Over the past several months, Linn Energy (NASDAQ: LINE) and its sister company Linn Co. (NASDAQ: LNCO) have been the subject of intense debate in the media. Particularly since July 1st (the day on which Linn voluntarily disclosed that the SEC had commenced a non-public inquiry regarding the company), there has been a flurry of back-and-forth centering primarily on the way in which Linn treats the cost of certain derivatives in calculating its distributable cash flow ("DCF"). To say the debate has been high profile would be an understatement. It seems that everyone, from a hedge fund that initially stirred the pot to Jim Cramer to the company itself (read presentations here and here) to the SEC, has taken a position on the issues surrounding Linn Energy.
Despite all of the debate, uncertainty about Linn's true value seems to be higher than ever. After closing at $33.29 on July 1st, Linn's unit price has dropped as low as $22 and change and bounced as high as a touch above $28. This extreme volatility begs the ultimate question - what is one unit of Linn truly worth? An interesting starting point in answering that question is to ask what "intrinsic value" Warren Buffett, chairman of Berkshire Hathaway (NYSE:BRK.A), might place on Linn's units using the valuation framework outlined in his 1986 letter to Berkshire shareholders on "owner earnings."
Intrinsic Value Defined
On pages 4-5 of Berkshire's "Owner's Manual," Buffett defines the "intrinsic value" of a business as follows:
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
The intrinsic value of a business, then, is the aggregate amount of cash that can be paid out by a business over the business's lifetime, a metric Buffett calls "owner earnings," discounted at an appropriate rate.
Buffett defined "owner earnings" in his 1986 letter to shareholders as follows:
[Owner earnings] represent A. reported earnings plus B. depreciation, depletion, amortization, and certain other non-cash charges ... less C. the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
Now that we've established Buffett's framework (and ignoring for the time being other Buffett considerations like a sustainable competitive advantage), we can apply these principles to Linn Energy. As will be shown below, the calculation is much more involved than the simple + - calculation described above might lead you to believe. While and can be pulled relatively easy from a company's GAAP financial statements, is much more difficult to calculate or to state with precision.
Calculating Linn Energy's Intrinsic Value
After reading Buffett's owner earnings formula above, a relatively experienced MLP investor who is familiar with the calculation of DCF (which, in this context, is short for distributable cash flow and not discounted cash flow) might think that such calculation is a snap. In fact, Linn (and virtually all other MLPs) appear to do the owner earnings calculation for us.
As an example, take a look at the screenshots below, which comes straight from Linn's Q4 2012 investor presentation. The first screenshot calculates reported earnings plus DD&A and other non-cash charges, which constitute steps in Buffett's intrinsic value formula. Linn calls this + metric "Adjusted EBITDA." (Note that Linn adds back interest expense in Adjusted EBITDA, which is not a part of Buffett's non-cash charges in . However, interest gets backed out again in the next step as shown below, so ignore interest expense in Adjusted EBITDA for now.)
But Linn doesn't stop there. Two slides later, Linn also purports to complete the "owner earnings" calculation for us when it subtracts out of Adjusted EBITDA (i) interest expense and (ii) a metric that it calls "maintenance capex," which is supposed to approximate, the third and final prong in Buffett's formula for calculating owner earnings. (More - much, much more - on maintenance capex in a minute.)
And so it turns out that Linn appears to have calculated owner earnings according to Buffett's + - formula. For example, Linn calculated the owner earnings for the fiscal year ended December 31, 2012 as follows:
- GAAP profit (loss): $386.6 million loss
- Non-cash items: $1,428.3 million (note that a portion of interest expense was non-cash)
- Maintenance capital expenditures to maintain long-term competitive position: $362.4 million
Linn's 2012 owner earnings would therefore equal Buffett's + - , or $(386.6) + $1,428.3 - $362.4 = $679.3 million. If we've calculated owner's earnings, all that is left in our "intrinsic value" calculation is to project future growth and then discount such earnings by an appropriate discount rate, right?
Though the debate about Linn Energy to date has focused primarily on the derivatives issue described in the first paragraph above, relatively scant attention has been paid to an issue of far more consequence to an investor in Linn - maintenance capex. As will be demonstrated below, the maintenance capex number that Linn provides is, by almost any measure, an understatement (perhaps significantly so) of the true maintenance capex required to maintain the long-term competitive position of Linn Energy.
Maintenance Capex Explained
Just what is maintenance capex, and how is it defined? As we've already covered above, Buffett defines maintenance capex as "the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume." For an E&P company, their most important capital assets - the assets from which the E&P company derives its value - are the company's reserves of oil, NGLs and natural gas. Maintaining these reserves from year to year is absolutely essential if the company is to maintain its competitive position (and to consistently produce from the same). Applying this to an E&P MLP like Linn, it seems fair to say that maintenance capex for Linn should be the average annual amount of capitalized expenditures to keep reserves flat from the beginning of the period to the end of the period after accounting for production and other adjustments.
Likewise, Linn Energy defines maintenance capex in a similar way, stating in its April 1, 2013 presentation, that maintenance capex "is defined as the cost to hold reserves and production flat." Linn is referring here to the capex necessary to keep the company's aggregate reserves and production at the same levels at the end of the year as at the beginning of the year. The vast majority of Linn's capital expenditures are spent on acquiring new reserves through acquisition and through the drill bit. Hence, with the exception of a couple of nuances, both Buffett and Linn Energy appear to be in substantial agreement on the definition of maintenance capex. Why, then, can't we just rely on Linn's estimate of maintenance capex and, by extension, owner earnings?
What Happens When Distribution Payouts Are in Excess of Maintenance Capex?
Maintenance capex may have a boring name, but it is vitally important to investors. When a company pays out more in distributions than its "owner earnings," such payouts diminish the company's ability to generate future earnings at a level equal to current earnings. Over the long term, if a company continually pays out in excess of its owner earnings then, absent an infusion of either debt or equity capital, the earnings power of the company's assets will track toward zero until the company has effectively self-liquidated.
Buffett described the consequences of paying out in excess of owner earnings in his 1984 letter to shareholders. Buffett's comments were made in the context of inflation, but the concept (referred to below as "restricted earnings" rather than "maintenance capex") applies to maintenance capex.
[Restricted earnings] cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Most MLP investors recognize the importance of an MLP retaining "restricted earnings" rather than paying them out, which is why MLPs that trade at less than 1.0x their distribution "coverage ratio" usually trade at a significantly higher yield than MLPs with coverage ratios over 1.0x. This is particularly true when an MLP maintains a coverage ratio of less than 1.0x for a lengthy period of time. It's clear, then, that if Linn is understating maintenance capex in a significant way, such that its coverage ratio has been less than 1.0x for a lengthy period of time and management continues to make such payouts into the future, Linn, too, could, as Buffett said, be "destined for oblivion."
A Closer Examination of Linn's Calculation of Maintenance Capex Raises Questions
As it turns out, Linn's calculation of maintenance capex may be based on assumptions with which reasonable investors, perhaps even including Buffett, might take issue. After digging into Linn's calculation of maintenance capex and its public statements about such calculation, we begin to see some questionable assumptions upon which their calculation is based, such as the following:
- Linn's first questionable assumption: Maintenance capex should not correlate with depreciation, depletion and amortization ("DD&A"), even though both DD&A and maintenance capex represent the average historical cost of the oil and natural gas produced with the only difference being the time in which the costs were incurred.
- Linn's second questionable assumption: When allocating F&D expense between maintenance and growth, management should categorize the lowest cost drilling opportunities as maintenance capex and the highest cost drilling opportunities as "growth" capex. Recall that Buffett defined maintenance capex as the average annual amount of capex needed to maintain a company's long-term competitive position, not the lowest.
- Linn's third questionable assumption: Maintenance capex should include only the drilling capital spent to prove up reserves and should not include the cost of leasing the land on which the drilling occurred.
- Linn's fourth questionable assumption: Maintenance capex need not include the amortized cost of puts realized during such period.
- Linn's fifth questionable assumption: Maintenance capex should be based on the cost to add reserves that keep aggregate reserves owned by the company flat from year to year and need not take into account issuances of units during the period for purposes other than growth capex.
The remainder of this article will be devoted to examining the reasonableness of each of Linn's assumptions, and we will then apply our analysis to come up with a value for Linn Energy's common units.
