In my previous article on Linn Energy (LINE, LNCO), I suggested that the stock, then trading at $23, was worth at least $27. In that article, I valued the company assuming a distribution cut and that the Berry acquisition would fail. Since that article around a month ago, LINE shares have appreciated by about 20% to $28, above my original price target.
Two recent events, Linn's update on the merger and Linn's pending acquisition of Permian Basin assets, have reduced the probability that the SEC has serious issues with Linn. In turn, I have raised my estimated fair value of Linn to $31, reflecting a weighted-average of five different possible outcomes. I have put my scenarios, probabilities and price targets in a table near the end of this article.
The update on the merger says that "comments," presumably from the SEC, are leading Linn to amend their S-4 acquisition filing. The press release omits any discussion of a revision to either 10-K or 10-Q (i.e. their earnings reports). In addition, Linn filed a 10-Q after the SEC investigation was already announced. The update seems to significantly reduce the probability of a very poor outcome, that the SEC forces Linn to restate historical earnings or DCF metrics strongly downward.
Indeed the focus on the S-4 raises the question: if Linn never tried to acquire Berry, would the SEC even be involved? If the answer to that turns out to be "no" then the intense investor focus around accounting and the SEC has been seriously overblown.
The second event, the acquisition of Permian Basin assets, suggests that Linn is both allowed to and able to acquire producing assets. In turn, it implies (to me) that the SEC's core concerns are with the acquisition of public companies, but not the acquisition of assets of companies. For example, it seemingly would be acceptable for Linn to buy substantial assets from Berry, even if Berry (the corporation) itself cannot be acquired.
Those two events seem to reduce the probability that the SEC has a problem with Linn's earnings reports or acquisitions in general; it seemingly has scoped down to the acquisition of other public companies - something that is not really necessary for Linn's continued growth.
There are still considerable unknowns surrounding Linn. We do not know the substance of the SEC investigation - whether the amended S-4 will contain large or small changes. We do not know whether the Berry merger will complete - Berry itself is trading with the expectation that either LNCO's price will increase, or that LNCO will sweeten its offer. So with all of those unknowns, I have adopted an approach of applying probabilities to five different outcomes, which I have outlined below:
SEC forces a significant downward restatement of past earnings and/or DCF; 40% distribution price cut.
(8% yield on $1.74 distribution)
SEC and Linn's stock price makes it difficult for Linn to make further substantial acquisitions; 20% distribution cut.
(former base case; 8% yield on $2.32 distribution)
SEC and/or shareholder votes mean that the Berry acquisition fails, but other accretive asset acquisitions continue; no distribution cut.
Linn completes the Berry acquisition, but must raise its offer; no distribution cut.
SEC's complaints are minor and easily fixed; Linn completes the Berry acquisition at the current exchange ratio; slight rise in distributions
(low end of post-Berry, pre-SEC price)
Weighted Average Scenario
The two recent announcements have reduced the probability of the worst outcomes (the first two) and increased the probabilities of the other three. I calculate a weighted average outcome of $31. In addition, the weighted average distribution comes out to $2.77, suggesting a total return of approximately 20% over the next 12 months.
Additional disclosure: My investment company also holds LINE on behalf of clients.