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On Friday, November 1st, Linn Energy (NASDAQ:LINE) and its corporate clone, Linn Co (NASDAQ:LNCO), announced that the SEC has stopped objecting to the S4 merger filing in the deal with Berry Petroleum (NYSE:BRY). The companies announced a Conference Call that has subsequently been moved up to Tuesday, November 5th. This is, no doubt, preliminary to having a shareholder vote on the modified deal terms.

After recently making a case that LINE/LNCO's valuation was lower than Berry's, I was surprised by Monday's announcement that LINE/LNCO was going to not only raise their bid, but raise it to a significantly higher level.

There are two aspects of a deal. One is what value you are getting and the other is the price you will pay. I am going to deal with both of these aspects.

Is this really good performance, or were expectations just really low?

When reading the press release, I was specifically surprised by the LINE/LNCO CEO being quoted:

Mr. Ellis continued, "Since initially engaging with Berry, their operations have consistently outperformed expectations, which is evidenced by their recent third quarter 2013 results."

I had looked at Berry's report of the third quarter and, while it was better, the year-to-date results were not what I would consider surprisingly good. In case I missed something, I went to my spreadsheet and took a look at how Berry did this year, annualizing the 9 month results. (Note for purists, I am using dividends here to include distributions paid by LINE and the dividends paid by LNCO. I will also call LINE's units, "shares".)

BRY Results: 2012 actual with 2013 pro forma from 9 mo. Data

change

2013 e

2012 a

in 1000s except per share

0%

55,278

55,287

mean weighted shares diluted

0%

$ 259,719

$ 259,660

Earnings Before Taxes

10%

$ 97,084

$ 88,121

tax

-5%

$ 162,635

$ 171,539

net earnings

-6%

$ 2.92

$ 3.10

EPS

20%

$ 99,416

$ 83,136

Interest

24%

$ 282,956

$ 227,700

DDAw/electricity

10%

$ 97,084

$ 88,121

tax

4064%

$ 3,289

$ 79

impairment

-25%

$ 645,380

$ 860,507

EBITDDAI

-25%

$ 11.60

$ 15.46

EBITDDAI/share

-25%

$ 448,880

$ 598,507

EBDDAI

-25%

$ 8.07

$ 10.75

EBDDAI/share

Earnings per share, an unimportant measure in the scheme of things for a petroleum explorer and producer, declined by 6%.

The E&P equivalent of EBITDA, EBITDDAI, declined by 25% in 2013.

Cash Flow, earnings before depletion, depreciation, amortization and impairments, also declined by 25%.

Looking at the annualized 9 month results, Berry underperformed its own results from 2012. While Berry's third quarter was very good considering its past reports, it can just as easily be viewed that Q3 looked good because prior performance was not good. Perhaps Berry's past performance gave Mr. Ellis low expectations and that is why he was pleasantly surprised. I could not help but notice that he did not brag about how well they did. He only indicated that Berry has "outperformed" his "expectations".

A long-term investment represented by a merger is not done on the basis of one good quarter. Given that the official buyout offer was made in February 2013, we can presume that Mr. Ellis' views about how good Berry is doing, "Since initially engaging with Berry" dates from approximately year-end 2012.

I therefore ignored the pre-2013 poorer performance and just considered how well Berry did for just the 9 months in 2013.

BRY 9 mo. Results: 2012 compared to 2013

change

9mo'13

9mo'12

in 1000s except per share

1%

55,651

55,278

mean weighted shares diluted

-9%

$ 194,789

$ 214,323

Earnings before Taxes

-10%

$ 72,813

$ 81,282

Tax

-8%

$ 121,976

$ 133,040

net earnings

-9%

$ 2.19

$ 2.41

EPS

21%

$ 74,562

$ 61,446

Interest

32%

$ 212,217

$ 160,251

DDAw/electricity

-10%

$ 72,813

$ 81,282

Tax

3582%

$ 2,467

$ 67

impairment

11%

$ 484,035

$ 436,086

EBITDDAI

10%

$ 8.70

$ 7.89

EBITDDAI/share

15%

$ 336,660

$ 293,358

EBDDAI

14%

$ 6.05

$ 5.31

EBDDAI/share

The results are certainly better than the pro forma comparison with the full 2012 year.

Earnings per share, still an unimportant measure in the scheme of things, declined by 9%.

The E&P equivalent of EBITDA, EBITDDAI increased by 11% year over year.

Cash Flow, earnings before depletion, depreciation, amortization and impairments, increased by 14%, which was pretty good for Berry.

So there was improvement and it is understandable that Mr. Ellis was pleased and perhaps a bit pleasantly surprised, given past performance. The largest percentage change in the 2013 is that impairment charges went up 3528% in 2013, reducing the assets to be transferred to LINE/LNCO by $2.467 million, which is not much considering the $625.564 million Berry wrote off in 2011. It seems like Berry had a lot of land positions that weren't worth anything. That makes me wonder whether Berry still holds lands that LINE will write off. If they do, the write-down will at least provide a tax deduction, after the merger.

