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Executive Summary

The merger agreement between Berry Petroleum (BRY) and Linn Energy (LINE and LNCO) has passed its official end date, so it is no longer binding on either Party. BRY shareholders and management would like to get a higher price. LINE/LNCO management, if they bother to look, will find that the market is currently valuing BRY twice as highly as LINE/LNCO and other fast growing companies, like Whiting Petroleum (NYSE:WLL), SM Energy (NYSE:SM), and Carrizo Oil & Gas (NASDAQ:CRZO). In fact, all options are open and good sense may see Linn management let the Berry deal remain dead, especially if BRY wants more. There are lots of other fish in the sea, and they are plumper and less expensive. BRY shareholder beware of gluttony.

The Current Situation

On Feb. 23, 2013, Berry Petroleum filed an 8K with the SEC, announcing that it would be acquired by LinnCo (NASDAQ:LNCO), the corporate arm of Linn Energy (NASDAQ:LINE). That day, BRY stock closed at $46.02, up significantly from the $38.59 closing pre-buyout price the day before. It is easy to pick out that day in February on the chart.

LINE/LNCO filed a timely S4 merger document with the SEC, which did not accept it originally. You can also see the day in July when the news hit that the SEC returned the S4 for revisions, possibly because of their inquiry into LINE's accounting.

On Friday, November 1, 2013, Linn announced that the SEC "has no further comments on Amendment No. 6 to the Joint Registration Statement on Form S-4."

We should note that LINE did not write that the S4 has been accepted by the SEC or that the merger process will now proceed. Nevertheless, it appears that the market took the lack of further objections by the SEC as a positive for both LNCO and LINE. On the day of the announcement, the chart (below) shows a sharp jump in the price of both LINE and LNCO and a slight rise in Berry. It is possible that this effect was aided a tiny bit by my article, published the same day, suggesting that BRY shareholders who liked LNCO could get more than the 1.25 shares in the deal offer, if they sold Berry and bought LNCO in the open market, without waiting for the deal to close.

Even after the recent Linn Energy press release, there is no certainty that the merger agreement with Berry will close. Berry shareholders can still sell their shares in the market and buy LNCO shares (or LINE shares) or keep the cash, and not have to wait to see if the merger happens.

No Clarity Now

Presumably, there will be more clarity about Linn Energy's intentions in the Conference Call scheduled for Wednesday, November 6th. Mark Ellis will deliver prepared remarks, giving "an update on the Berry merger" at that time. Note that the LINE press release did not explain the nature of the update or assert that, now that they heard from the SEC, the deal would proceed to a close.

Despite the reaction to the market, there is no definitive clarity at this point, if you pay attention to the legal aspects of the Merger Agreement. On page 17 of the amended S4 filing, on page 17, you will find this:

"Termination of the Merger Agreement

The merger agreement can be terminated at any time prior to completion by:

  • mutual written consent of Berry and LinnCo;
  • Berry, LinnCo or LINN, if the merger has not been completed on or prior to October 31, 2013 (the "End Date"), which date may be extended in certain circumstances described in the merger agreement;"

    in certain circumstances described in the merger agreement;"

It is obvious that the Merger has not been completed by October 31, 2013, so there is no longer an obligation to do the deal. Of course, the merger agreement allows the parties to extend the agreement as explained on page 169 of the S4/A:

"Berry, Linn or LinnCo, if the merger will not have been completed on or prior the End Date, provided that if all conditions have been satisfied or be capable of being satisfied other than the conditions relating to expiration or termination of the applicable waiting period under the HSR Act, effectiveness of the registration statement on Form S-4 of which this joint proxy statement/prospectus is a part or absence of injunctions relating to the transactions, then the End Date may be extended by Berry, Linn or LinnCo by written notice to the other up to a date not later than January 31, 2014, and provided further that the right to terminate is not available to a party if the failure of closing by the End Date results from a material breach by such party of any representation, warranty, covenant or other agreement under the merger agreement;"

I note that the Linn Energy press release did not announce an extension of the End Date for the merger and BRY did not issue any explanatory press release to bring clarity to the situation. If the current deal is to be extended, all the two sides had to do was to agree that the End Date was expended. The absence of an announcement of that in the November first LINE press release suggests there is no such agreement and that, at this point in time, there is no legal merger agreement.

What's Next?

