The debate about Linn Energy (LINE) is basically over. In an amended S-4/A filing in response to SEC comments, Linn Energy and Linn Co (LNCO) have effectively, and for all practical purposes, implicitly admitted that they have materially misled investors in several fundamental respects over the past few years. Specifically, on page 235 of the aforementioned SEC filing, LINN has implicitly admitted that they have been effectively forced by the SEC to revamp their accounting of such fundamental items as:
- "Adjusted EBITDA"
- "Maintenance Capex"
- "Distributable Cash flow or DCF"
- "Premiums paid on put options that settled during the period"
- "Cash flows from acquisitions and divestitures between the effective date and the closing date."
The scale and scope of Linn's effective admissions regarding misleading and/or questionable accounting practices, and the consequent changes that the company has been forced to implement, are absolutely breathtaking. These effective admissions and corrective changes are extremely significant and fundamentally alter the manner in which Linn will be forced to report its financial statements in the future (including possible restatements of financial statements of prior periods)
The analytical victory by analysts that have been critical of LINE's accounting practices has been stunning; almost total. The only question remaining is what, if any, SEC sanctions will follow and what restatements of prior financial statements the SEC will require. Linn has reported that the SEC investigations of possible wrongdoings continue.
Linn's Effective Admissions And Announced Accounting Changes
There can be little doubt at this point that LINN is being forced to very substantially modify its accounting practices due to as of yet undisclosed formal or informal SEC findings to the effect that Linn may have misled investors in various critical respects. Below, I quote in its entirety a section of the S4/A entitled "Explanatory Note Regarding Non-GAAP Financial Measures and Distribution Practices." In this section, Linn details the areas where it seems that they have essentially been forced to admit, as a result of the ongoing SEC investigation, that their past accounting has been misleading, or at least highly questionable.
Historically, LINN's management has recommended, and the LINN board of directors has made a determination regarding, the appropriate level of cash distributions to unitholders by starting with "Adjusted EBITDA," which previously included adjustments for cash flows from acquisitions and divestitures between the effective date and the closing date and did not deduct premiums paid for put options, and deducting interest expense, "maintenance capital expenditures" and provision for legal matters. Going forward, LINN has decided to describe its methodology for evaluating distributions in the following manner:
- Adjusted EBITDA will no longer include adjustments for cash flows from acquisitions and divestitures between the effective date and the closing date and will deduct the premiums paid for put options that settled during the period.
- Adjusted EBITDA will no longer be the starting point for explaining LINN's management's recommendation of and the LINN board of directors' determination of the appropriate level of cash distributions to unitholders.
- In explaining LINN's management's recommendation of and the LINN board of directors' methodology for determining the appropriate level of cash distributions to unitholders, LINN's approach:
- no longer uses the term "distributable cash flow;"
- starts with net cash provided by (used in) operating activities as determined in accordance with GAAP and as set forth on LINN's
- statement of cash flows;
- shows the difference between net cash provided by (used in) operating activities and the amount of cash distributions actually paid to unitholders for the applicable period; and
- describes the discretionary adjustments made by the LINN board of directors when determining the amount of cash distributions to pay unitholders.
LINN's intent is to describe the specific adjustments considered by LINN's management and the LINN board of directors in recommending and determining the level of distributions and to allow investors to evaluate these adjustments.
LINN's limited liability company agreement requires that LINN distribute, at a minimum, all "available cash" to unitholders with respect to each quarter, subject to any limitations contained under the Delaware Limited Liability Company Act. "Available cash" is generally defined as all cash on hand as of the end of a quarter, including cash from working capital borrowings, less the amount of any cash reserves established by the LINN board of directors to (I) provide for the proper conduct of LINN's business (including reserves for future capital expenditures including drilling and acquisitions and for anticipated future credit needs), (ii) comply with applicable law or any of LINN's agreements or obligations or (III) provide funds for distributions with respect to any one or more of the next four quarters. It is under this broad grant of authority that the LINN board of directors makes its discretionary determinations regarding the appropriate adjustments to net cash provided by (used in) operating activities when determining the distribution.
- LINN will discontinue the use of the term "maintenance capital expenditures" and, instead, use the term "discretionary reductions for a portion of oil and natural gas development costs." As reflected in this terminology, the LINN board of directors reduces net cash provided by (used in) operating activities for purposes of determining the appropriate level of distributions by only a portion of the total costs for "development of oil and natural gas properties" as determined under GAAP and set forth on LINN's statement of cash flows. Unlike many publicly traded partnerships, LINN's limited liability company agreement does not include the concept of "maintenance capital expenditures," but LINN has historically used this term because of its broad market acceptance among publicly traded partnerships, analysts and investors as a way of distinguishing between different types of capital expenditures for purposes of distribution payments. For more information on how the LINN board of directors views "discretionary reductions for a portion of oil and nature gas development costs," please read footnote (5) to the table beginning on page 237.
From these statements it is clear that, with regards to the battle over accounting practices and disclosures, Linn's defeat has been resounding and profoundly humiliating; the victory of the critics has been totally decisive.
