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Goldman Sachs downgraded shares of Linn Energy (NASDAQ:LINE) and LinnCo (NASDAQ:LNCO) Tuesday morning citing the fact the company has recouped most of its SEC inquiry related losses and now needs to show operational improvements to drive prices higher. On Monday, I argued a similar case, noting that shares were within 5% of their pre-SEC level and that investors should take profits and look elsewhere in the E&P space. On news of the Goldman downgrade, shares fell 4%.

This morning, management held an eagerly anticipated conference call to discuss operational results, which provided investors with reason for caution. First, CEO Mark Ellis stated, "The inquiry is still ongoing. Investors should not draw any conclusions with respect to the inquiry from any future declaration by the Division of Corporation Finance that the Form S-4 is effective. They are separate events, and investors should treat them as such. As part of the inquiry, the SEC staff has requested documents and communications related to our use of non-GAAP financial measures and hedging strategy."

Many investors had taken the fact SEC had no comment on the most recent S-4 as a sign the inquiry was over. Mr. Ellis clearly stated otherwise, and there remains a risk of action against the company as a consequence. This suggests a disconnect between the stock price and reality as the stock had just recouped its SEC-related losses. Until and unless this inquiry is closed without action, I do not believe Linn shares will be able to trade above $32 while any action, however unlikely, could seriously impair the share price. The fact that the SEC is allowing the Berry (NYSE:BRY) deal would suggest major action is unlikely, though management did stress that they should be treated as "separate events." News that the inquiry is still ongoing is inconvertibly bad for Linn as it caps upside while expanding potential downside in the coming months, making the risk/reward profile of LINE unfavorable in my opinion.

Moreover, management in my opinion was unable to justify the higher price it is paying for Berry. Management rightly notes that Berry has improved results this year; the question is whether that improvement merits an additional 34% premium on top of the 30% premium of the original offer. In the past year, BRY is now up 54%. During this time, Berry has grown production 14%. While 14% production growth is great, it is far overshadowed by the increase in its value. Linn management also was unable to offer guidance on what the maintenance cap-ex requirements of Berry will be, making it difficult to estimate how accretive it will be to the distribution. Given the added dilution, this call offers no reason to expect a benefit of more than $0.16.

Management also tried to explain how it now calculates distribution figures to appease the SEC by starting with cash flow provided by operations. From there, the company's board makes "discretionary adjustments." This can be read essentially as maintenance cap-ex, which unlike expansionary cap-ex is taken out of cash flow before distribution. If the company finishes with cash in excess of distribution, Linn argues it has a coverage ratio of greater than 1x. My concern is that a major line-item is dubbed "discretionary," giving management significant flexibility on what to consider maintenance vs. expansionary, which would have a significant impact on the coverage ratio. I would feel more comfortable if management released a comprehensive rules-based methodology on how it differentiates maintenance from cap-ex expenditures to ensure the distribution really is safe but don't foresee such action.

Linn spent $343 million in total cap-ex in the quarter and grew oil and gas revenue by $96 million. The company is spending a lot of money and generating far less additional revenue, raising questions about the efficacy of the program. Yet, the company only labeled $115 million as maintenance, which would suggest the firm spent $228 million on expansionary projects to expand revenue by $96, and cap-ex spending shows no signs of slowing down. Either the company is generating a terrible ROI, which is bad news for future distributions, or the company should allocate more maintenance cap-ex under "discretionary adjustments." Questions remain unanswered about the distribution's future.

Without specific criteria on how Linn measures cap-ex, investors cannot be sure of future distribution sustainability and growth. Management also postponed expectations for a distribution hike on the call and will not be able to offer a 2014 road map until February. A distribution hike is unlikely until the second quarter at the earliest. Management also did not offer a convincing case on why it is not over paying for Berry even as the price hike has far exceeded production increases, and if a similar proportion of Berry's cap-ex is labeled maintenance, this deal will prove not to be accretive for investors with a best case scenario of $0.16 in my opinion. The stock has moved ahead of the fundamentals with the SEC inquiry yet to close. I see limited upside until the SEC inquiry is closed, and even then, Linn will have to prove it can make BRY an accretive deal. Investors would be wise to look elsewhere. Goldman Sachs is right.

Source: Debriefing The Linn Energy Call