With both sides released from the merger agreement (unless they mutually decide to extend it), it is logical to presume LINE/LNCO and Berry are reviewing their options.

Berry shareholders, seeing that the LNCO price times the 1.25 deal multiple does not equal the price of BRY shares, likely want more value. A revised 1.5 deal premium has been discussed.

LINE/LNCO, on the other hand, have offered a considerable premium to Berry shareholders that will also result in a huge effective dividend increase to BRY owners. If LINE refuses to raise the price, the deal could fall through… but in fact, it is a good guess that BRY is only at the current price because of the anticipation of the buyout. Without a bid for Berry, its share price could easily drop $10 in a day, or more. I make this suggestion based on the share price of Berry at the beginning of the year and because of the valuation of Berry compared to other petroleum companies… including LINE.

I think LINE is cheap relative to BRY

My continuing study of various petroleum companies, is telling me that, at current prices, LINE is relatively undervalued compared to Berry. If LINE is overpaying for Berry, it will hurt LINE's share price and ability to pay dividends in the longer term. To create value, LINE should be buying a company valued less highly than LINE so that the cash flow in LINE's name is capitalized at a higher ratio. My research, looking at the growth adjusted value of the two companies indicates the market is currently valuing BRY twice as highly as LINE/LNCO, especially if you take growth into account, despite the miniscule dividend paid by Berry.

I have developed a better opinion of LINE's business since my first article on the subject, because I start to focus more on the growth rate of its cash flow (although I still think it would be a much better company if it did not spend so much cash on dividends). Over the past 3 full years, LINE has grown at more than twice the compound annual growth rate of BRY. This is obviously a function of the lands that the companies own and managements' ability to maximize drilling success, production mix, hedging and everything else needed to be a successful company.

To determine value, I start with a simple Cash Flow measure. It is EBDDAI , which equals GAAP Net Income plus Depreciation, Depletion, Amortization, and Impairment write-offs. In essence, this is the cash flow available to spend for drilling and/or dividends.

In order to correct for the variations in debt utilization between companies, I use Enterprise Value (EV) as a value comparison instead of Market Capitalization. I use EV per share instead of just market price per share because EV takes relative debt levels into account. LINE, because of its high dividend payout tends to add significant debt every year, has an EV/share of about $65.35, more than twice its $30.82 share price. Berry on the other hand is no slouch when it comes to debt, but is not quite as prolific, with EV/share $87.70, slightly less than twice the $48.75 share price (note, priced at the close, Nov. 1, 2013).

Active oil companies know they need to drill new wells each year, just to keep production stagnant. A depleting reservoir of oil results in declining income unless drilling leads to a significant increase in production that more than offsets decline. Companies and investors are looking for high potential growth and they generally are willing to pay more for increased growth.

To gauge value and include growth, most people use the price to earnings to growth (PEG) ratio. There are various ways to calculate this, the typical way being to divide a stock's Price to Earnings ratio by the Growth Rate.

Since cash flow is more crucial for petroleum companies than GAAP net income, instead of a Price to Earnings ratio and to take into account different levels of debt in different companies, I calculate the latest Enterprise Value to EBDDAI ratio.

I then divide the EV:EBDDAI ratio by the compound annual growth rate (CAGR) of EBDDAI over the last 3 years to get the "Enterprise PEG Ratio" (in the Tables below). I'd prefer to use the CAGR over the next three years, but my crystal ball is in the shop being repaired. I think that past results are an approximation of a company's lands and its management's ability to exploit them. Past behavior is an indicator of future behavior.

LINE

BRY

Share Price

$27.76

$47.90

EBDDAI/share 2012

$3.15

$3.14

Price to Cash Flow Ratio

8.8

15.3

(price/share)/(EBDDAI/share)

Market Cap (millions)

$5,656.79

$2,648.25

Enterprise Value (million)

$12,692.56

$4,801.83

Cash Flow Growth

66%

40%

EBDDAI/share CAGR

Enterprise PEG Ratio

29.9

69.6

(EV:EBDDAI)/(EBDDAI/share CAGR)

BRY is priced almost twice as high, on a cash flow basis, than LINE, at current level. When you correct for growth, Berry Petroleum's PEG multiple of 69.6 is more than twice as high as LINE's PEG of 29.9. If LINE actually had the money to buy Berry at the current price, LINE would get at least twice the benefit from buying its own shares back compared to buying BRY. And if LINE did that, it would save more than 2/3 of what the dividend liability would be if the merger proceeded according to the expired Merger Agreement. To make that more real, the dividend savings from buying back half its own stock and avoiding payments to BRY shareholders would come to over $600,000,000 a year.