Linn's first questionable assumption: DD&A and maintenance capex are unrelated metrics
As a general proposition, it makes sense that DD&A and maintenance capex should usually be related to one another. Consider as an example a small trucking company that owns ten trucks purchased for a total of $1,000,000. Let's assume the useful life of each truck is 10 years, meaning the owner can take a non-cash depreciation expense of $100,000 per year. Assume that each year one truck wears out and needs to be replaced. The company has taken a depreciation expense of $100,000 for the year. How does this DD&A amount compare to the maintenance capex necessary to replace the truck?
The replacement of one truck each year constitutes maintenance capex for the owner; it is an expenditure necessary to maintain the company's ability to continue providing the same level of trucking services to customers. Wouldn't it make sense that the cost to replace one truck each year (the maintenance capex) would be approximately equal to the amount of DD&A that the owner has taken on trucks in that year ($100,000 of depreciation)? In other words, DD&A is a measure of historical cost of an item; isn't an item's historical cost often a decent approximation of the same item's cost in the future? If so, then we would generally expect that DD&A and maintenance capex are likely to be similar, though not identical, in magnitude.
Furthermore, when DD&A and maintenance capex diverge from one another, we would typically expect that maintenance capex would be higher than DD&A due to inflation. Continuing with our trucking company example above, due to inflation truck prices are likely to go up each year, resulting in the cost to buy a new truck (i.e., maintenance capex) being slightly higher than the annual depreciation expense of the historical cost of trucks bought in the past. Warren Buffett made a similar observation about DD&A usually understating maintenance capex, when he stated in his 1986 letter to Berkshire shareholders as follows:
Most managers probably will acknowledge that they need to spend something more than [the DD&A in Buffett's + - owner earnings formula described above] on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. ... [DD&A and maintenance capex] are not identical, of course. For example, at See's [Candy, a Berkshire company] we annually make capitalized expenditures that exceed depreciation by $500,000 to $1 million, simply to hold our ground competitively.
Both Buffett's observation and the trucking example above lend support to the notion that, at least in most circumstances, DD&A should be a decent, if understated, estimate of the cost of maintenance capex.
Buffet's Statements re: Maintenance Capex for E&P Companies
Interestingly, Buffett has made specific statements about maintenance capex spending by E&P companies. Returning again to Buffett's + - formula for calculating intrinsic value in his 1986 shareholder letter, Buffett stated as follows:
When exceeds , GAAP earnings overstate owner earnings. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only each year, they would have guaranteed their shrinkage in real terms. (Emphasis added)
This seems to imply that, at least during the time period around 1986, if an E&P company spent less in maintenance capex than its expenses in DD&A then it would shrink in real terms. However, only two paragraphs later, Buffett appears to take a contrary position about E&P companies with extremely long-lived assets, saying:
"Cash Flow," true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. (Emphasis added)
Buffett, therefore, appears to separate a "typical" E&P operation whose lifeblood is the steep end of the decline curve, from an MLP line Linn, which lives on the shallow end of the decline curve and which targets long-lived assets with low declines. Hence, for an MLP like Linn, perhaps it does not need to spend more on maintenance capex than it takes in DD&A expense each year. Note, however, that it is not at all clear that Linn's operations are more analogous to an "extremely long-lived gas field" than they are to a typical MLP. Considering that Linn has spent capex of $984 million, $575 million and $205 million on "development of oil and natural gas properties" in 2012, 2011 and 2010, respectively, it is at least debatable whether such expenditures would qualify as "only tiny outlays" (of the type described by Buffett above) after the initial outlay to acquire the properties.
To make matters more confusing, in the very next sentence of the letter, Buffett muddies the waters by saying:
But "cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays. (Emphasis added)
Reconciling these statements, then, Buffett's position on E&P maintenance capex appears to be that maintenance capex for an E&P company will likely be similar to, if not higher than, DD&A over time, (i) an E&P company, as an extractive company, will always have significant maintenance capex, and (ii) for an E&P company with extremely long-lived reserves, cash flow may be a "shorthand" of some use but is still not the correct number to use when performing a valuation of intrinsic value.
In contrast to Buffett's observation about the relationship between DD&A and maintenance capex, Linn Energy takes the position that DD&A and maintenance capex are unrelated metrics. The charts below shows the maintenance capex per mcfe as estimated by Linn compared to the DD&A expense from Linn's audited financial statements during the same period. Note that there is a substantial difference between the two numbers and, in contrast to what we would expect, Linn states that DD&A is actually substantially higher than maintenance capex. (Recall in the trucking company example above that, due to inflation, we would typically expect that DD&A is lower than maintenance capex, not higher.)
As can be seen in the charts above, DD&A expense has stayed relatively flat from 2008-2012 at approximately $2.50 per mcfe. By contrast, Linn's estimate of the cost of the maintenance capex that it has spent to keep reserves flat has been less than $1.50 per mcfe in all periods. The fact that Linn's estimated maintenance capex is 40-60% lower than its DD&A expense, as shown in the chart on the right, should cause a reasonable investor to at least ask some questions about why current costs are so much lower than historical costs. What could account for such a divergence?
Linn's Public Statements on Its Calculation of Maintenance Capex
Linn has made public statements with respect to DD&A and its bearing (or lack thereof) on maintenance capex. On page 6 of its April 1, 2013 presentation, Linn stated the following:
- DD&A and maintenance capex are not the same thing.
- DD&A represents the amortization of historical costs paid for oil and natural gas properties and does not represent the current development costs and specific development opportunities.
- DD&A is higher than maintenance capex for several reasons, including the fact that DD&A does not represent current development costs and specific development opportunities.
Clearly, DD&A and maintenance capex are not the same. As Linn rightfully points out, DD&A is a measure of historical costs over a long period (sometimes far in the past, when costs may have been different than today's costs), while maintenance capex is a measure of the costs in the most recent period only. However, the question is not whether DD&A and maintenance capex are the same thing; rather, the question is whether it makes logical sense that there would be a wide divergence between DD&A and maintenance capex as Linn's numbers show. Put another way, since both DD&A and maintenance capex are measuring the same thing (i.e., drilling and certain other costs) and the only difference between such metrics is the time period during which the costs were incurred, shouldn't they be similar to one another?
Can Increases in Drilling Efficiency and Decreases in Drilling Costs Account for the Divergence between Maintenance Capex and DD&A?
Over the past five years, there have been tremendous advances and breakthroughs in drilling technology, chief among them the widespread adoption of horizontal drilling to increase production per well drilled. Could this be the reason why DD&A, as a measure of historical costs, is substantially higher than maintenance capex, as a measure of today's costs?
As it turns out, the numbers bear this theory out - to some degree, anyway. Just as the price of certain tech gadgets (e.g., TVs, computers, etc.) have come down over time, so, too, does it appear that technological advances have lowered Linn's drilling costs today on a per mcfe basis relative to Linn's historical costs. Take a look at the numbers in the chart below, which shows the aggregate amount of drilling costs Linn has incurred each year since 2007 and the reserves added as a result of that drilling. (Note that these numbers can be pulled from Linn's cash flow statements and the oil and gas note included in each of Linn's annual reports. Note additionally that Linn provided the "Other revisions (net of price changes)" information for years 2009-2012 in its April 1, 2013 investor presentation.)
Source: Linn's annual reports
The red line in the chart above shows Linn's historical costs per mcfe, as reflected by its DD&A expense. In contrast, the blue line shows Linn's current finding and development costs per mcfe (defined as the amount of capex spent in the current year on drilling divided by the aggregate reserve adds net of price changes). As the chart shows, the blue line (current costs) falls below the red line (historical costs) in all years except 2012. Hence, except for 2012, it appears that Linn's drilling costs truly are lower today than they were historically, meaning we would generally expect maintenance capex to be lower than DD&A.
Conclusions re: Linn's first questionable assumption (DD&A and maintenance capex are unrelated metrics)
DD&A and maintenance capex are related metrics. As described above, DD&A and maintenance capex measure the same costs; the only difference between them is that they measure costs over different time periods. In the absence of a material decline in drilling costs over time, DD&A and maintenance capex on a per mcfe basis should be similar to one another. However, as Linn states in its April 2013 investor presentation, there is substantial evidence showing that drilling efficiencies have lowered drilling costs on a per mcfe basis. Hence, the fact that maintenance capex is lower than DD&A on a per mcfe basis does not necessarily mean that Linn is understating maintenance capex.
