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Executive Summary & Introduction

Berry Petroleum (BRY) management has decided to sell the company to Linn Energy (LINE) via their C-Corp Clone, Linnco (LNCO). There is only about 1 week to go before shareholders of all three companies vote on the deal. I don't think the deal will go through on the current terms and it appears not to be in the shareholders' interest.

In June, I analyzed the value of the deal for both Berry and LINE shareholders. At the time I concluded that shareholders of BRY and LINN/LNCO shareholders had something to gain from the transaction. Things have changed since then. A second look convinces me that, if you own BRY shares, it would be wise to sell them in the market. I also believe that it is bad for LINE's already unsustainable business model to close the acquisition and extremely unwise to sweeten their offer for BRY to close the deal (which doesn't preclude them doing it, given their track record).


(Click to enlarge)

Deal Benefit to LINE/LNCO Shareholders

The day before the deal, BRY closed at $38.59. It looks to me that rumors of the deal started at the beginning of February, with the close at January 30th at $35.19. Before the deal Berry's production and reserves per share were valued at much lower than LINE's, so buying BRY would add to LINE production per unit (aka: share) and to reserves/share. Offsetting these benefits to LINE-LNCO shareholders, Berry production and reserves per share were relatively stagnant, implying that the quality of their lands were not as good and that BRY was spending more on capex to maintain production than LINE, meaning that future capex would likely be higher with the BRY assets in the LINE fold. Another drawback for LINE shareholders was that LINE-LNCO would have to pay dividends on 1.25 times the number of BRY shares. LINE Management bribed their shareholders to favor the deal with a promise of raising the dividend by 18 cents to counteract this added waste of cash flow.

Benefit to BRY Shareholders

The benefit to BRY shareholders would be getting securities much higher in market value in return for getting rid of shares of a relatively stagnant company that, over the prior few years, had minimal reserve and production growth per share, high capex expenses, and a low dividend. In fact, BRY management, unlike LINE, put most of their cash flow to work drilling, only paying a low 0.8% dividend of 32 cents per share. To cement the deal LINE offered BRY shareholders a dividend that was almost 1000% higher than they were getting, even though this would add to the fast growing LINE debt.

What Has Changed

The SEC decided to run an inquiry into LINE-LNCO accounting and reporting, based upon allegations that they were misstating their results in order to make themselves look better than they actually were. The prices of LINE and LNCO plunged. The SEC has published a partial ruling that agreed with the allegations but cleared the way for the acquisition of Berry Petroleum. The share prices of LINE and LNCO have recovered part, but not all, of their decline. Before the controversy, BRY shares were priced below the 1.25 LNCO shares in the LINE offer. Now, Berry shares are priced significantly above the market value of 1.25 LNCO shares.

Deal Metrics & What the Market is Telling Us About the Deal

Here is a comparison of the share prices and the value of the deal, given that BRY shareholders are to get 1.25 shares of LNCO for each share of BRY. When I wrote the first article, on June 29th, 2013, the deal looked like it would go through but the expected delay provided significant Arbitrage profit.

LINE

LNCO

LNCOx1.25

BRY

28-Jun-13

$ 33.18

$ 37.27

$ 46.59

$ 42.32

20-Sep-13

$ 25.96

$ 29.04

$ 36.30

$ 42.56

It looked simple; just buy Berry shares and sell 1.25 times the number of Berry shares of LNCO, like this:

June 28th Arbitrage Play

Action

Stock

shares

price

proceeds

BUY

BRY

100

$ 42.32

-$4,232.00

SHORT

LNCO

125

$ 37.27

$ 4,658.75

RESULT

Profit

$ 426.75

Normally, deal arbitrage, by buying the undervalued member of the acquisition pair (usually the target), and selling the overvalued member of the paid (usually the acquirer), acts to push the prices to levels where there is no longer any profit by the time the deal is about to close. In this case, it was pushing the price of BRY higher and reducing the LNCO market value.

But the outcry about LINE's accounting practices and whether they were misleading the public, making their results look better, sent the share prices of LINE and LNCO tumbling, although the price of BRY remained relatively constant. Subsequently, the SEC ruled in favor of the LINE critics and, while some of the regulatory uncertainty is gone, the share prices of LINE and LNCO have yet to substantially recover.

If an investment bank arbitrage desk had put on the LNCO-BRY deal in June they will still have the same $426.75 profit per 100 shares of BRY (ignoring commissions) locked in, if the deal goes through. But the current low value of the LNCO shares makes it look unlikely the deal will close as presently constituted, given that the price of a Berry share is much higher than 1.25 times a LNCO share.

Today, no arbitrage operation is going to put on the same trade, because it would guarantee them a loss, as illustrated in the following Table.

June Arbitrage Play in September

Action

Stock

shares

Price

proceeds

BUY

BRY

100

$ 42.56

-$4,256.00

SHORT

LNCO

125

$ 29.04

$ 3,630.00

RESULT

Loss

-$ 626.00

Instead of buying BRY and selling LNCO, the arbitrage play now is to do the opposite; buy LNCO and short BRY, like this:

September Arbitrage Play

Action

Stock

shares

Price

proceeds

SHORT

BRY

100

$ 42.56

$ 4,256.00

BUY

LNCO

125

$ 29.04

-$3,630.00

RESULT

Profit

$ 626.00

Current deal arbitrage, to the extent there is confidence that the deal will close shortly after the votes scheduled for September 30, 2013, would push the price of LNCO up, while reducing the BRY, with the profit from this maneuver trending to zero if/when the deal is closed. But the large (643.8% on an annualized basis) arbitrage profit available, only a few Market-days prior to the vote, suggests the deal will not close, at least not at the current terms. When LNCO announced that the SEC gave a partial ruling and that the buyout of BRY was going to proceed on Sept. 11th, LNCO was at $28.62. It has not moved up significantly since then, suggesting that there is no rush by arbitrageurs to earn the high return represented by the $626 profit per 100 shares of BRY.

