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What Berry Petroleum (BRY) is worth; with or without Linn Energy (LNCO)?

This year has been an attention-grabbing journey for Berry Petroleum. Initially it was all set to be acquired by Linn Energy for about $46/share, a 20% premium to the closing price of $39 on February 21, 2013. As the year progressed, both stocks were under pressure and when the SEC stepped in on July 1, shares for both the companies dropped. Since then, Berry had reported strong quarterly results and the horizontal Permian is taking off. Recently, the deal is again in news with raised offering from the acquirers. However, in depth analysis and peer comparison reveals that BRY is still not trading at potential level and is worth more than current $50 price with or without Linn Energy. BRY is worth at least $60 (20-25% upside with no fundamental downside) based on peer multiple and conservative estimate of reserve valuation, hence a buy. Market is too focused on M&A news and relying on Bid offer as the sole criterion for share price without assessing BRY on its own merit or catch for LINN in the deal. BRY is worth more than current valuation, in both scenarios, i.e. if the deal does not get executed (better outcome for the shareholders) or at the very least more accretive to Linn Energy than what is being anticipated by the market.

What makes Berry Petroleum interesting?

Berry Petroleum is an independent energy company engaged in the production, development, exploitation, and acquisition of oil and natural gas. The Company's principal reserves and producing properties are located in California, Texas, Utah and Colorado. The Company's track record over the years is average, but its main output is oil, production is stable and its reserves are long lived. These qualities make it an ideal acquisition target for any upstream MLP and Linn Energy seems to be the first in line with disclosed interests.

What is in the deal for Linn Energy?

Linn Energy is the largest member of the upstream oil and gas MLP group. While midstream MLPs own long lived assets that throw off steady cash flow, upstream MLPs are inherently more volatile because of their exposure to commodities and because of reservoir depletion. They require a lot more capital to maintain and must pay out a significant amount of cash as dividends to attract buyers. Given these dynamics, it should not be surprising to hear that upstream MLPs are constantly raising capital or making serial acquisitions to replace depleted assets.

In light of aforementioned situation and given the fact that Linn is highly levered and is only funding 90% of its dividend from cash flows, it becomes obvious why Linn needs the Berry deal; to be able to fully fund its dividend and de-lever its balance sheet. Linn must acquire an accretive asset or else it will not be able to cover its dividend without either incurring more leverage or cutting its dividend. As evidenced by other MLPs and yield based equities that have cut their dividends, the result of a dividend cut is massive shareholder value destruction.

With this acquisition, Linn's dividend coverage ratio will go from approximately 90% to over 100% pro forma for the Berry transaction at the new exchange ratio and since the payment is in stock so it's a win-win situation. Also, with this deal being executed, industry will see more consolidation in the upstream MLP sector over the next 3-5 years as eventually other companies will copy the Linn structure. This will place Linn ahead of peers from strategic viewpoint.

What is being missed here?

In all this, the point that is being missed is the true potential of BRY, whether the deal gets executed or not. Analysis show that deal not being executed seems to be a favorable outcome for BRY shareholders because even at the new exchange ratio, they are not getting the right price. Berry's stock has appreciated nicely in October. Berry's Q3 2013 results reported earlier showed a massive improvement in production and cash flow and resultantly Linn increased the bid price but it remains discounted as shown in following table.

Berry on relative basis is worth $70-74 ( at peer multiple of 20-21x of EV/proved reserves) with average valuation of around $63 as an E&P, $61 as standalone upstream MLP and at $62 as a C-Corp. Additionally, a conservative estimate of proved reserves is $5 billion, or $60 per share.

(Source: Company Reports and Presentations, Peer Review)

Hence, BRY is worth at least $60 (20-25% upside with no fundamental downside). Recent increase in bid supports this fact and makes BRY a buy even if the deal does not get executed (better outcome for the shareholders).

On the other side of the podium, even if the deal gets executed, BRY, at the very least, is more accretive to Linn Energy than what is being anticipated by the market given the standalone valuation. With this acquisition, Linn's dividend coverage ratio will shoot from 90% to over 100% pro forma and opportunities for deleveraging will arise. All this will help Linn trade at a higher multiple compared to current 30% discount from the peer group.

Thus, BRY remains a buy in either case with possibility to pair trade with LNCO not being overruled.

Source: Berry Petroleum Is Worth More With Or Without Linn Energy