Yesterday (Oct 28th) I penned an article entitled Linn Energy (LINE): What I Am Looking For Today. In that article I discussed exactly what I was looking for in the mysterious earnings release that lacked an accompanying conference call. The release added to the drama of one the most interesting master limited partnerships today that is discussed widely on financial forums. By not commenting on performance many investors are left in the dark on whether monthly dividend yielding north of 11% from its oil and gas operations can be sustained. Most investors believe that the company will grow and offer capital appreciation, on top of the bountiful dividend. As I have stated before, LNCO and LINE's current holdings are impressive and likely can sustain revenues and dividends paid, though perhaps not as high as shareholders are accustomed without growth. What I was hoping for was some commentary on the Berry Petroleum (BRY) acquisition, as well as commentary regarding the future direction of the company in 2014. We didn't get much of that, in fact, it has led other fellow Seeking Alpha contributors to question whether LINE has cut out transparency all together. The purpose of this article is to discuss what the realities of the quarterly report were versus the expectations I laid out yesterday, and to discuss my take on the performance of the company moving forward as it pertains to my opinion that the stock is a good long-term buy and healthy master limited partnership. Finally I will discuss what has had many investors on edge, the lack of clarity regarding the BRY merger and its importance to the company long-term.
Recall I was looking for performance on the key metrics that were reported in the second quarter 2013. First and foremost I wanted to see the revenues. Last quarter, revenues totaled $839 million, which did include non-cash changes in fair value of commodity derivatives of $271 million, and including the reduction of put option premium value over time. This led to net income of $1.47 per unit for the second quarter 2012, which consisted of $1.15 per unit of non-cash changes in fair value of commodity derivatives. Looking at the non-GAAP EBITDA for LINE in Q2, the company saw $362 million in earnings. What plays into the dividend is distributable cash flow. In Q2 2013, this metric was $0.65 per unit and thus based on dividends paid the company netted a distribution coverage ratio of 0.89x. Here in the third quarter, revenues were up nicely from the comparable 2012 quarter, though lower than the second quarter. Revenues were up $447 million compared to Q3 2012 to $495 million, which was ahead of my expectation of $475 million. This did include $99 million in non-cash changes in fair value of unsettled commodity derivatives. All things considered, there was a net loss of $0.13 per unit for the quarter, which was substantially less than the loss in the comparable 2012 quarter of $2.18. What about distributable cash flow? Well isn't that peculiar, they did not provide this information. Thus, they also did not provide a distribution coverage ratio. However, this number can be calculated. I will not provide the calculation in this article as the coverage ratio is well less than 100%, which is unsustainable. For those who want the exact number and do not want to wait for the pending conference call (time and date to be determined), please see the appendix at the end of this article. What they did provide was some "excess of cash" metric that they were unclear as to exactly how it is calculated. Thus, I am unsure how to comment as this is the first time they have abandoned distributable cash flow calculations in favor of this excess cash metric.
Their hedging practices have been the subject of inquiries and reviews. However, the hedges were pretty transparent in the supplementary informational release for the quarter. During the quarter LINE's hedged realized average price for natural gas was $5.29 per Mcf. This is $1.10 per Mcf more than its unhedged realized average price of $4.10 per Mcf. The company's hedged realized average price for oil was $95.57 per Bbl. Realized average price for NGL production was $26.81 per Bbl for the quarter. As I expected that their hedging practices would deliver, I am pleased that their hedged prices were significantly better than their unhedged prices. I expect this performance to continue in the fourth quarter
Lease, Transportation, Taxes and Other Expenses
Each of these expenses directly impact revenue and distributable cash flow which impact the coverage ratio which is well less than 100%. Expenses were generally higher in Q3 2013 versus 2012, though were on aggregate lower on a per Mcfe basis. Lease operating expenses for the quarter were approximately $87 million, or $1.15 per Mcfe, compared to $92 million, or $1.28 per Mcfe, for the third quarter 2012. Transportation expenses for the third quarter 2013 were approximately $36 million, or $0.47 per Mcfe, compared to $18 million, or $0.25 per Mcfe, for the third quarter 2012. Taxes, other than income taxes for the third quarter 2013, were approximately $36 million, or $0.48 per Mcfe, compared to $38 million, or $0.53 per Mcfe, for the third quarter 2012. General and administrative expenses for the third quarter 2013 were approximately $45 million, or $0.60 per Mcfe, compared to $45 million, or $0.63 per Mcfe, for the third quarter 2012. Depreciation, depletion and amortization expenses for the third quarter 2013 were approximately $209 million, or $2.76 per Mcfe, compared to $168 million, or $2.33 per Mcfe, for the third quarter 2012. For the most part, I expected little change from prior quarters, but while expenses were greater on an absolute basis, they were lower on a per unit production basis, which is a huge sign of strength.