But Linn claims that maintenance capex is far less than DD&A. That begs our next question - just how much lower than DD&A expense can maintenance capex be? Some readers may notice a strange inconsistency between the chart above (measuring F&D cost vs. DD&A) and the chart immediately preceding it (measuring maintenance capex vs. DD&A). Why is the average cost per mcfe to find and develop oil and gas so much higher in a particular year than Linn's estimated maintenance capex for the same year? After all, maintenance capex is just Linn's estimated cost to find and develop enough oil and gas to replace reserves lost during the year through production and adjustments. Shouldn't F&D expense and maintenance capex approximate one another? Let's address this question next.
Linn's Second Questionable Assumption: When allocating F&D expense between maintenance and growth, management should categorize the lowest cost drilling opportunities as maintenance capex and the highest cost drilling opportunities as "growth" capex.
Based, again, on the disclosure in Linn's April 2013 investor presentation, it is clear that Linn allocates its lower cost drilling opportunities in any year to maintenance capex and its higher cost drilling opportunities to growth capex. In essence, Linn "cherry picks" rather than using the Buffett approach of average annual cost of drilling opportunities. (Recall that Buffett defined maintenance capex as the average annual amount of capex needed to maintain a company's long-term competitive position, not the lowest. The maintenance capex number, then, should reflect the average annual cost to maintain the business over the long term.)
Linn admits to its cherry-picking very clearly, when it states as follows on page 2 of the April presentation:
LINN continually ranks its extensive inventory of future drilling locations and other maintenance activities based on efficiency and implements the most efficient projects in its maintenance program.
By default, then, the least efficient projects undertaken in any year are allocated to Linn's growth program. The chart below shows the per mcfe cost of Linn's maintenance capex, growth capex and F&D costs. Note that, by definition, the F&D costs are just the volume weighted average of the maintenance and growth expenses. In other words, all we're doing is dividing up F&D costs into two piles. We call one pile "maintenance" and it contains the lower cost drilling projects in the company's inventory for that year. These projects are paid out of internally generated cash flow. We call the other pile "growth" and it contains the higher cost drilling projects. These projects are externally financed through either issuing debt or equity. So just how much less efficient are the growth projects relative to the maintenance projects (where efficiency is measured on the basis of how much it costs to prove up reserves on an mcfe basis)? Quite a bit, as it turns out. This difference is illustrated by the difference between the red line in the chart below (which represents the cost to add one Mcfe of reserves through growth capex) and the blue line (which represents the cost to add one Mcfe of reserves through maintenance capex).
Source: LINE Annual Reports ; derived from "Supplemental Oil and Natural Gas Data"
As shown in the chart above, it costs far more for Linn to add one Mcfe of reserves through its growth capex than it does through its maintenance capex - to the point of raising some obvious questions about the extreme divergence in some years between maintenance and growth. Let's take 2012 as an example. Linn spent an average of $2.88 per mcfe of reserves added "through the drill bit" in 2012. As described above, Linn then sorted those overall expenses into two buckets - maintenance and growth. In 2012, the projects that were sorted into Linn's "growth" bucket were 3.87 times more expensive than its "maintenance" projects ($5.69 vs. $1.47 per mcfe).
Even more curious, the average cost to add one mcfe of reserves through its "growth" expenditures in 2012 was extremely high at $5.69 per mcfe. Per Linn's 2012 10-K, even after accounting for Linn's favorable hedges Linn realized an average of only $5.48 of revenue (before any costs are taken into account) per mcfe in 2012 (and would have realized only $2.87 per mcfe without its hedges). In other words, in 2012 Linn paid more to add each mcfe of proved reserves through "growth" projects than it could generate in revenue from the sale of one mcf of natural gas! Put another way, even before any expenses were accounted for, Linn would be in the red on all of its proved reserves added in 2012 through "growth" capex. This is equivalent to a retailer paying Apple $569 for each iPad in its store inventory even though he knows he can only sell it for $548; unless prices improve, the retailer is guaranteed to lose money.
You might be thinking that comparing one mcfe of reserve adds in 2012 to the price Linn could realize on the sale of one mcf of natural gas is an unfair comparison, since the mcfe measures both oil and natural gas and oil trades at such a premium to natural gas on an energy equivalent basis. After all, if Linn was assigning its more expensive (but more lucrative on an energy equivalent basis) oil drilling projects to "growth" then it would be realizing substantially more than $5.48 per mcfe. That's exactly what I thought was occurring ... until I looked at the numbers more closely.
The chart below shows Linn's net reserve adds in 2012 by commodity - oil, natural gas liquids (NGLS) and natural gas. The chart expressly excludes reserve adds as a result of acquisitions, as Linn categorizes all such additions as "growth" capex (hence why they are externally financed). As stated above, because of the extremely high cost of Linn's "growth" capex in 2012, we would expect to see a significant increase in oil reserves from the beginning of the year to the end of the year. That would serve as strong evidence that Linn's growth capex was spent on drilling oil wells and was therefore economic.
Source: "Supplemental Oil and Natural Gas Data" footnote in 2012 LINE Annual Report. The numbers in the grey box show the increase or decrease in proved reserves by commodity type. Note, importantly, that this number excludes reserves added through acquisitions.
The data clearly shows that neither Linn's growth capex (nor any of its other nearly $1 billion of 2012 drilling-related capex) was able to increase oil reserves. In fact, net of acquisitions Linn's oil reserves actually fell by 21 million barrels during the year. Clearly, then, the theory posited above - that Linn's growth capex, which cost $5.69 per mcfe, went toward increasing its (more valuable) oil reserves - doesn't hold water. However, Linn's proved NGL reserves did increase in 2012. NGL prices have historically aligned more with oil prices than natural gas prices, so perhaps Linn's growth capex could still be economical at $5.69 per mcfe if it increased proved NGL reserves.
But that math doesn't work, either. In 2012, Linn realized a weighted average price for NGLs of $32.10 per barrel. Converting the per barrel price realized for NGLs to a per mcfe price (1 bbl = 6 mcf on an energy equivalent basis), Linn realized an average of only $5.35 per mcfe. Hence, we again see that if we believe Linn spent only $1.47 per mcfe on maintenance capex, then we must also believe that the money Linn spent on "growth" capex in 2012 was uneconomic. Put another way, absent an increase in realized commodity prices in the future, each dollar Linn spent in "growth" capex in 2012 will result in less than $1 in future revenue (and far less than $1 in cash flow after expenses).
Surely this is not the case. Surely Linn did not destroy unitholder value through its growth capex. I don't have enough information to be able to prove it, but I strongly suspect that a portion of the growth capex in 2012 will not yield production until 2013 and beyond - thereby skewing the growth capex number higher than it should be (and higher than it has been historically). In addition, the two years in which the spread between growth capex and maintenance capex blew out (i.e., 2009 and 2012) were years in which commodity prices collapsed (e.g., oil in 2009 and nat gas in 2012). The lower natural gas prices in 2012, for instance, likely resulted in an understatement of the amount of new reserves added through drilling (i.e., the "Extensions, discoveries and other additions" line above). Because of the very low nat gas prices, the amount of reserves that would have been economically recoverable through such year's drilling activities were likely lower than they otherwise would have been. Both of these factors likely contributed to the spike in growth capex per mcfe, likely resulting in an overstatement of such metric (i.e., growth capex likely was at least marginally economic). Nonetheless, the absurdities that flow from Linn's cherry-picking calls into question the credibility of its "cherry-picking" approach to the calculation of maintenance capex.
Would Buffett Agree with Linn's Cherry-Picking Approach to Maintenance Capex?
Even if we accept that there truly is a bucket of low-cost drilling opportunities that Linn could take advantage of in 2012, is it correct to categorize them as maintenance capex (completely ignoring the much more expensive "growth" drilling opportunities)?
Recall that Warren Buffett defined maintenance capex as the average annual amount of capex needed to maintain a company's long-term competitive position, not the lowest. Per Linn's own admission, its maintenance capex number is not based on the average annual amount of capex that it needs to spend to maintain its reserves; rather, Linn's maintenance capex number is the result of cherry-picking the lowest cost opportunities. Wouldn't it be more consistent with Buffett's definition of maintenance capex to use average F&D expense, which is by definition the average amount of capex that Linn actually spent in the period to replace production and grow its reserves?