In my last article on the subject, I suggested that companies like Carrizo (NASDAQ:CRZO), Whiting (NYSE:WLL) SM Energy (NYSE:SM) and LINE were valued by the market much lower than Berry. In other words, depending upon your point of view, it is not difficult to conclude that there are faster growing companies out there with good acreage positions in the Bakken and Permian that could be bought much more cheaply than Berry because the Market is mispricing them.

The Price To Be Paid

LINE/LNCO just agreed to increase the price to be paid for Berry. That price is to be paid in more than one way. First, LINE/LNCO pays by diluting the ownership of shareholders by issuing shares to give to Berry shareholders. The share-exchange multiple in the new merger deal contained an increase of 34%. This will cause a 40% increase in the number of LINE/LNCO shares outstanding.

DEAL NUMBERS

All 1000s except per share

55,678

BRY shares Q3, 2013

69,598

New LNCO with $1.25 buyout multiple

93,539

New LNCO shares with $1.68 buyout multiple

34%

increase in offer

233,522

LINE shares Q2'13

327,061

LINE shares after offer

40%

increase in LINE shares outstanding

In addition to LINE/LNCO paying a price in share dilution, the price will also be paid, every year, in increased dividends that LINE/LNCO will have to fund.

There are a number of ways to look at the dividend increases. From the point of view of the BRY shareholder, the increase in dividends is huge compared to the small dividend that BRY pays. From the point of view of LINE/LNCO shareholders the prospects probably look attractive because LINE has promised to increase the yearly total dividend by 25 cents a share, from $2.90 per year to $3.15. Let's see how that stacks up:

DEAL NUMBERS

All 1000s except per share

$ 2.90

current annualized LINE Div./share

$ 677,214

current dividend liability

$ 3.15

dividend promised after closing

$ 735,594

dividend liability to existing shares

$ 294,648

ex-BRY share dividend Liability

$ 1,030,242

total post deal div. liability

52%

increase in dividend liability

After the deal closes, LINE will have increased its dividend promise to shareholders to over $1 billion, an increase of 52% compared to the current annualized total. To see how LINE/LNCO is going to pay for that, I looked at distributable cash, defined as earnings before depreciation, depletion, amortization, and impairment write-offs (EBDDAI).

DEAL NUMBERS

All 1000s except per share

$ 860,507

BRY 2012 EBDDAI

$ 642,033

LINE 2012 EBDDAI

$ 1,502,540

Total Pro Forma 2012 EBDDAI

Using the cash flow generated during the full 2012 year for the combined entity, 2/3 of distributable cash would be paid to shareholders as dividends. If there is an improvement in the business, over performance in 2012, the post-merger entity may have ~10% more cash left over. With the approximately $0.5 billion left over after dividends, the combined entity will still have to pay for Non-Acquisition Capital Expenditures (Capex).

DEAL NUMBERS

All 1000s except per share

$ 1,045,079

LINE 2012 non-acquisition Capex

$ 676,160

BRY 2012 non-acquisition Capex

$ 1,721,239

Total Pro Forma 2012 Non-Acq. Capex

The first thing you may notice is that projected non-acquisition capex is over $200 million more than the total cash available, before any cash is paid out as dividends. Certainly, with only about $0.5 billion left after dividends, the combined entity will have to borrow at least another $1 billion to drill, unless it cuts the drilling budget. A drilling budget cut will likely reduce future production and cash flow, so that is not something Management will do unless they have no choice.

DEAL NUMBERS

All 1000s except per share

$ 1,721,239

Total Pro Forma 2012 EBDDAI

$ 1,030,242

total post deal div. liability

$ 690,997

cash left after dividends

$1,502,540

Capex spent in 2012 by both

-$ 811,543

Cash to be borrowed/raised

Should LINE/LNCO be creating that much dilution, increasing dividend liability to over $1 billion annually and increasing their capex needs? If you are a shareholder, you get to decide when you vote on the deal.

I think we can be extremely sure that BRY shareholders will vote in favor of the deal. That should probably tell LINE/LNCO shareholders something, although in a good deal, both sides benefit.

My guess is that LINE/LNCO shareholders will also vote to approve the merger because they generally trust Management. I am guessing that the shareholders with less trust likely sold their shares when the LINE accounting questions were brought to light. In general, from what I have seen, LINE/LNCO shareholders are happy, not concerned, about all of the cash going to pay dividends. Either they don't believe that the cash will have to be borrowed or they don't care. With estimated borrowing at over $0.8 billion and post-merger dividend commitments at $1.03 billion, there is not much doubt that more money will have to be raised.

If LINE/LNCO was a normal E&P company, it would pay no dividend and be able to fund most or all of its non-acquisition capex from cash flow. LINE/LNCO is not a normal company and it seems obvious that the thing about LINE/LNCO that is attractive to individual investors is the high dividend. The money to pay that dividend will continue to be borrowed from lenders (or obtained by selling more shares) and recycled to the investors.

My concern continues to be that this does not seem to be a sustainable business plan. I don't think that a company can keep borrowing money to pay dividends (because it is not earning enough to cover the cost), forever.

Source: Linn After The Deal: Is A $1 Billion Dividend Bill A Good Thing?