I think it is time to buy Linn Energy (LINE). Several catalysts are in play as I write this article. Those owning shares of its holding company (LNCO) should be pleased with recent releases from the company. The purpose of this article is to discuss the reasons why I believe the worst is behind LINE and lay out the reasons why I got back into this master limited partnership on Friday November 1st at market open, and why I will be adding shares on weakness in the next few weeks.
Earnings Were Strong
Overall, the most recent earnings report was quite strong. Below I will highlight the main points, that lead me to believe things are definitely on the mend.
Revenues, earnings and distribution coverage
Revenues were up significantly from the comparable 2012 quarter, though lower than the second quarter 2013. Revenues were up a whopping $447 million compared to Q3 2012, coming in at $495 million, which was ahead of my expectation of $475 million. I won't go into too much detail about what was factored into it, but 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? LINE has moved away from providing this information so they did not provide a distribution coverage ratio. However, this number can be calculated.
Over the weekend I had a dinner conversation with an analyst colleague at JP Morgan who does some work with the stock to discuss my recent purchase and go over the financials of the partnership. Parsing through the numbers, it seems my initial reaction to the distribution coverage ratio being slightly less than 1.0 may have been incorrect. Now I bought units before I knew this based on revenues and other issues I will discuss below, but this news was definitely a big positive as LINE has had issues with coverage in the past. Based on the unaudited financials in the Q3 release, we see EBIDTA between $385 and 389 million and distributable cash flow between $172 to $175 million. They did provide an "excess of cash" metric that they were unclear as to exactly how it is calculated, but was around $2 million. Based on these numbers, I believe LINE had a perfect coverage to a 2% favorable coverage (1.00 to 1.02 ratio). There will be a conference call tomorrow (Tuesday November 5th), and hopefully we get a concrete number that solidifies this estimate.
Hedging Continued To Perform Well
LINE's hedging practices 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 and am confident that their strategy will continue to be implemented successfully.
Expenses We Up Overall But Down Per Mcfe
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. 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. As the expenses were Mcfe were trending lower, I felt that management was making a strong effort to get costs and expenses under control, which directly impacts distributable cash flow numbers.
Operational Results In Q3
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 of the estimate of 820 MMcfe/d. This 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 and I believe the rising trend will continue.
Upcoming Catalysts and The Latest on the Merger with Berry Petroleum (BRY)
All the panic surrounding the October 31 walkaway date is beginning to dissipate despite the fact that there is no deal, yet. Recall the deal has been under SEC review for a bit. Panic ensued when the 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 ..."
When LINE reported they did not say much mostly because SEC rules force them to remain quiet on the issue now. 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.
But on Friday morning, we learned that the SEC had completed its review and had no further comment on the merger. This is when I decided to reinitiate a position. Simply put, there is no more government 'red tape' to get through. And the timing of this buy was nice as the stock had a nice 11% pop, which is continuing at the time of this writing. Perhaps in an effort to coax the deal along, we learned today that the merger agreement has been amended. Under the amended terms of the agreement, LNCO has agreed to increase the number of common shares it is issuing to 1.68 common shares, from 1.25 common shares, for each common share of Berry outstanding prior to the merger for total consideration of approximately $4.9 billion, including the assumption of debt. Leadership of both companies spoke favorably about the deal this morning.
Mark E. Ellis of LINE, and Robert F. Heinemann of BRY issued a joint statement and stated:
"The boards and management teams of LINN and Berry remain committed to completing this merger. We continue to believe that, upon completion, this transaction will create tremendous value for LINN Energy, LinnCo and Berry investors."
Mark Ellis further stated:
"Since initially engaging with Berry, their operations have consistently outperformed expectations, which is evidenced by their recent third quarter 2013 results. We have great respect for the Berry employees and look forward to welcoming them to the LINN Energy team."
I had continued to caution that I wanted to see clarity on this deal before getting in. Now I think the time has come to safely buy LINE. I did miss the first 10% of the rebound as I waited, but now I believe the deal will most likely happened. Shorts are scrambling to cover. The upside looks very good. The stock is on pace to return to the $36 level by year end. This deal going through many not have been absolutely necessary to LINE, but it an incredible help to the growth of the company. 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.
Distribution is Being Maintained And Will Likely Grow.
LINE declared a monthly distribution of $0.2416 per unit, or $2.90 per unit on an annualized basis, for all of its outstanding common units. It will be payable November 15, 2013, to unitholders of record as of the close of business on November 11, 2013. This was in line with the prior October distribution. Given that it seems they had sufficient cash flow to fully cover the distributions, and now that the merger is set to go through, I expect the payout is heading higher in future months.
A lot has changed for LINE in the last few trading sessions. As soon as the red tape of the SEC was lifted for the merger I decided it was time to come in off the sidelines. Earnings are on the mend. Production is up. Revenues are up. Our calculations suggest that distributable cash flow is now successfully covering the distribution to unit holders. All of this combined with a merger with BRY that is most likely going to happen, and it is clear that it is time to buy, in my opinion.
Disclosure: I am long LINE. 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.