Let's go back to the example of the trucking company described above. Recall that the trucking company has to replace one of its trucks each year just to maintain its fleet. The cost to replace that truck would be deemed maintenance capex. What if next year the company buys five identical trucks rather than one? Clearly, one of the trucks should be considered maintenance (because it maintains the fleet size at 10 and replaces the worn-out truck) and the other four should be considered growth (because it increases the total fleet size from 10 to 14 trucks). Assume the company buys all five trucks at the same time. It gets a really good deal on one of the trucks ($90,000) and a really bad deal on the other four trucks ($110,000 per), for an average price of $106,000. How much should the trucking company consider as maintenance capex?
Using Linn Energy's cherry-picking approach, we would assign the $90,000 truck to the maintenance bucket and each of the $110,000 trucks to the growth bucket. Which number (the cherry-picked $90,000 or the average truck cost for the year of $106,000) is a more accurate estimate of the average annual amount of capex the trucking company needed to maintain its fleet? Which is more representative of the amount that the trucking company will have to spend over the long term to buy replacement vehicles? Which number is more likely to be repeatable over time, year after year? If the lowest number was repeatable in future periods, then why didn't the company repeat it in the present period (i.e., buy all of its trucks at the lower cost)?
Linn might take exception with the analogy above, perhaps stating that Linn knew certain drilling opportunities would generate new reserves at significantly lower "per mcfe" costs than other drilling opportunities. Linn might argue that, if it intended only to maintain its reserves and not to grow such reserves, it would have only drilled the lowest cost opportunities and bypassed the higher cost opportunities. However, at some point in the future, Linn will run out of such low cost opportunities and Linn's lowest cost drilling opportunities will be the "growth" drilling opportunities that Linn decided to forgo. Put another way, whether Linn drills such high-cost opportunities this year or instead waits to drill them five years down the road, in either case Linn will ultimately have to drill them. Consistent with the fact that maintenance capex is a measure of a company's ability to maintain its competitive position over the long term, it stands to reason that when calculating a company's maintenance capex in any given year such calculation should reflect the average annual amount of capex that a company needs to spend over the long term, not just the current year. As discussed above, whether or not higher cost opportunities are bypassed in the current year to keep maintenance capex low in such year, this merely delays, rather than eliminating, these drilling costs. Hence, an investor trying to calculate owner earnings and maintenance capex would likely be better served using average F&D expense rather than using Linn's cherry-picked number.
What would be Linn's distribution coverage ratio if it used average F&D expense rather than cherry-picking its lowest drilling cost opportunities?
If Linn used its average F&D expense for the year rather than including only its most "efficient" drilling projects in its maintenance capex calculation, then its distribution coverage would be significantly lower. The chart below shows Linn's stated coverage ratio for the periods shown as well as its coverage ratio had Linn used average F&D expense to estimate maintenance capex. The blue bar in the chart below shows the company's stated coverage ratio, while the red bar adjust the company's number to account for what Linn's coverage would have been had it not cherry-picked maintenance capex. Essentially, the difference between the blue bar and the red bar represents the "cherry-picking adjustment."
Source: Company filings and author estimates
The blue bars in the chart above show the distribution coverage ratio each year from 2007 through 2012 using Linn's numbers for maintenance capex. Note that distribution coverage using Linn's numbers was well in excess of 1.0x in each year, meaning, if Linn's numbers are accurate, that Linn's ability to maintain this level of earnings was not diminished by the distributions that were paid.
The red bars in the chart above show the distribution coverage ratio during the same period if, instead of using the company's estimate of maintenance capex, we use the average F&D expense for the year (which, as we described above, is arguably more representative of the average annual capex cost to maintain Linn's reserves over the long term than the methodology that Linn uses). Note that using this methodology the company's coverage ratio was substantially lower than Linn's estimates. However, Linn is generally still within the margin of safety. In all years but 2012, Linn's distribution coverage ratio was around or above 1.0x, meaning that Linn was internally financing all of its maintenance capex and that its distributions were truly distributions of excess cash flow rather than a return of capital. So long as the results seen in 2012 are not repeated in the future, Linn's distribution would appear to be safe.
Conclusions re: Linn's Second Questionable Assumption (Should Linn's maintenance capex be calculated on the basis of the cheapest available projects ("cherry picking") or on the basis of F&D expense (which represents the average cost of adding reserves during the period)?)
As described above, Buffett would likely calculate maintenance capex on the basis of F&D expense because it is a more accurate reflection of average costs to add reserves over the long term (which is consistent with the fact that maintenance capex is a metric measuring the long term viability of the company). However, as shown in the chart above, this differentiation is of little consequence in the years 2007-2011, for under either metric Linn has achieved a coverage ratio of at least 1.0x in such years. However, note that the coverage ratio falls dramatically in 2012 to approximately half (0.56x) of Linn's stated ratio (1.14x), meaning Linn's distributable cash flow fell far short of covering its distribution. This is not sustainable over the long term and so is something that investors must watch closely.
Linn's Third Questionable Assumption: Maintenance capex should include only the drilling capital spent to prove up reserves and should not include the cost of leasing the land on which the drilling occurred.
Let's return again to Linn's April 2013 investor presentation, in which we learned a lot about how Linn calculates maintenance capex, including the following:
As we've already discussed, Linn "cherry-picks," counting only the lowest cost projects undertaken during the year when calculating maintenance capex. ("LINN continually ranks its extensive inventory of future drilling locations and other maintenance activities based on efficiency and implements the most efficient projects in its maintenance program.")
- Linn appears to count only the drilling capex when calculating maintenance capex, as is evidenced by the references in Slide 5 ("Drilling Capital Summary") and the numbers derived therefrom.
Conspicuously absent from Linn's calculations (or impossible to determine) is another source of significant cost to Linn - land acquisition costs. I'm referring to the cost to lease the unproved acreage from the mineral rights owners, such as the cost of bonus payments. (For those who are unfamiliar with the terminology used in oil and gas leases, bonus payments represent the amount that the oil company pays to the owner of the mineral rights that gives the oil company the right to drill on the mineral rights owner's land for a period of time.)
These land acquisition costs can be substantial - in the Eagle Ford, for example, companies (not Linn) have paid in the neighborhood of $30,000 per acre in upfront bonuses to landowners. However, similar to the puts Linn has purchased over the years (which are discussed in a separate section below), bonus payments are made upfront and (very likely) significantly prior to the time the company will recognize a benefit. Hence, Linn appears to disregard land acquisition costs when calculating its maintenance capex, probably because such costs were likely incurred in a period prior to the period in which the acquired land was actually drilled. However, the fact that land acquisition costs may have been incurred in a prior period does not make such costs any less real or any less relevant when calculating Linn's actual cost to prove up reserves during the period. After all, but for the past acquisition of land Linn would have had no land to drill (and, therefore, no reserves to add through drilling). Similarly, but for future acquisitions of unproved acreage Linn will eventually run out of probable and possible reserves to drill and will be unable to add substantial reserves through drilling. Clearly, then, land acquisition costs, which are very real costs incurred by the company and are necessary to add reserves during a period, should be included in the maintenance capex calculation as a cost necessary to maintain the long-term competitive position of the company (e.g., future drilling locations).
Undoubtedly, such costs are usually far lower than drilling costs. For purposes of this analysis, let's assume that the cost of acquiring unproved acreage drilled in a period equals 10% of the total drilling capex spent during the same period. The chart below shows DCF and coverage ratio under three scenarios: Linn's own estimates; the "cherry-picking" adjustment described in a previous section (i.e., Linn's estimates adjusted to use F&D expense instead of cherry-picked drilling expenses); and a further adjustment to Linn's stated coverage ratio to reflect land acquisition costs for the period.
Source: Company filings and author estimates
The blue and red bars are exactly the same as in the chart in the previous section. The blue bars show the distribution coverage ratio each year from 2007 through 2012 using Linn's numbers for maintenance capex. Again, note that distribution coverage using Linn's numbers was well in excess of 1.0x in each year, meaning, if Linn's numbers are accurate, that Linn's ability to maintain future earnings power at its current level was not diminished by the distributions that were paid.