Operational Results In Q3
I reminded most of you that at the end of Q2, Mark E. Ellis, President and CEO stated:
"While challenges have made for a disappointing first half of 2013, we are optimistic about the remainder of the year and expect to deliver annual production growth of 8%-10%."
Management stated that LINE "anticipates production to average approximately 820 MMcfe/d for the third quarter." I told you that I was looking for this important cutoff. Anything below this number would be a huge disappointment while a number above this benchmark will be a sign of health. A perfectly in line number, I stated, would be kudos to management, as they really know their company. So what did we get? Well LINE managed to increase production 5% to an average of 823 MMcfe/d for the third quarter 2013, compared to 782 MMcfe/d for the third quarter 2012. Therefore, the number was just slightly better than in line. To me, it's a huge vote of confidence in so far as the management knows the company. Further, it was a sign of health in the company. What was slightly off-putting is that management did state that this increase in production was primarily attributable to acquisitions completed in 2012, reiterating a familiar argument that LINE needs acquisitions to meaningfully grow production. I don't think they necessarily require acquisitions to grow, but it certainly helps accelerate production growth. Where I believe the company needs to focus is on oil production growth, as most of their production is gas. All in all, it was a strong quarter for production.
Location Specific Updates
I was looking for production updates and more development milestones for many of the properties, including the Permian Basin, Jonah Field, Hugoton Field and the Granite Wash. In the release, LINE gave a few updates regarding these locations. More detail is provided in the release, but here are the most important highlights and my take on them.
At Hugoton, LINE drilled and completed 60 wells in 2013. LINE plans to drill an additional 80 wells in 2014, for a 133% increase in wells at the location. This is huge organic growth. LINE believes it has a sufficient number of locations identified to sustain this program for the next five years. Assuming no merger with BRY, this field will be key to organic production growth from 2014-2018.
In 2013, LINE drilled 68 wells and has achieved a 15% reduction in drilling and completion costs to approximately $2 million per well. Due to increasing horizontal activity by the industry, much of the Company's acreage could be prospective for horizontal drilling. LINN plans to participate in four non-operated horizontal wells and preparations are underway for the drilling of the first operated horizontal well in 2014. Horizontal drilling could provide excellent use of existing land/properties to access more resources, further production and maximize site life.
LINE added an additional operated rig and now has two operated rigs drilling in the Jonah Field. LINE owns an average 50% working interest in the field's wells. An additional 19 operated and non-operated wells are expected to be completed by year-end 2013 and 24 more are expected to be drilling or awaiting completion at that time. These wells have expected drilling and completion costs of approximately $3.5 million per well. While lower initial production capacity of 5 MMcf/d versus Hugoton (which is 30 MMcf/d), these wells are important to organic growth of the company.
LINN now has eight rigs running in the Granite Wash, six of which are focused on developing high-return, liquids-rich opportunities in the Texas panhandle. The Company now has 12 wells producing in the Mayfield area with gross average initial production rates of approximately 1,800 Bbls of oil, 1,000 Bbls of NGLs and 6 MMcf of natural gas per day. Continued expansion in Granite Wash is key to organic liquid oil production growth, which the company, in my opinion, needs to produce more of relative to gas.
So What Did LINE Say About BRY?
