Last week, Linn Energy (NASDAQ:LINE) fell after the company announced a quarter that disappointed many investors (press release available here). Production of 889 MMcfe/d was disappointing to some, especially after factoring out the 44 MMcfe/d Berry provided. For investors unaware, Linn Energy closed its acquisition of Berry late in the quarter. Going forward, Berry should provide 200-250 MMcfe/d to production. While production is obviously important when evaluating an energy company, most investors focus on distributable cash flow ("DCF") as this determines how much LINE can pay to shareholders. Most investors own LINE for its 9% yield, and the security of that payout is critical to the future performance of units. Unfortunately, that distribution has little room to grow. As a side note, this analysis also applies to LinnCo (NASDAQ:LNCO), an LLC that owns LINE.
Last year, Linn Energy was buffeted by short calls from Kevin Kaiser of Hedgeye and Barron's. In fact, the SEC even launched an inquiry into Linn's non-GAAP accounting methodology, which resulted in Linn changing some of its wording in regards to cash flow. These concerns pushed units lower, which made Berry Petroleum holders concerned that the merger no longer made since. Responding to this, Linn agreed to up the exchange rate from 1.25 shares of LNCO per share of Berry to 1.68 (details of the transaction available here). While the Berry deal was no doubt transformational, results and guidance suggest it may prove uneconomical.
In 2014, Linn is projecting an increase in production of 34% to 1070-1140 MMcfe/d (guidance available here). The vast majority of this growth will come from the addition of Berry. In other words, Berry is contributing a 34% jump in production. Importantly, this figure is a good long-term estimate as the deal also led to a 34% increase in proved reserves to 6.4 Tcfe. Now given this jump, it would seem that the Berry deal is extremely accretive. While Berry made Linn Energy a bigger company, this benefit does not actually translate to individual holders.
With the higher exchange rate, Linn had to issue a lot of units with the year-over-year increase being 94 million. This translates to a 40% in the unit count. To keep per unit production and per unit reserves constant, each would have to jump 40% this year. Instead, they are only jumping 34%, meaning existing holders are being diluted by approximately 4%. Under the original terms of the merger, Linn's unit count would have jumped closer to 30%, meaning it would have been accretive to existing holders by 3%.
Frankly under the original terms of the deal, Linn was paying a pretty fully price but would get a mild benefit. By upping the offer so dramatically, the deal has become dilutive. In fact, Linn Energy took an impairment of $790 million in the quarter. Assets that Linn paid roughly $1.8 billion for, it is now trying to sell for only $1 billion. This is indicative of a company that tends to overpay for production, which will hurt per unit data. For investors, per unit figures are far more important than consolidated results.
This weakness is reflected in the company's guidance. It expects to generate cash in excess of the distribution of about $12 million. At the current level of $2.90 per annum, the coverage ratio is a tenuous 1.01x. In other words, Linn has no room to raise the payout this year and has little margin of error. When originally announced, Linn had hoped the Berry deal would add $0.40 to the annual distribution. Now, Linn can barely maintain the current level. Since Linn overpaid for Berry, it will be unable to increase the distribution as the cash it pays to the newly issued units will exceed the cash generated by Berry's assets.
Now, even without distribution growth, LINE still yields 9%, which is nothing to sneeze at. However investors who had been hoping for a growing distribution will be disappointed. Based on current estimates, it looks like Linn overpaid for Berry, and this deal will be a major headwind for distribution growth. While Berry will increase production and reserves appreciably, it increased the unit count even more. The Berry takeover is looking like a strategic error, and Linn should not have raised its offer so substantially as it eliminated all the accretion. While Linn pays you to wait, I would be uncomfortable owning LINE when it continues to pay more for assets than they are worth. The Berry deal increasing looks like a mistake.