There has been much debate about Linn Energy (LINE) lately. The subject of numerous short attacks, negative articles from Barron's and now an informal SEC investigation, Linn has become a real battleground stock. Linn is a popular stock among distribution income-minded retail investors who have been shaken by this uncertainty. Not able to definitively answer for themselves some basic questions about Linn's business, many have simply thrown up their hands in confusion. As a rule of thumb, upstream MLPs are a bit more complicated than most corporations. And because of its unique hedging, large size and even larger balance sheet, Linn could be the most complicated of all. This could be why many retail investors have been particularly nervous as the shorts, Barron's and now the SEC are circling the wagon.
To be sure, there has already been some great debate on Seeking Alpha, and some great points made on both sides. Personally, I'm a fan of Linn and have been since I started looking at the stock in mid 2012. I've written a couple articles on it, one of which had the terrible timing to be published just an hour after Linn announced they were being informally investigated by the SEC. The purpose of this article today is to answer some of the more pressing questions retail investors have that are floating around right now.
Linn Energy 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.
GAAP Earnings Not An Indicator of Profitability
First of all, those expecting to get a picture of Linn's profitability will be disappointed looking at their GAAP income statement. GAAP measures economic value of assets each year. And they do it in a mark-to-market way. This means that if the market value of Linn's long-lived assets differs from what is on the books, that change must be recorded as an impairment in the income statement.
Last year, Linn had a $422 million impairment on its assets. This impairment wasn't even on equipment or plants, but of the economic value of their oil and gas holding properties. The reason? A decline in oil and gas prices brought about a revaluing of their book. These swings are to be expected.
Mark-to-market rules will also cause Linn in particular to have wild GAAP earnings swings as Linn has purchased put option contracts to lock in oil and gas income for up to five years. When commodity prices change, so do the spot prices for those contracts. So, Linn must revalue its entire hedge portfolio.
Without the asset impairment, Linn would have shown a small GAAP profit. Have a look:
In addition to the asset impairment, there were heightened Depreciation and Amortization expenses this year at over $606 million. Much of this seems to be in relation to Linn massively expanding its hedge book this year due to acquisitions and production growth. The premiums for Linn's puts must be paid up front and are recorded in the GAAP income statement. However, their revenues will not be realized for up to five years.
As you can see, these factors all make GAAP earnings less than reliable for most upstream MLPs and particularly useless for Linn due to its put-buying.
What About DCF? Is That A Valid Earnings Indicator?
In a word, no. Not really. DCF stands for Distributable Cash Flow. In Linn's case, DCF is Adjusted EBITDA minus interest expense minus capital expenditure for maintenance. Here's a simpler way to look at it:
Linn DCF = Adjusted EBITDA - (Interest expense + capex for maintenance)
A couple of things stand out here. Linn's interest expense is significant. These upstream MLPs are levered instruments. Amortization (the 'A' in EBITDA) is also a very important metric, especially in Linn's case because they count the substantial puts they buy and classify them as an amortized asset. They do not count the put premium, an important part of their business model, in DCF.
So, Should Linn Amortize the Puts Or Count It Up Front In DCF?
There are really merits for both arguments, but again the issue arises mostly from Linn's practice of put buying. Many MLPs buy a put to get a floor and buy a corresponding call to establish a ceiling. This is called a collar. The ceiling is put in to mitigate the premium cost of the floor.
Here is where Linn is unique. When hedging, they often simply buy a put to act as a floor. This means Linn must pay much more for their hedging and also keep a substantial value of hedges as an asset on the balance sheet.
Because the puts are classified as amortized assets, the cost of these puts are not included in DCF. This causes the obvious problem of Linn getting the benefit of locked-in cash flow, but does not include its cost in the same equation. We can see, then, how this "loophole" could be abused with put hedging.
But on the other hand, think of the alternative. Linn hedges out for four to five years. Because much of the hedging is puts, Linn would have to subtract the cost of hedges from this year's DCF, even though they are multiple years out. And to make it even more unfair, Linn is in growth mode due to its plethora of acquisitions. In four to five years, Linn will be producing more than it is today. Because they hedge 100% of production, that means they are currently hedging much more than what they produce. Saying they aren't profitable because they've spent to hedge larger, future production amounts is equally unfair. Maybe worse.
So, the issue is not Linn's compliance with SEC rules. I don't think they've broken any. The issue is simply their hedge strategy. It would technically be possible for Linn to "hide" unreasonably expensive hedge costs while publishing nice DCF coverage numbers and then piling on tons of debt on the other end to finance it. Many who alleged this is a Ponzi scheme are saying just that.
No Ponzi Scheme
But that's not what they're doing, and it isn't the case. Yes, Linn has issued equity and increased debt. There is no doubt about that. But it hasn't significantly been done in order to pay distributions. In its history, Linn has taken out $12 billion in debt and equity.
- Only $1 billion was to purchase puts.
- Another $1 billion was to refinance debt,
- but a whopping $10 billion was for acquisitions.