Recall that management of BRY said in a Securities and Exchange Commission filing:
"There can be no assurances as to whether the parties will agree to extend the end date or that the parties will refrain from exercising their rights to terminate the merger agreement ..."
We are now two days away from the October 31 "walk away" option date. For more on the potential significance of this deal, please see this recent article.
So what did LINE say? Nothing, really. This is mostly because SEC rules force them to remain quiet on the issue now. They could have been more transparent along the way but now they are forced into an artificial quiet period as it were. They stated that they acknowledged BRY's filing and hope to address this issue and other questions in a conference call at a later date. The company did file a new S-4. In that document, if you are good with legal language, you can parse through the official language. On page 169, the terms are laid out. If the deal doesn't close before the 31st, either party can file to extend the deal. Should BRY decide to walk away, they will have to pay a fee for breaking away from the deal.
I believe the deal will happen. I think it is important for LINE, long-term. BRY has over 3,000 producing wells covering more than 200,000 acres of land. Acquiring this land is huge for LINE's growth prospects. BRY's assets have relatively low-decline in quality/quantity and long life which makes it a great fit for LINE's master limited partnership structure. The deal will help LINE expand its growth into markets in California, the Permian Basin, Texas and the Uinta Basin. With the annual production that occurs in BRY's properties, LINE could see its production increase anywhere from 20%-40%. Most importantly, about three quarters of BRY's reserves are in oil, which will increase LINE's liquid oil exposure by approximately 17% on a relative scale. That is serious growth that cannot be overlooked, as I have repeatedly argued the company needs more liquid oil production.
For now, the dividend is safe. Perhaps management is banking on the merger happening. Perhaps they are confident in their organic growth potential. Either way, LINE declared a monthly cash dividend of $0.2416 per common share, or $2.90 per share on an annualized basis, for all of its outstanding common shares. The dividend will be payable November 15, 2013, to shareholders of record as of the close of business on November 11, 2013. This was in line with the prior October distribution.
This release was important. Overall, it was a solid quarter in my opinion. I am less than thrilled about LINE's new found lack of transparency however. For those wishing to calculate the distributable cash flow and coverage ratio, please see appendix 1. Coverage was well less than 100%. Should there be no acquisition, understanding where the company stands on meeting its production guidance, its expenses, its location specific performance and its distribution coverage will be key moving forward. I have no position in LINE, but am on the sidelines, waiting to get in. I believe the company is a good long-term position, but I also believe that we need clarity on the BRY deal before I am comfortable getting in. If the acquisition goes through, it will lead to a huge jump in oil production and assets for LINE. We must watch and listen closely to the upcoming earnings call, and await the results of the BRY merger.
Appendix I. Calculations of EBITDA, Adjusted EBIDTA, Distributable Cash Flow, And Coverage Ratio.
LINE defines EBITDA as net income (loss) plus the following adjustments:
•Income tax expense (benefit); and
•Depreciation, depletion and amortization.
LINE defines adjusted EBITDA as EBITDA plus the following adjustments:
•Net operating cash flow from acquisitions and divestitures, effective date through closing date;
•Impairment of long-lived assets;
•Write-off of deferred financing fees;
•(Gains) losses on sale of assets and other, net;
•Loss on extinguishment of debt;
•Changes in fair value on unsettled commodity derivatives;
•Changes in fair value on unsettled interest rate derivatives;
•Cash settlements on interest rate derivatives;
•Cash settlements on canceled derivatives;
•Cash recoveries of bankruptcy claim;
•Unit-based compensation expenses;
•Exploration costs; and
•Merger transaction costs.
Distributable cash flow ("DCF") is a supplemental financial measure used by LINE management in determining (prior to the establishment of any reserves by its Board of Directors) the amount of cash available for distribution to the Company's unitholders. Specifically, this financial measure indicates to investors whether or not the Company is generating cash flow at a level that can sustain or support an increase in its distribution rates and serves as an indicator of the Company's success in providing a return on investments. The Company defines DCF as adjusted EBITDA with the following adjustments:
•Maintenance capital expenditures; and
•Provision for legal matters.
Coverage ratio is then the ratio of the distributable cash flow over distributions to unitholders.