I recently called out Jim Cramer on Linn Energy (LINE) when he stated that it was too low to sell arguing it could go lower and it did. In the same article, I had discussed that I would look to get back into LINE when skies were looking a bit clearer. For those unfamiliar with the company LINE is a master limited partnership and a subsidiary of Linn Co (LNCO) that pays a hefty monthly distribution from its oil and gas operations. LINE's properties are located in the Hugoton basin, the Green River basin, the Permian basin, Michigan, Illinois, the Williston/Powder River basin, California, and East Texas in the United States. At the end of 2012, LINE boasted impressive proven reserves of 4,796 billion cubic feet equivalent oil, natural gas, and natural gas liquids; and operated 15,804 gross productive wells. It is on path to make two moves of critical importance to the company's long-term growth. The first is a merger with Berry Petroleum (BRY) and the second is the expansion of its Permian Basin Properties.
Negative Price Action, A Turn Around And Jim Cramer's Take
Prices of LINE units have been decimated in recent months for several reasons. This includes fear over oil prices declining and concerns over the accounting surrounding its hedging practices. Another prevalent issue has been modest operational performance from its recently acquired assets. This has led to concerns over a worsening distribution coverage ratio and many unitholders to suspect a future distribution cut. This week Jim Cramer has a more bullish stance on the company stating that LINE is seeing favorable price action "because it is making acquisitions to enhance market share and decrease competition". Yes Mr. Cramer, this is my feeling exactly, with the exception that judgment day for the company is right around the corner from its proposed merger with Berry Petroleum. In this article I will review the importance of the deal and why the results of the vote on the merger will be a major catalyst for the company's share price, either positive or negative. In addition, I will provide insight into the future of the company based on existing operations should the deal fall through.
Importance of The Deal
Without repeating much of my prior analyses on this issue, please refer to this piece, where I detail why the BRY merger is not expensive relative to past acquisitions. I see the deal as critical because LINE will assume all of BRY's assets as well as the expertise of those working with BRY. BRY has over 3,000 producing wells covering more than 202,000 acres of land. Further these 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 from BRY's properties LINE could see its production numbers increase anywhere from 20%-40%. Further, a good portion (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. However, the deal will need final approval before it can move forward. From my research I do not see any reason the deal will not go through but judgment day is approaching.
Judgment Day is Nigh
The deal is heading to unitholders for a vote on whether to bless the merger. Unitholders of LINE, LNCO and BRY have been mailed proxy materials in connection with the upcoming meetings for the purpose of voting on the merger agreement. For all three companies meetings will be held THIS MONDAY December 16, 2013. For those who may have recently purchased units of the partnership, or are considering a purchase this week, please note that in order to participate in the vote the record date for ownership of the respective companies was November 14, 2013. For those of you who may be interested information regarding the participants in the proxy solicitations and a description of their interests, by security holdings or otherwise, will be contained in the joint proxy statement/prospectus and other relevant materials to be filed with the SEC regarding the proposed transactions when they become available. Results of the vote will come early afternoon Monday. After the release we are going to see a big move up or down for the price of units. I've heard the arguments that a merger is priced into the units current price. I respectfully disagree and still expect a minimum 3% move up after approval and a 10% move down if it falls through.
If The Deal Falls Through, Is Line Doomed?
Hardly. Not even considering any potential future boosts to production that could come from the BRY merger, the company now expects daily production of 840 MMcfe to 860 MMcfe compared to an earlier forecast of 850 MMcfe. This is great news as management has kept the target about the same while stating it could come in ahead. Should it be less than 850 MMcfe then we have been warned. There has been some negative weather pounding Texas and the Permian Basin so lower production numbers are indeed possible. However, even with this possibility LINE has maintained their target. Furthermore, management has boosted its distributable cash flow number (this was the old name). Now it is a more convoluted less clear calculation of available cash. It is know referred to as excess of net cash provided by operating activities after distributions to unitholders and discretionary adjustments considered by the Board of Directors. Management boosted their estimates to be 5-10% above its current monthly payout of $0.2416.
In the most recent quarterly report LINE moved to this metric away from the easy to understand distributable cash flow and coverage ratio numbers. I traveled down to NYC to discuss with an analyst over dinner this new measure and how we could estimate the coverage ratio. Our work, based on unaudited financials, suggests a favorable coverage ratio. This is because we see EBIDTA between $385 and 389 million and distributable cash flow between $172 to $175 million. Their excess of cash was around $2 million. Based on these numbers, LINE had a perfect coverage to a 2% favorable coverage (1.00 to 1.02 ratio). Therefore, because management upped their financial guidance recently from the previously expected perfect coverage ratio to a significant 5-10% favorable ratio, I am extremely bullish about the company, despite any dealings with BRY. This forecast was key and suggests LINE will continue to pay out its distribution for months to come, independent of BRY dealings.
Jim Cramer was right, sort of. LINE is trying to make an acquisition that will boost operations and reduce competition but it hasn't happened yet. That said judgment day is approaching. Come Monday, the future of this company will change. Either it will pay for BRY, boost operations and subsequently boost distributions (most likely) down the road, or the deal will fall through and unit prices will get shaved by at least 10%. Should this happen it is important to realize that LINE's existing operations are improving, the cash situation is strong and the worst is likely over for LINE. My recommendation is to buy ahead of the vote to catch this important catalyst. When the deal goes through I will then agree with Mr. Cramer that yes, LINE has taken the proper steps and is a really good buy. For now it is just a good buy.