Investors should not fool themselves. Linn has not all of the sudden "seen the light" and decided voluntarily that the very core of its accounting of distributable cash flow was merely questionable or potentially confusing. It seems clear that LINN has effectively been forced to admit that its previous accounting practices were misleading and to announce that it will consequently change these misleading accounting practices.
Future Implications For Linn
It is as of yet unclear what, if any, action the SEC action may take with respect to Linn's the accounting irregularities that Linn has effectively admitted to.
However, the accounting changes announced by Linn are profound. These changes will have a major impact on Linn and will probably reverberate throughout the entire MLP industry, particularly amongst upstream MLPs such as (BBEP) and perhaps even the Kinder Morgan group (KMP) and (KMI) that not only have upstream operations, but have engaged in questionable accounting practices with regards to their accounting of maintenance capex and DCF.
It appears that Linn is being forced to cease and desist from certain past unsound practices. For example, in the future Linn will be forced to deduct premiums paid from put options that have settled in its calculation of "adjusted EBITDA." This is exactly what many analysts believe that Linn should have been doing all along and which Linn had vehemently refused to do. Indeed, if Linn had done this previously, it would have been clear that Linn's distribution coverage was below 100% -- i.e. Linn was paying out more in distribution than it was truly earning from its business in economic terms.
However, while it seems that the SEC is forcing Linn to clean some of its business practices up, in other regards, it appears that Linn intends to continue to engage in unsound business practices. The most alarming instance of this can be observed in Linn's announcement that they will stop using the term "maintenance capex," and will start using a term called, "discretionary reductions for a portion of oil and natural gas development costs." Since it appears that the SEC feels that Linn's previous use of the term "maintenance capex" was misleading, Linn has decided to simply make up a completely new non-GAAP term.
What this effectively means is that Linn will set the level of cash flow that it believes is distributable to shareholders at whatever it pleases in accordance with its discretionary definition of (a portion of) oil and gas development costs. Linn will no longer bother to adhere to any established accounting rules regarding the accounting of oil and gas development costs; it will simply report those costs in a discretionary manner for purposes of determining its distributions.
The irony should be clear. The cash spent on oil and gas development will be very real and objectively quantifiable; however, Linn's reporting of these outlays for purposes of determining cash available for distributions will be a figment of management's discretion. But never mind. Linn figures that as long as they don't continue to mislead investors by calling this "maintenance capex," and they simply make it clear in the labeling and fine print that this is just a made-up figure that they determine at their discretion, everything is hunky dory.
Instead of ceasing and desisting from engaging in the unsound business practice of understating their sustainable maintenance capex and their sustainable development costs in particular, Linn has apparently decided to continue said unsound practices and simply make up a new non-GAAP accounting concept to label these practices such that it can't be accused of substantially misleading investors.
Some sell-side analysts are already trying to downplay this humiliation of Linn. For example, the analyst at Raymond James has said the following:
"So even though the categories are getting relabeled, LINN's underlying cash flow does not change. Meaning there is a lot of heartache going on but no change in the company's ability to pay its distribution or how much cash flow LINN actually generates."
This line of argumentation is extremely misleading. This isn't just about "a lot of heartache" at Linn. First of all, the humiliation of company management over accounting practices is no trivial matter; it is is material to the value of the stock. Second, contrary to what the analyst suggests, the implications of "relabeling" are highly material to the value of Linn because they highlight discrepancies in Linn's the measurement of cash flow which is the ultimate basis for all equity valuation. Of course it is trivially true that re-labeling accounting categories does not change the underlying amount of cash Linn generates or its ability to pay distributions. But this simply begs the question: What is Linn's sustainable free cash flow? The fact of the matter is that Linn's most recent S-4/A simply confirms by admission what had already been proven beyond any reasonable doubt by myself and a few other analysts: That Linn has systematically distributed more cash in distributions than what it legitimately earns form a economic point of view. Linn's re-labeling of accounting categories will not change this underlying fact. Therefore, properly framed, the argument by the Raymond James analyst is hardly exculpatory of Linn; it serves to highlight the fact that re-labeling accounting items may make Linn's accounting less misleading or fraudulent; it won't make Linn's past or future distributions any more sustainable.
I have previously written three articles that have been highly critical of Linn. Two of these articles have been published through Seeking Alpha and another through my free newsletter. My purpose in writing these articles has been to educate and inform the public about what I believe to be unsound accounting and business practices systematically practiced by Linn. At this point, virtually all of the most important substantive criticisms that I have made regarding Linn have been implicitly admitted by Linn management in its S-4/A SEC filing on September 18, 2013. The only real question now is what investors should do about it.
In view of the fundamental and critical facts that others and I have brought to light, and which have now been implicitly admitted by Linn management, people will have to make their own choices. I make absolutely no recommendation to buy, sell or sell short. I have no opinion about whether the proposed acquisition of Berry Petroleum (BRY) will ultimately go through. I have no opinion regarding what, if any, actions the SEC will take in this case. If investors, including Berry shareholders still wish to purchase or own, that is their problem and I have absolutely no interest in stopping them.