The red bars in the chart above are the same as the previous section - they show the distribution coverage ratio during the same period if, instead of using the company's estimate of maintenance capex, we use the average F&D expense for the year (which, as we described above, is arguably more representative of the average annual capex cost to maintain Linn's reserves over the long term than the methodology that Linn uses). The difference between the blue bar and the red bar in each time period represents the "cherry-picking adjustment" - the amount by which Linn's stated coverage ratio is understated after adjusting for the effects of Linn's cherry-picking on maintenance capex.
The green bars show the distribution coverage ratio during the same period if maintenance capex is calculated using both the average F&D expense, which represents only the average drilling capex spent during each period to prove up such reserves, and the cost of acquiring unproved acreage drilled in such period, which we have assumed equals approximately 10% of the total drilling capex spent during the same period. After making both of these adjustments, we see that the high coverage ratio that Linn reports for the period from 2007-2011 shrinks from an average of about 1.20x to just a hair over 1.0x.
While the coverage ratio does shrink, it still appears that the amount that Linn paid out from 2007 to 2011 is sustainable in the long run (even if only by a razor's edge). To circle back to Buffett's intrinsic value formula, the amount of distributions that Linn paid out during that period was almost exactly equal to Buffett's "owner earnings."
However, things changed significantly in 2012. While Linn reported a coverage ratio of 1.14x, we've already seen that by adjusting for the effects of Linn's cherry-picking Linn's coverage ratio drops to a meager 0.56x. This is clearly not long-term sustainable. Adjusting for the costs of acquiring the leases to the land on which the period's drilling occurred, this coverage ratio drops even further - this time to a dangerously low 0.44x.
This extremely low level of coverage begins to get into "red flag" territory. If this continues for another year or more into the future, then the sustainability of Linn's distribution will soon be called into question.
Conclusions re: Linn's Third Questionable Assumption (Should maintenance capex include only the drilling capital spent to prove up reserves and not include the cost of leasing the land on which the drilling occurred?)
It is consistent with Buffett's definition of maintenance capex ("the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume") to include the cost to lease the land on which drilling occurs. Failing to include such costs (which are substantial) in the calculation of maintenance capex understates the actual cost to Linn to drill up the reserves that it adds each period. As anyone who has been around the E&P world knows, you cannot drill on a landowner's land without paying him for the right to do so. These costs can be substantial and are a real cash cost to Linn (though they are incurred upfront and often well in advance of the time period during which the drilling begins). Furthermore, without continuing to lease land, Linn will eventually run out of drilling locations and, hence, the ability to prove up more reserves through drilling. Hence, such costs, which we've conservatively estimated at 10% of drilling capex, must be included in maintenance capex because they are essential to maintaining Linn's long-term competitive position, its reserves and its production volume.
Linn's Fourth Questionable Assumption: Maintenance capex need not include the amortized cost of puts realized during such period.
Linn's Fifth Questionable Assumption: Maintenance capex should be based on the cost to add reserves that keep aggregate reserves owned by the company flat from year to year and need not take into account issuances of units during the period for purposes other than growth capex.
Should Maintenance Capex Be Calculated on an Aggregate Basis or a "Per Unit" Basis?
Linn's public statements in response to "anonymous short sellers" have provided a tremendous amount of (extremely valuable) information to the public about how Linn thinks about maintenance capex. As we've already discussed, Linn, in its April 2013 presentation, has clearly defined maintenance capex as "the cost to hold reserves and production flat." It is clear from the context of Linn's statements that when Linn refers to holding reserves and production flat it is referring to aggregate reserves and aggregate production. In other words, Linn's position, which seems reasonable enough on first blush, is that Linn calculates maintenance capex as the amount of money it must spend to keep the size of the "Linn proved reserves pie" the same size at the end of the year as it was at the beginning of the year.
But do you, as a Linn unitholder, care about the size of the Linn pie in the aggregate or the size of your piece of the pie? Of course, you only care about your piece. While measurement of the "entire pie" might accurately measure value created by the company from the viewpoint of management (e.g., think kingdom building - the bigger the castle, the more the king gets paid), measurement on a per unit basis much more accurately measures value created by the company from the viewpoint of individual unitholders. For instance, if Linn doubles its proved reserves next year would you be happy as a unitholder? What if, to achieve this doubling, it quadrupled the number of units outstanding? Simple math - double the pie split into four times as many pieces - says that management would have destroyed value on a per unit basis.
Warren Buffett has come to a similar conclusion. In his "Owner's Manual," Buffett states that his third business principle is the following:
Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire's average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. (emphasis added)
Applying this concept to maintenance capex, just as Buffett would evaluate value creation on a per unit basis and not an aggregate basis, so, too, would Buffett measure intrinsic value (and, hence, maintenance capex) on a per unit basis and not an aggregate basis.
We will circle back to this concept (that maintenance capex should be calculated on a per unit basis and not in the aggregate) in a bit, but first we must loop in an intertwined concept - a topic about which so much has already been written ... Linn's put options.
Use of Put Options by an E&P MLP Can Be A Good Thing
As a quick aside for those new to the E&P MLP space, most folks view put options (and hedges generally) as a good thing. An E&P company's success in any period really depends on three primary factors:
- Production: oil and gas production during the period;
- Prices: the price at which the E&P company can sell its production; and
- Reserves: the cost to replace and grow its reserves (which is discussed in substantial detail above).
Of these three factors, production and reserves growth are primarily within the control of the company, meaning they can be forecasted with a relatively high degree of certainty. This holds particularly true in the case of a company like Linn that acquires mature oil wells that are producing from the flat end of the decline curve. The price at which a company can sell its production, however, is completely outside of the company's control. Put another way, even if an E&P company flawlessly executes its plans with respect to growth in reserves and production, it will fail (or at least experience significant volatility in its cash flow) if the price at which it can sell its production falls significantly. Volatility of cash flow is the enemy of an MLP, whose (primarily retail) investor base demands predictable and stable cash distributions. In fact, because of the highly volatile nature of commodities prices, the MLP form would not be suitable for an E&P company but for a substantial hedging program.
Linn's Use of Put Options
As has been widely reported, Linn Energy, like other E&P MLPs, buys substantial amounts of puts to put a floor on the price at which it can sell its future oil and natural gas production. There is no malicious intent behind the purchase of these hedges; rather, they are using hedging (very successfully, I might add) to virtually eliminate the price risk, which is outside of management's control, to drastically reduce volatility in its financial results. The chart below shows the magnitude of Linn's purchases of puts, which, from 2007 to present, have cost approximately $1.3 billion to acquire.
Linn has been quite transparent about its hedging strategy. In its February 2013 "Response to Anonymous Short Sellers," Linn states that its hedging goals are actually value enhancing - they reduce commodity price risk, lock in margins, and provide stability in cash flows, among other things. I agree completely with management on this particular point.
Because the cost to acquire puts is considerable (more than $1.3 billion since 2007), Linn externally finances the cost of puts through debt and equity offerings. Again harking back to Linn's February 2013 "Response to Anonymous Short Sellers," Linn states that it has spent in excess of $1 billion to finance its acquisition of puts.
As will be discussed below, my issue is not with the puts themselves but rather with the company's treatment of the cost of such puts when calculating distributable cash flow (item in Buffett's calculation of owner earnings described at the beginning of this article). I believe that management's characterization of the amortized costs of the puts is wrong and results in a substantial overstatement of distributable cash flow and, hence, a substantial understatement of Linn's coverage ratio.
Before diving into this (controversial) area, I want to address two sources of confusion about Linn's GAAP vs. non-GAAP reporting.
Quickly Dispelling Two GAAP vs. non-GAAP Myths
First, we have no reason to believe that Linn's audited financial statements, which are reported on a GAAP basis, are inaccurate. Linn's auditors, KPMG, have delivered an opinion (see page 67 of Linn's most recent annual report) that gives an unqualified opinion as follows:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Linn Energy, LLC and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
This is an open-and-shut case. From a GAAP perspective, Linn reports its hedges consistent with GAAP standards. Linn's auditor, KPMG, is one of the "big four" accounting firms, and none but the most extreme of conspiracy theorists out there would believe that KPMG would jeopardize its brand (and thereby its entire business) by giving an unqualified opinion if it thought Linn was reporting its puts in a way inconsistent or in conflict with GAAP.
