preferred vehicle when the MLP structure was originally conceived: infrastructure, pipelines, etc. The rise in recent years of the E&P format within the MLP structure is a compromise between the two contrasting business models. Using cash to make acquisitions has long been Warren Buffett's preferred way of making acquisitions. But using a strong currency to buy cheap assets has also had its place in American financial history.
Jimmy Ling perfected the art of 'bootstrapping' in the 1960s with LTV Corporation: using a high-priced currency stock to buy cheaper companies, which would then have their assets revalued higher at the new currency's higher P/E ratio. It worked perfectly for LTV and other conglomerates until rising inflation, interest rates, and reduced asset prices stopped the merry-go-round during the early-1970s. But today's E&P MLPs have a seemingly endless supply of consolidation opportunities from new and forthcoming shale plays, E&P spin-offs and drop-downs, and sales from the supermajor oil companies. They are also acquiring properties that become more efficient with scale and are similar in composition (a natural gas field in the Marcellus is not much different than one in the Eagle Ford). So the unwieldy nature of different businesses that doomed the Conglomerate Era is not likely to reappear with the upstream MLPs. And because of the MLP tax shield at the parent level, MLPs trade at a premium to C-corps and this helps facilitate the M&A referenced earlier:
(Click to enlarge)
Finally, my fifth major objection to the Hedgeye analysis is with the bashing of LNCO, the C-corp holding company for LINE units. LNCO originally traded at a discount to LINE, now it trades at a 17% premium as of July 12th. Yes, conceptually the two should probably trade closer to parity but why does that mean that LNCO must fall in price -- perhaps LINE will rise to equalize the discrepancy? But there were valid reasons for LNCO to move from a discount to a premium relative to LINE. Any retail investor will tell you that dealing with the tax and accounting issues regarding a K-1 from an MLP which operates in multiple tax jurisdictions and states can be a major headache. MLPs are also not suitable for tax-deferred accounts like Traditional or Roth IRAs. Finally, institutional investors are historically hesitant to purchase MLPs because of those same issues.
By creating the LNCO stock structure all LINE did was utilize the existing tax code to create a more shareholder and tax-friendly structure that would help its retail-shareholder base and also help with future acquisitions (target companies may similarly prefer the LNCO currency over LINE). They did nothing wrong, and one can look at tracking stocks, A and B shares, and family-controlled companies which are much greater violations of shareholder rights than the LINE-LNCO dual class structure. Linn Energy does not control the premiums or discounts of the two respective share classes. And any future tax leakage would be an annoyance but not fatal to the stated nominal yield of LNCO relative to LINE.
The yield on LNCO is 180 bp. less than LINE because of the price premium, but both yields are ridiculously large relative to where they were a few months ago. The spread will no doubt narrow once the stock prices normalize. But if investors are willing to take less yield with LNCO for the convenience of being able to purchase in a tax-deferred account, and even if that yield is reduced a few basis points in the future from possible tax leakage, why is Hedgeye upset with an investor preference for a slightly lower yield with simplicity?
Having explained some of Linn's business decisions and their counter-argument to Hedgeye, let's see why Linn has chosen those practices and why the E&P MLP sector has seen such rapid growth.
As you know, MLPs have traditionally sought long-lived assets from which to throw off generous income streams for retail investors. The E&P format within the MLP structure is relatively new, made possible by the higher multiple afforded to E&P MLPs relative to their targeted acquisitions. MLPs have been stellar performers since 2009 as retail investors have sought out yield plays:
Linn has steadily increased her dividend and is forecast to do so in the future:
The lower cost of capital for LINE and for the E&P MLPs in general has been a big advantage in allowing them to do accretive acquisitions:
E&P MLPs should continue to trade above their C-corp peers and have a lower cost of capital. Their business is lower-risk as the MLPs acquire low-risk properties, minimize exploration risk, and then hedge out most of the production to reduce commodity risk. The companies then pay generous distributions instead of reinvesting in growth or wildcatting opportunities. Finally, the MLP structure eliminates the double-taxation issue.
The short attack and misconceptions regarding the upstream E&P variant to the MLP structure has left the entire sector trading at low valuation metrics:
BreitBurn Energy Partners (BBEP) and Vanguard Natural Resources (VNR) are two sister upstream MLPs that have similar business models to Linn and have been caught in the crossfire. But the entire sector's DCF ratios are still not much below the MLP sector average, despite all the worries surrounding LINE and the E&P MLPs in aggregate:
As with LINE and LNCO, the upstream MLP yield spread has widened tremendously in recent months, and you can see that relative to the AMZ MLP yield here:
Conclusions: the sector is a relatively new creation within the MLP space, and both historical operating results as well as investor comfort will take some time to develop. The upstream MLP business model is less risky and volatile than the traditional C-corp E&P vehicles. Shale properties, E&P acreage, and even large integrated oil companies provide the future growth opportunity for the E&P MLP sector, as those properties are not core or of material size to move the operating needles for their current owners but are desirable for the E&P MLPs. The entire market capitalization is small, and so is the retail and institutional shareholder base. Other MLP stocks, including heavyweights like Kinder Morgan Energy Partners (KMP), went through similar growing pains many years ago when they too were much smaller and their business models were similarly questioned
Add it all up, and while the future looks bright, the confusion regarding financial and accounting issues raised by Hedgeye has clouded the short-term picture. But other GAAP income-losing sectors like cable TV and cell phones had their detractors regarding the sustainability of 'losses' and the use of EBITDA and other adjusted cash flow measures. Today, these companies generate income and cash flows by any measure you choose to measure by.
Investors who keep the faith should be amply rewarded by investing in this burgeoning sector in general and Linn Energy in particular.