Shares of Linn Energy (LINE) and LinnCo (LNCO), Linn's sister company, spiked 10% on a press release (available here) stating that the SEC has no further comment on its S-4 and that it will host a conference call on Wednesday, November 6. Investors in Linn are assuming that its accounting issues are behind it and that its deal with Berry Petroleum (BRY) appears to be a go. While this is certainly good news, I think investors should be wary of several factors that should temper their enthusiasm.
First, the SEC inquiry has not concluded. This press release states that the SEC has no comment on the S-4, not that it has concluded its probe into Linn's accounting standards. Investors should be wary that an SEC enforcement action is still a possibility; the risk of this occurring, while probably diminished, is not zero. While the company has altered its terminology, its calculation of maintenance cap-ex as compared to growth cap-ex remains opaque and at the very least lead to questions regarding sustainable distribution.
Second, now that we have entered November, Berry has stated it is easier for the company to exit the merger. The merger agreement does include an $84 million break-up fee, though some have suggested that the company could avoid paying this fee given the fact it has greater flexibility after 10/31/13. At the very least, it could be using this fact to leverage a better price. In fact, Berry shares are pricing in Linn's inability to close the deal at its current price.
Under the terms of the deal, BRY shareholders receive 1.25 shares of LNCO for each share they own. After today's spike in LCNO to $33, the deal values BRY at $41.58. However, shares of BRY are trading at $47.70 and are virtually unchanged today on the news. BRY shares would only trade at this significant premium to the deal price if investors were convinced Linn would raise its offer to about 1.45-1.50 shares. In fact, any current holder in BRY would be wise to vote against the merger as at the current price BRY shareholders would lose 15% upon consummation while taking on Linn's problems.
If Linn raised the offer to 1.5 as Berry shares anticipate, it would be issuing another 11 million units to LNCO, diluting existing shareholders by another 5.7%, which would significantly weaken (if not eliminate) the accretive nature of this deal. While Linn had stated, this deal could add $0.40 to the annual distribution, but with required dilution to get the deal down, I see BRY adding closer to $0.10-$0.15 to the distribution.
This leaves investors with two questions: what distribution can Linn itself pay and what is the required rate of return? While BRY can add up to $0.15 to the distribution, I do not believe Linn can afford $2.90 in its annual distribution. In the first nine months of the year, Linn has generated $135 million in free cash while its distribution has an annual cost of $682 million. Yes, it is fair to add some cap-ex back to get a sustainable distribution, but I question Linn's cap-ex breakdown. The company is spending $1.3 billion in cap-ex, earmarking about 1/3 as maintenance cap-ex, but with $900 million in expansion cap-ex, the company should be growing revenue 20-25% faster than it is. Either new wells are especially disappointing (which is not good for future distributions) or the company should consider less cap-ex expansionary (which would cut the distribution).
Linn has continually maintained a distribution coverage ratio of less than 100%. Assuming everything is proper, the company cannot maintain a $2.90 payout on its own. With Berry, the best case scenario is that it reaches a 100% coverage ratio and is able to hold its distribution steady. Berry does not alter the fact that management is spending too much and producing too little. I think Linn can sustainably pay closer to $2.50, so with BRY, it could pay up to $2.65. With a required return of 10%, the stock should trade no higher than $27. The stock is rallying on hopes the BRY deal is imminent and will boost the distribution. Both assumptions are misguided as Berry shares are pricing in a higher deal price and the Linn distribution is likely not sustainable. I would use the spike today to take profits.