Second, there is nothing that prohibits Linn from reporting non-GAAP financial measures in addition to GAAP financial measures. The SEC has even expressly blessed the reporting of such measures and has set out guidelines for issuers to follow. The most well-known is called "Regulation G," and it requires, among other things, that non-GAAP financial measures be reconciled to the most directly comparable GAAP financial measure. A huge number of companies report non-GAAP financial measures alongside their GAAP measures. For example, companies frequently report one or more of the following - PV-10, EBITDA, Adjusted EBITDA, or Distributable Cash Flow - all of which are non-GAAP financial measures. This is another open-and-shut case where there is no doubt that Linn can report non-GAAP financial measures.
Flowchart Illustrating the GAAP and Non-GAAP Treatment of Linn's Puts
The GAAP and non-GAAP treatment of Linn's put options has been a source of contention and confusion. In an attempt to simplify things for investors who do not want to try to wade through the financial statements (and accounting textbooks) to figure out exactly what is occurring, I have put together the flow chart below. The flow chart is meant to summarize key points around Linn's hedging and the impact of the hedging on investors. I strongly encourage readers to read and understand it.
(If you skipped over the flow chart without reading, then I highly recommend you go back and read it.)
As described in the flow chart above, when calculating its GAAP net income, Linn deducts the amortized cost of the portion of puts that mature/expire each year and counts those as an expense. This appears to be the correct GAAP accounting treatment, and KPMG's unqualified opinion (described above) supports this conclusion. Note, in particular, that because the cost of amortized puts is treated as a real expense, net income is reduced by the amount of such amortized puts.
In contrast to GAAP net income, Linn does not reduce its non-GAAP distributable cash flow by the cost of amortized puts during any period. Recall that Linn's most important non-GAAP financial measure, distributable cash flow, measures the amount of cash distributions that Linn can sustainably make in any period. Because the cash costs associated with the amortized puts were made in a prior period, the amortized put expense is a non-cash expense in the current period.
In its February 2013 "Response to Anonymous Short Sellers," Linn made the following statement about how it views the amortization of puts on its ability to make distributions:
LINN considers the cost of puts as a "capital" investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that "depreciation" of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a "capital" expense, and the company views puts the same way. (emphasis added)
The second sentence stated above is remarkable and worthy of additional discussion. Linn is essentially saying that, when calculating EBITDA and DCF, the expense associated with amortization of puts, as a non-cash expense, should be treated in the same way as depreciation, which is another non-cash expense. What is particularly curious about that statement is that Linn, in its computation of DCF and its add back of maintenance capex, de facto acknowledges that at least a portion of the depreciation expense for such period is a real expense. That's why it deducts maintenance capex from EBITDA when calculating DCF. Why, then, shouldn't there also be an add-back for the same real expense associated with the amortized puts? This expense is every bit a real expense, even if the actual cash outlay was in a previous period.
Let's break it down a bit further (and in a simplified fashion).
|Linn's Simplified Calculation of EBITDA and DCF|
|GAAP Net Income|
|+||Non-cash items (including depreciation and amortized puts)|
|-||Maintenance capex (i.e., the part of depreciation expense added back above that Linn considers "real" even though it is non-cash)|
|=||Distributable cash flow|
Recall that in the quote above Linn's management argued that depreciation and amortized puts should be treated in the same way for purposes of calculating both EBITDA and DCF. Yet its words do not match its actions. Linn deducts from EBITDA its estimate for the "real" (and non-cash) expense associated with the depreciation in the period (i.e., its maintenance capex deduction), but it makes no deduction at all for the equally "real" (and non-cash) expense associated with the $1.3 billion of cash it has paid for puts. Which begs the question - if even Linn itself thinks these two metrics should be treated the same, then why isn't there a deduction from EBITDA for the "real" cost of the amortized puts as they've done for depreciation?
The Vicious Cycle Created By Linn's Failure to Add Back Put Expense in DCF Calculation
As described in the flow chart above, Linn's failure to recognize the amortized puts as a real expense has significant ramifications for Linn investors and results in permanent increases in both debt and equity even after the puts have matured. In particular, amortization expense from puts bought in a previous period are a non-cash expense for the current period (even though they were a real cash expense in a previous period). Hence, amortized puts get added back to the DCF calculation, and any amounts realized through in-the-money puts get paid out as distributions to unitholders. Recall that Linn pays for puts through debt and equity issuances. Even though the puts expiring in the current period either expire worthless (i.e., put resulted in a total loss) or in the money (i.e., increased DCF; proceeds paid out to unitholders), the debt and equity used to purchase the puts is still outstanding even after the resulting cash flow from such puts has been paid out to unitholders. Put another way, none of the proceeds that Linn ultimately receives from the puts goes to paying down the debt or buying back the equity Linn used to buy the puts in the first place. The result for unitholders is a permanent increase in debt (and associated interest expense) and a permanent increase in equity (and associated distribution expense and dilution in per unit reserves) with no offsetting future cash flow to cover such expenses.
More debt and dilution in units (and, importantly, dilution in per unit reserves) - certainly a cause for concern. Just how much concern?
Quantifying the Impact of Dilution from Put Options on Linn's Maintenance Capex
We now turn back to the principal established earlier - namely, that, consistent with both Buffett's investment principles and plain common sense, maintenance capex should be measured on a per unit basis rather than on an aggregate basis as Linn does (i.e., the idea that you don't care about the pie size so much as you care that your slice is not being nibbled away by others). As we've just described, Linn's use of puts (and its failure to account for them as a real expense through a "maintenance" capitalization deduction) results in a permanent increase in the number of units outstanding. Using the analogy above, the size of Linn's pie does not increase through the use of puts, but it does get cut into more pieces. The result is that the amount of reserves per unit has now decreased by the amount of equity dilution; your piece of the pie is now smaller. The process for measuring pie piece shrinkage is outlined below.
Step 1: Estimate annual put amortization expense
The chart below provides a (very) rough estimate of the amortized put expenses that Linn has incurred each year since 2007. The column on the far right shows the amount of puts actually purchased with cash in each year (from Linn's financial statements), while the columns on the left are meant to estimate the amortization expense associated with each set of put purchases. Because I am unaware of a way to figure out the actual amortization expense associated with puts in any particular year (if you know of a way, please contact me), I made the simplifying assumption that all puts were amortized equally over five years (including the year in which they were purchased). (Note that for the puts purchased in 2012, I amortized over six years, because the company stated that the puts covered the period from 2012-17).
Source: Company financials and author estimates
As shown in the last row of the chart above, Linn had amortized put expense ranging from $56 million to $193 million from 2007 to 2012. Note, also, that even though Linn has stated that it presently has no intention of buying additional puts in 2013, Linn unitholders will still bear the brunt of approximately $633 million of amortized puts expense during the 2013-17 period. (More on this later.)
Step 2: Estimate the amount of equity issued to finance the amortized put expense
As discussed earlier, Linn finances its puts through both debt and equity. Approximately half of the annual amortized put expense shown in the chart above was likely financed with debt and the other half with equity, as Linn's debt and equity issuances were approximately equal over the same period ($5.6 billion of debt vs. $5.9 billion of equity). Hence, about half of the aggregate amortized expense shown in the chart above during 2007-12 was financed with equity and resulted in per unit dilution of proved reserves.
The chart below estimates the number of units that were permanently issued to finance puts. The best way to read the chart is to compare the second (i.e., highlighted in grey) row, which represents the amortized put expense for the year, with the fifth and sixth rows, which represent the author's estimate of how amortized put expense was financed as between debt and equity (which was based on the ratio of debt to equity issued in each such year). Note, for instance, that in 2008 Linn issued no equity during the year; hence, we assumed that all amortized put expense from that year was made with equity. Similarly, in 2009, there was actually a net paydown in debt and so all amortized put expense from 2009 was assumed to have been made with equity.
Source: Company financials and author estimates
As shown in the last line of the chart above, we see that annual unit dilution was relatively modest, ranging from 0% to 3.5% of total units outstanding at previous year end. In particular, dilution during the last three years has been only about 1% annually. Hence, in calculating maintenance capex on a per unit basis, we should add to the maintenance capex calculated in Section 3 above the cost of increasing proved reserves by the amount of the annual dilution so that reserves per unit remain the same (i.e., between 0% and 3.5%, depending on the year).