If I were a LINE or LNCO shareholder, I'd rather see a share buyback than to see huge dilution buying an overvalued company (compared to LINE/LNCO) like Berry Petroleum. I'd want my management to take the opportunity of the missed deadline to terminate the merger deal.

If I were a Berry shareholder, although I'd want more money or stock for my shares, I would consider the old saying that "bulls can make money and bears can make money, but pigs make bacon." If LINE/LNCO pays attention to valuation, BRY shareholders will be lucky to get 1.25 shares of LNCO in a deal.

In fact, Berry shareholders should hope that LINE/LNCO management are oblivious to the relative valuation, not just between BRY and LINE/LNCO, but between BRY and a lot of really good petroleum companies.

Berry Petroleum is Grossly Overvalued

You don't have to look far to see BRY is overvalued. Pick some of the best companies with land in prolific basins like the Williston or Permian and do the comparison. I have been performing relative valuation analyses on petroleum companies, looking for bargains. I am going to share some of the data with you today, to underline my point about Berry Petroleum being significantly overvalued. Share prices are from the middle of last week, but that does not change the size of the huge valuation differences, and the earlier prices makes BRY's over-valuation appear smaller because its price has increased and the others have declined.

BRY

CRZO

WLL

SM

Share Price

$47.90

$44.75

$69.75

$88.89

EBDDAI/share 2012

$3.14

$7.39

$11.95

$13.55

Price to Cash Flow Ratio

15.3

6.1

5.8

6.6

Market Cap (millions)

$2,648.25

$1,791.16

$8,302.20

$5,790.12

Enterprise Value (million)

$4,801.83

$2,903.16

$7,134.62

$7,134.62

Cash Flow Growth/share

40%

91%

15%

28%

Enterprise PEG Ratio

69.6

9.0

49.4

29.4

As you can see, both the price to cash flow ratios and the PEG ratio for Whiting Petroleum , SM Energy, and Carrizo Oil and Gas, the fastest growing company of the group, are all much better values than Berry Petroleum. LINE could afford to pay a substantial premium to WLL, SM or CRZO shareholders and still get more for its money than by buying BRY at the current level. This would be true even if LINE/LNCO's share price climbed so that 1.25 times the LNCO share price equaled the current Berry share price. On a (past 3 year) growth basis, Whiting, SM Energy, and especially Carrizo, are dirt cheap compared to Berry and to LINE, which means buying them increases shareholder value for LINE/LNCO.

How Will It Turn Out?

There are only questions at this point because LINE/LNCO did not reveal their intentions in their November 1st press release.

I am sure that was not an accident.

Berry has not showed its hand, either, but if you read what shareholders have been writing, it is easy to presume they want a higher price for their shares. I wonder which management will start thinking more outside the Merger Agreement Box and see what the alternative to the current deal really is.

If I was a BRY shareholder and wanted to own LNCO, I would have sold my BRY shares and I'd already be the owner of 1.62 shares of LNCO for every BRY share I had owned (as suggested in my last article on the merger). If I did not do that, I would hope that Berry management was not so demanding that they'd ruin the deal. If I thought they could keep the deal from being renewed by demanding a higher price, I'd sell my shares in the market, or hedge my bet and sell half.

If I were a LINE/LNCO shareholder, I'd hope that management took a second look at the deal to see if they can get as good or better assets at a fraction of the price, by purchasing some other company; a company with lands in basins where production and reserves were growing much faster than those at Berry Petroleum. It is easy to find such companies selling at a discount to BRY these days and, if management at LINE thinks outside the box, they will reduce or not renew their offer to Berry and buy some other company if BRY balks.

But make no mistake, legally, the LINE/LNCO - BRY deal has passed its official End Date.

Anything can happen.

I presume that both Linn and Berry managements are considering all their options and deciding about whether and how to proceed. If you are an owner of shares of these companies, you should be contemplating your own options. Perhaps you should convey your views to the management of the company whose shares you own.

Whatever happens, it should be an interesting week. As an interested bystander, who always roots for the individual investor, I wish you all Good Luck.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Merger Agreement Has Expired: Will Linn Still Buy Berry?