The most important change is that Linn will use a new method for calculating cash flow for distributions starting in the third quarter. The market, as well as this recent article, seems to have assumed that these changes will hurt Linn. On the contrary, a simple look at year-to-date 2013 numbers shows that their new metric of operating cash flow will show substantially higher coverage for their distribution.
Earlier I wrote an article suggesting that Linn might need to take a 20% distribution cut. The new S-4 suggests they can sustain their present distribution rate of $2.90 with or without the Berry acquisition closing. This implies a fair value of $32 (at a 9% distribution yield) plus $2.90 in distributions, for a total return of about 33% in one year.
#1) No Distribution Cuts Under New Methodology
On page 235 of the S-4, Linn states:
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:
. 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.
I agree with the use of cash from operations, a GAAP measurement, instead of DCF which is both non-GAAP and full of adjustments, most of which were designed to be in Linn's favor.
I've complied a series of cash flow metrics for 2013 including both the old metric (distributable cash flow) and two new ones (operating cash flow, operating cash flow minus maintenance cap-x). The results are below:
|Operating Cash Flow (OCF)||$561,356|
|OCF - Maint Cap-X||$339,146|
|Distributable Cash Flow||$302,653|
|OCF-Maint Cap-X coverage||99%|
A significant amount of investor concern has come from Linn's DCF coverage of 89%, which indicates they have overpaid their distribution in 2013. But the SEC seems to be pushing them to use operating cash flow metrics -- which show better coverage ratios for 2013, and a sustainable distribution rate, even if you subtract out maintenance cap-X. For example, had Linn been using Operating Cash Flow throughout the year, their coverage would have been either 99% or 165% depending on the definition they ultimately adopt.
Going forward, I believe Linn can maintain operating cash flow ratios of 100% or more. Q3 production is already up materially from Q2 levels; and Linn acknowledged several mistakes in the first half that hopefully will not be repeated. That is to say, from the baseline of the first half when they already met their coverage numbers, I believe the second half (and beyond) will only show improvements.
To me, the most important issue for Linn has been the sustainability of their distribution. In an earlier article, I had assumed a cut; but today's information seems to imply they can sustain their $2.90 distribution at present levels.
#2) No Historical Restatement
On page 235 of the S-4:
Historically, [Adjusted EBITDA methodology]. Going forward, [operating cash flow methodology].
The S-4 seems to indicate that Linn will switch accounting "going forward." This eliminates another worry of mine that Linn would be forced to restate historical financials downward, which of course would hurt the stock price.
#3) No change in Berry offer
If the merger is completed, Berry stockholders will receive 1.25 LinnCo common shares for each share of Berry common stock that they own.
Some had speculated that Linn would raise its offer, but that does not appear to be the case.
The current offer puts Berry (BRY) shareholders in an interesting situation. Currently, LNCO shares trade at about $30.50, while Berry shares trade at about $44. At current prices, Berry shareholders would lose roughly $6/share if they vote for the proposal. However, Berry shareholders may also lose money if they vote against the proposal. If a no vote means that Berry sinks to its pre-merger price, Berry shareholders will lose a similar amount whether they vote "yes" or "no."
The termination clause in the merger agreement suggests that Berry might have to pay Linn $25.7 million if Berry shareholders vote down the merger. However, Berry shareholders may try to invoke a material adverse clause, and blame the break-up of the merger on Linn, which would cause Linn to pay fees to Berry. There may be some difficulty with Berry invoking the material adverse clause, especially if Linn does not have to restate any historical financials.
I find this merger difficult to handicap - there are many moving parts involving both company's stock prices, and the breakup fees could go in either direction. Right now, my working assumption is that the merger is more likely to fail than succeed, which is partially out of conservatism, and partially because Berry shareholders would lose money should they vote for the acquisition due to LNCO's low price.
#4) Linn is Free to Make More Acquisitions
Based on their S-4 and the acquisition of Permian Basin assets, it appears that Linn is able to acquire either assets or companies going forward. The Berry acquisition itself is in flux, but nothing precludes Linn from continued growth through acquisitions. For example, should the Berry acquisition fail, Linn could consider buying some of Berry's (or other corporation's) oil producing assets instead.
With a low-priced credit line at LIBOR+2.5% (currently below 3%), they should be able to find accretive acquisitions moving forward, with or without Berry. The Permian Basin acquisition is rumored to add 10-15c of operating cash flow once it is completed, which further suggests that Linn's distributions can be sustained at the $2.90 level.
I believe a sustainable $2.90 distribution will eventually equilibrate at a 9% distribution yield or lower, implying a unit price of $32 or higher. That, plus the $2.90 in distributions means a total payout of about $35, for a 1-year return of about 33%.
Additional disclosure: I acquired more LINE after the S-4 was released.