The chart below shows the aggregate amount of Linn's reserves at the beginning of each year, as well as the amount of reserves that would need to be added to keep reserves per unit flat during each year. (Note that this chart ignores reserves adds that need to be made to replace production, adjustments, etc., as those are covered in previous sections of this article.)
Source: Company financials and author estimates
The last line of the chart above reflects the aggregate cost to add enough reserves to counteract the dilution in per unit reserves. This is the amount that should be added to the maintenance capex number calculated above in each year, as but for such expense per unit reserves would decline.
Step 3: Calculate Maintenance Capex and Coverage Ratio
The chart below shows DCF and coverage ratio under the three scenarios we've already covered above and a fourth scenario in which we adjust for the cost of "topping up" reserves to account for unit dilution from amortized put expense.
Source: Company filings and author estimates
Essentially, the blue bars above show the coverage ratio that Linn quotes publicly. We then make three adjustments as follows:
- Red bar: Linn's number adjusted for the "cherry-picking" described in a previous section;
- Green bar: Linn's number further adjusted for the land acquisition and leasing costs described in a previous section; and
- Purple bar: Linn's number further adjusted for the dilution to existing unitholders caused by Linn paying out all of the proceeds generated by its hedges each year.
The graph and table above should be enough to make any Linn investor pause. During the 2007-11 period, Linn's distribution coverage was below 1.0x in all years but 2008 (a year in which Linn did not issue any equity and so financed its puts entirely with debt, which was not paid off with the proceeds of the puts and thereby became a permanent part of their capital structure). Even more startling, we see that 2012 coverage went from Linn's stated 1.14x coverage to an abysmally low 0.19x. We've already discussed some reasons why Linn's "as adjusted" coverage may not be as bad as it appears on first blush (though only time will tell for sure), but regardless of whether F&D expense (used for our first adjustment) was artificially high for the year Linn is in dangerous territory.
Why Do We Care About Put Expense? The Company Has Stopped Buying Them, Right?
Some readers may agree with the conclusions above but nonetheless dismiss them on a going forward basis, given Linn's public statement that it has no plans to buy additional puts in 2013. The statement, from the now oft-cited April 2013 investor presentation, says as follows:
LINN has not purchased any puts in 2013 and currently has no plans to do so. If it does not buy additional puts, GAAP cash flow from operating activities is expected to support LINN's distribution and the maintenance portion of its development capital expenditures ("maintenance capex") going forward.
If Linn never again buys puts, then was all of the analysis in this section for naught? I sure don't think so, for two reasons.
First, though some have interpreted Linn's statement above to mean that Linn will never again buy puts, that is clearly not what Linn intended. Rather, such statement was merely a statement of present intention, and that present intention was further limited to one specific future period - the year 2013. Absent something unexpected from the SEC's investigation or an extremely unfavorable market reaction to future use of puts, Linn is, in my opinion, likely to buy puts again in the future. If it accounts for them in the same way it does now, then Linn will continue to pay out in excess of its DCF / owner earnings and Linn's competitive position will eventually deteriorate.
Second, even if Linn never again buys another put, Linn's past sins - huge purchases of puts (costing $1.3 billion) combined with the decision to pay out all proceeds from such puts without reducing debt / buying back equity - will not stop haunting Linn unitholders until 2018. As is shown in the chart below (which is a reproduction of the chart appearing earlier in this article), more than $600 million of puts will be amortized from now through 2017. Unless Linn reforms its ways, Linn will pay out the proceeds it receives from the maturity of such puts - likely resulting in several hundred million dollars worth of additional payouts in excess of DCF and further deterioration of per unit value.
And so the vicious cycle is destined to continue for at least the next five years.
A Couple of Quick Counterpoints Likely to Be Asserted by Linn Supporters and My Rebuttals
Linn supporters may feel the need to advocate two (partial) rebuttals to my analysis of Linn's puts. First, they may assert that Linn has been quite successful in locking in high put prices that benefit unitholders, thereby justifying Linn's actions. Second, Linn supporters may say that much, if not all, of the dilution described above is counteracted by an increase in commodity prices, and this price movement largely keeps Linn unitholders "whole" on a per unit basis despite additional issuances to finance puts.
Linn Counterpoint #1: Linn has successfully locked in puts that have turned out to net proceeds in excess of market rates
Linn appears to have done a very good job (particularly on the natural gas side) of hedging future production at the right time when prices were high, which has allowed Linn to sell its nat gas production at prices that are often substantially higher than the prevailing market prices. Linn cites to this point in its February 2013 presentation (somewhat snarky in tone):
Additional confusion arises when some investors look at the price levels for the company's hedge positions. This is largely due to the fact that most of LINN's hedges were executed when prices were higher. Obviously this is the reason the company hedged in the first place. LINN wanted to insulate the company from just such an event.
I do not deny that Linn's management has a strong track record of entering into puts that enhance unitholder value. Neither do I deny that puts (and other commodity price hedges) are an absolutely vital part of any E&P MLP's strategy.
What I do take issue with, however, is the fact that Linn has historically paid out the entirety of its hedge gain to unitholders as a distribution without holding back some of the proceeds to pay for the hedge. Even setting aside the equity dilution that occurs from such payouts, investors should not lose sight of an even more dangerous issue - Linn is building its debt year by year on an activity that will generate no resulting future cash flow to help pay off the principal (let alone the interest)!
As a thought experiment, consider the following series of events:
- Company X buys $1.3 billion of proved (non-producing) reserves in the current period. Company X finances the acquisition with $650 million of debt and $650 million of equity. These reserves will produce future cash flow for Company X when it sells the reserves in future periods.
- Over a five-year period, Company X sells all of the reserves it previously purchased in future periods for $1.5 billion, resulting in a $200 million gain.
- The Smart Move: Company X's total gain on the reserves was $200 million. Hence, Company X could use $1.3 billion of the proceeds to repay the debt it incurred, repurchase the equity it issued to buy the hedges and still have $200 million leftover to pay out to its equity holders. Value has been created!
- The Linn Energy Move: Company X pays out all $1.5 billion in proceeds as distributions to its unitholders. Company X now has $650 million more equity outstanding (meaning the "pie" has to be split with $650 million of new equity holders). Even more troubling, Company X now also has $650 million of debt with no new cash flow to pay it off or even pay the interest (meaning the pie available to the equity holders actually shrinks in size by the amount of the interest on the debt)! Value has been destroyed (though the full extent of the destruction may not be apparent for years to come)!
As nonsensical as the behavior described in (4) above might sound, such behavior is functionally no different than Linn issuing debt and equity to buy puts and then paying out all proceeds to unitholders, completely neglecting to repay the debt or repurchase the equity necessary to generate the hedging gain. This obviously cannot continue forever, and without frequent equity infusions (which, as we've already described, are dilutive) Linn will eventually hit a debt wall.
The bottom line is that, regardless of how good or how well timed Linn's put purchases have been, such purchases destroy unitholder value if all proceeds from the puts are paid out as distributions.
Linn Counterpoint #2: Linn unitholders need not worry about dilution caused by equity issuance to buy puts, because increases in commodity prices will keep Linn unitholders "whole" on a per unit basis.
The crux of this argument, which I will not spend much time discussing, is that so long as commodity prices increase each year on a percentage basis by at least as much as the percentage of unit dilution then the per unit value of the reserves will stay steady or even rise. Put another way, these folks are essentially arguing that reserves should not be measured on an "energy equivalent basis" per unit but rather on a "dollar equivalent basis." For example, assume you own two barrels of oil in Year 1 for every common unit and the oil is valued at $50 per barrel. Assume in year two that substantial dilution occurs and so you own only one barrel of oil in Year 2 for every common unit you own, but oil is valued at $100 per barrel. On an energy equivalent basis (which is the way I used to calculate the dilution above), you would have experienced substantial dilution from Year 1 to Year 2 (i.e., from 2boe to 1boe). However, on a dollar equivalent basis, there was no change from period to period (i.e., you owned $100 worth of reserves in Year 1 and in Year 2).