- At the same time, Linn has paid out $2.4 billion in cash distributions since going public.
If Linn were really a Ponzi scheme, they would be spending larger portion of that on acquiring puts. As it turns out, they are issuing debt and equity to grow production and profits, which is what Linn has done over each of the past five years.
This is a system that Linn could abuse, but from what I can see, they simply haven't. As MLP Trader pointed out in his informative artice, the top heavy dynamic between hedges and DCF will continue for as long as Linn is growing production, or perhaps until they change their put strategy. Until then, an investment in Linn means trusting their management will do the right thing.
Must Linn Keep Acquiring or Face Shrinking Production and Distribution Cuts?
This concern has some merit to it, but is very overblown in my opinion. Oil and gas is by its nature a depletive business. The difference is that a corporate E&P will often explore to replenish production. Linn does not do that. Exploration more times than not is unsuccessful and Linn would rather pay distributions.
In exchange for a depletive business with no exploration, Linn dumps its would be exploration budget into distributions. This maximizes the advantage of the MLP structure, because their distributions are not taxed on the corporate level.
So yes, Linn must generally acquire to grow production. Without it, they would look more like a Royalty Trust. But that's not to say acquisitions aren't the best thing to do right now. The accelerated pace of acquisitions over the past few years? Linn does this from a position of strength. Right now there is an abundance of mature assets. The corporate E&Ps are eager to dispose of these assets and plow proceeds into the shale. For upstream MLPs, its a buyer's market with plenty supply. To put it another way, since there's plenty supply, why not acquire and grow?
For those concerned that Linn will eventually deplete all its assets and be left with nothing but a huge pile of debt, that day is a long way away, as long as capital markets stay open. Once the acquisition activity dies down or gets too expensive, upstream MLPs may very well change their strategy.
Is Linn Profitable?
This is really the big question that scares retail investors. If GAAP and EBITDA are not good measures of earnings and DCF does not measure the cost of hedging, at least in Linn's case, how can we know this company is profitable? After all, their debt is ballooning faster than they even pay dividends.
Kicking around a few numbers on last years 10K Annual Report (page 38), we see $1.77 billion in revenues with only about $602 million in fixed and variable expenses (this excludes depreciation, depletion and amortization, much of which is in put premiums, as well as the asset impairment this year). Also consider net cash provided by operating expenses last year. It was nearly $351 million and does account for premiums paid for derivatives.
Based on what I've seen, Linn is very profitable, but its hedge strategy is different. The picture is further complicated by growth and acquisitions, which gives it a top heavy structure. But Linn's substantial distributions, while adding only $1 billion in hedging debt, says that the company does have a viable business.
Is The Distribution Sustainable?
That depends on the metric we look at. As DCF is measured today, Linn will cover its distribution by 1.07 times. However, if we subtract last year's $583 million Linn spent on but buying puts, last year's DCF of $679 million would clearly not cover the $600 million in distributions.
Linn has paid generous cash distributions since going public some seven years ago. Considering that they've spent the vast majority of issued debt and equity to acquire (and not finance distributions), we should assume that their distribution strategy is sustainable.
Yet, the fine print in their 10K report states clearly that they often rely on debt to finance their distributions. So, what gives? It's pretty clear that while Linn's cash flow is enough to pay distributions in the big picture, they do use the capital markets to smooth over their regular distribution cycle. So long as they can continue accessing the capital market I don't see a huge problem with this.
What I'd Like To See Linn Do
- Provide some clarity on new hedging policies
Linn has recently stated they will stop buying puts as a hedging strategy. OK. I am alright with their puts, but this practice has made the partnership a short-seller target. I'd like to know what kind of hedging will replace their puts. Personally, I'd prefer them to follow Vanguard Natural Resources' (VNR) lead by accompanying their puts with calls, establishing a price ceiling and negating much of that costly premium. The "collar" strategy.
I'd also like to see Linn delever some. Consider that Linn's debt is 7.76 times DCF, compared with BreitBurn's 5.28 times and Vanguard's 5.12 times. I believe the market also sees Linn as too levered at this point.
So how can Linn delever? Secondary equity offerings are the most obvious choice, and that might be OK, but it's not unitholder friendly. Personally, I'd like to see something more sustainable, and that is using cash flow to pay down or at least level off debt. As a LINE unitholder, I would not be against halting distribution increases and nibbling down on the debt while DCF continues to grow. I would support a static distribution until Linn's debt/DCF ratio is even with Vanguard and BreitBurn, even if that takes a couple years.
Everything I can see points to Linn being a very profitable business. Unfortunately, GAAP accounting is particularly less useful in measuring Linn's profits. To make things even worse, DCF isn't all that great either. This makes an investment in Linn a certain leap of faith, but in my opinion one worth making. Most of all, Linn is still a valid way to build income.
Comparative debt data by Morningstar, comparative Q4 earnings transcripts from Vanguard and BreitBurn.