What Does this Tell BRY and LNCO shareholders?

I suppose the first thing for shareholders to do is to ask themselves whether they believe the arbitrage professionals would leave this much money on the table, if the deal was likely to close as and when it is scheduled by LINE, LNCO and BRY managements.

BRY Shareholders

If you think the deal is going through and you like LNCO so much, you would be wise to do the September arbitrage trade yourself. Sell your BRY shares and use the money to buy LNCO now, or buy LINE if you prefer an MLP.

If you think that the deal is not going to go through, or that it will go through but the LNCO share price may return to where it was before their SEC problems, and considering that BRY was only selling for $38.59 the day before the buyout offer was made public in February, it may be wise just to sell your BRY, take your profit and don't bother buying either LINE or LNCO. If you are a BRY shareholders, you couldn't be much of a yield hound anyway as Berry couldn't afford to pay high dividends (like LINE and LNCO) and didn't pay them (unlike LINE and LNCO). If you like growth Exploration and Production companies that grow production and reserves and don't require dividends, perhaps you should consider buying Bakken players, Oasis Petroleum (OAS).

If you own BRY and are not sure whether owning LINE-LNCO is a good idea, especially considering their accounting issues, perhaps you should think twice about buying a company that increases dividends by borrowing $Billions (see below).

LINE or LNCO shareholders

If you continue to like LINE and/or LNCO and don't mind their accounting and business model issues, you can no longer increase your holding at reduced cost by buying BRY. In fact, anyone holding BRY to get LNCO, would be wise to sell BRY use the money to buy LNCO or LINE, unless they think that LINE will offer more than 1.25 shares of LNCO to get the deal done.

If you are a LINE-LNCO shareholder, are you wise to want to get the deal done? Is the benefit of an 18 cent increase in the yearly cash distribution enough of a benefit to offset the cost to the company?

The Real Cost of Buying Berry

In addition to buying BRY shares for LNCO shares, LINE is assuming their considerable debt of over $1.7 billion, which comes with an interest bill of about $100 million per year.

LINE's Cost of Buying BRY at 1.25

BRY shares Q3'13

52,672,162

price of LNCO shares

$ 29.04

Value of LNCO shares at 1.25

$ 1,911,999,481

Total BRY Net debt June 20, 2013

$ 1,740,790,000

Total up-front cost

$ 3,652,789,481

cost per BRY share

$ 69.35

If LINE increases the Berry bid to 1.5 shares of LNCO, as the relative market prices suggests, the cost of buying gets higher. Based upon market share prices, BRY is 1.47 times the price of LNCO. This suggests that we can assume that arbitrageur expectations are that LINE will increase the deal multiple to 1.5 shares of LNCO per share of BRY. If that happens, it will increase the up-front cost of BRY.

LINE's Cost of Buying BRY at 1.5

Value of LNCO shares at 1.5

$ 2,294,399,377

Total up-front cost

$ 4,035,189,377

cost per BRY share

$ 77

Perhaps more disturbing for a company like LINE that has to borrow to fund its current capex and dividend payments is the ongoing effect of buying BRY; something that will drain cash from LINE and end up requiring substantial increases in LINE's already high net debt. +++

Cash Flow in Deal with 1.25 LNCO per 1 BRY

BRY Annualized EBDA

$ 465,096,000

Annualized Capex on BRY lands

-$ 596,494,000

Added dividend on new shares

-$ 202,787,824

Added dividend existing shares

-$ 42,337,800

Added interest on BRY debt

$ 99,516,000

Tot. Yr.1 effect on LINE Cash Flow

-$ 277,007,624

Overall the cash flow consequences of buying BRY at 1.25 LNCO shares will be a negative $277 million per year, after the acquisition, and that includes the income from BRY's production. And if LINE doesn't spend the capex required to maintain BRY production, that cash will decline year after year and the premise for buying BRY, in the first place, in invalidated.

If LINE Management increases the deal multiple to get the deal done, the cash drain gets even worse. I am not just focusing on the initial cost, but these carrying costs that will mount forever, because the additional shares will continue to require more dividends and the mounting debt will lead to increasing interest costs, leading to more and more debt.

Cash Flow in Deal with 1.5 LNCO per 1 BRY

Tot. Yr.1 effect at 1.25 multiple

-$ 277,007,624

Added cost of dividends at 1.5

-$ 40,557,565

Tot. Yr.1 effect at 1.5 deal multiple

-$ 317,565,188

My honest view is that LINE's business plan relies too much on incurring increasing debt, instead of earnings, to pay dividends. I think it is preferable to own high dividend Petroleum companies like Baytex (BTE) or Canadian Oilsands (OTCQX:COSWF) that don't have to substantially increase their borrowing each year in order to fund both capex and dividends.

In Summary

The market values are hinting that the deal will not close at a 1.25 multiple, because at that price it pays BRY shareholders to sell in the open market. The cost of the deal to LINE-LNCO is huge even at a 1.25 both up-front and because of ongoing dividend, interest and capex requirements that come with buying BRY. This is going to make LINE's business plan even more unsustainable than it is now. If the deal does close, it is yet another reason to sell LINE and find a more reliable source of ongoing dividends; ones that won't be crippled by higher interest rates and a too-large debt burden.

Source: Forget The Linn Offer, Sell Berry Petroleum