There is some validity to this line of reasoning, but allow me to point out at least a couple of issues:
- Linn has already hedged ~100% of its production over the next five years. Unless energy prices were in contango (meaning that future energy prices are expected to be higher than today's energy prices) at the time the puts were purchased, you as a Linn unitholder will not benefit from the rise in commodity prices for years to come. During that "lag" period, you would continue to be diluted on both an energy equivalent basis and a dollar equivalent basis.
- Commodity prices are volatile and can move up ... or down. If you take this position then you are effectively speculating that commodity prices will continue to rise indefinitely into the future. History shows that what goes up can also go down.
- Because costs can move up or down, the dollar equivalent basis calculation can cut both ways, too. Take the example above. Recall that in Year 1 you owned 2 barrels of oil, each valued at $50 per barrel, for every unit you owned. What if in Year 2 prices went from $50 per barrel to $40? Measuring your dilution on an energy equivalent basis, you've been diluted by 50%. But it's even worse from a dollar equivalent basis - the value of the reserves you own per unit have gone down by 60% from $100 per unit to $40 per unit. Comparing on a dollar equivalent basis will not always make things better.
- Even if commodity prices rise, extraction costs could rise even more quickly. Put another way, you are speculating not only on commodity prices growing faster than dilution from Linn's puts; you are also speculating that commodity prices will outpace drilling and extraction costs.
The bottom line is that the dollar equivalent basis described above is, in my opinion, a bad method for calculating dilution. If you are looking to speculate on future commodities prices, there are a number of ways to do so that will result in better payouts than buying Linn and banking on dilution being countered by rising prices!
Circling Back to Buffett
Even if Linn's true coverage in 2012 was materially higher than the 0.19x I've calculated above, such a low coverage ratio is unsustainable over the long term. The bottom line takeaway point from my analysis is that investors who salivate over Linn's fat yield in the 12% range and think it provides a floor on the price of Linn's units should think again. Only a fraction of such distribution is being covered by distributable cash flow (recall, again, that this is equivalent to Buffett's "owner earnings" metric), meaning the distribution is far from "safe."
As we've already covered, maintenance capex is vitally important to investors. When a company pays out more in distributions than its "owner earnings," such payouts diminish the company's ability to generate future earnings at a level equal to current earnings. This is exactly what Linn is doing, as is evidenced by the coverage ratio shown in the purple bars above. Over the long term, if a company continually pays out in excess of its owner earnings then, absent an infusion of either debt or equity capital, the earnings power of the company's assets will track toward zero until the company has effectively self-liquidated.
Recall, again, that Buffett described the consequences of paying out in excess of owner earnings in his 1984 letter to shareholders. Buffett's comments were made in the context of inflation, but the concept (referred to below as "restricted earnings" here) applies to maintenance capex.
[Restricted earnings] cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Linn's position and treatment of its annual amortized put expense results in exactly the behavior that Buffett warns against - namely, Linn is paying out "restricted earnings" and will therefore lose ground (as evidenced by the dilution described above) from the perspective of its long-term competitive position. It is about as clear as can be that Linn is understating maintenance capex in a significant way. If management does not alter its treatment of amortized put expenses, then, over the long run, perhaps Linn truly could be "destined for oblivion."
A Quick Note About Acquisitions and Debt
I could (though I won't in this article) demonstrate how Linn could mask and prolong the deteriorative effect that paying out in excess of its owner earnings will have on the company by maintaining or accelerating its pace with respect to acquisitions and layering on additional debt. It is these two key levers - continual acquisitions and issuing additional debt - that could help to prop up Linn's value over a substantial period of time. (You'll have to take my word for it, though, or do your own research - I've already spilled too much ink on a company in which I've decided not to invest). Over the very long term, though, little can be done to curtail the damage done by paying out substantially more than Linn's owner earnings / DCF generated in such period. And virtually no amount of acquisitions and debt could mask a 0.19x coverage ratio over the long term.
Conclusions re: Linn's Fourth Questionable Assumption (Maintenance capex need not include the amortized cost of puts realized during such period)
For the reasons above, maintenance capex absolutely must include the amortized cost of puts realized during any period. This results in a (sometime drastic) understatement of Linn's DCF / owner earnings.
Conclusions re: Linn's Fifth Questionable Assumption (Maintenance capex should be based on the cost to add reserves that keep aggregate reserves owned by the company flat from year to year and need not take into account issuances of units during the period for purposes other than growth capex)
Do you, as a Linn unitholder, care about the size of the Linn pie in the aggregate or the size of your piece of the pie? Of course, you only care about your piece. While measurement of the "entire pie" might accurately measure value created by the company from the viewpoint of management (e.g., think kingdom building - the bigger the castle, the more the king gets paid), measurement on a per unit basis much more accurately measures value created by the company from the viewpoint of individual unitholders. Warren Buffett has come to a similar conclusion. In his "Owner's Manual," Buffett states that his third business principle is the following:
Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire's average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
Applying this concept to maintenance capex, just as Buffett would evaluate value creation on a per unit basis and not an aggregate basis, so, too, would Buffett measure intrinsic value (and, hence, maintenance capex) on a per unit basis and not an aggregate basis. This also results in an understatement of Linn's DCF / owner earnings and means Linn's true coverage ratio is, in most periods, significantly lower than the coverage ratio stated by the company.
Bringing the Analysis Full-Circle: What "Intrinsic Value" Might Warren Buffett Assign to Linn Energy's common units?
As a reminder, Buffett defines the intrinsic value of a business as the aggregate amount of cash that can be paid out by a business over the business's lifetime, a metric Buffett calls "owner earnings," discounted at an appropriate rate.
Buffett defined "owner earnings" in his 1986 letter to shareholders as follows:
[Owner earnings] represent reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges ... less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
For the reasons described above, I believe that Linn's owner earnings are substantially less than its distributions to unitholders. I therefore believe that Warren Buffett would never calculate a price for the units because he would never invest in such a company (in addition to the shortcomings described above, I don't think it would meet several other criteria, either). And I am of the same opinion - Linn Energy's long-term prospects do not excite me and I have mentally eliminated the possibility of adding Linn to my portfolio. Why would I invest in Linn, with all its issues, when I could invest in fantastic MLPs like Summit Midstream (NYSE: SMLP)? Less risk, higher growth, stable cash flow - why bother with Linn?
With that caveat, and solely because the headline of the article implies that I will attempt to calculate a rough estimate of the intrinsic value on Linn Energy's units, here goes ...
- Plugging in my own estimate for in Buffett's + - formula, and assuming the Berry merger does not go through, I estimate that the intrinsic value for Linn Energy's common units of somewhere in the range of $20-22 per unit. I assume a 10% discount rate (to reflect the higher risk in LINE relative to many other MLPs), an eventual yield of 9%, and a very small-to-flat growth rate in Linn's per-unit owner earnings.
- Assuming the Berry merger does go through on the same terms initially announced (which is highly unlikely in my opinion), I think an investor could justify an intrinsic value of between $24-26 per unit using the same 10% discount rate, 9% exit yield and a small annualized growth rate.
Even these valuations could be quite optimistic, given that it appears clear to me that Linn is currently paying well in excess of its owner earnings. Forecasting any growth (other than negative growth) in owner earnings on a per unit basis is probably foolish in such circumstances, meaning the assumptions above may not be reflective of reality. For the reasons described above, paying out in excess of owner earnings is not long-term sustainable. Unless Linn cuts its distribution (which I think would actually be a good thing for Linn unitholders), Linn may actually show negative per unit growth in owner earnings.
If the Berry merger does not go through, investors might have been well-served to sell at today's prices (around $24) given the potential ~20% downside to intrinsic value even using somewhat optimistic price inputs.
One final note: The prices above are my best guess as to the intrinsic value of Linn Energy's common units. As Buffett has noted many times, intrinsic value and market value often diverge from one another - sometimes for long periods of time. Markets are often irrational, and pricing irrationality is often compounded in the context of an extremely high-yielding security like Linn Energy and a yield-starved environment. Never underestimate the effect that ill-informed retail investors can have on a relatively thinly traded security. Regardless, Linn does not provide investors with an adequate margin of safety, nor does it meet many of Buffett's other investment criteria. For an investor who is looking to invest like Buffett, it may be wise to pass on Linn Energy.
Additional disclosure: This article does not constitute investment advice. You should do your own research and draw your own conclusions. Best of luck.