- LINE trades at an assumption of no distribution growth based on dividend discount model.
- The planned monetization of Wolfcamp would provide meaningful near-term distributable cash flow growth.
- Management's continued effort to drive down production decline rate and diversify asset portfolio should also help distributable cash flow growth.
- Investment return is substantial as potential distribution growth announcement should drive price upside and the unit offers a compelling yield at 9.5%.
Unit price of Linn Energy (NASDAQ:LINE) has been on an uptrend since dropping to its 1-year low in July 2013. Looking forward, I believe the units are poised for a material price upside driven by the current conservative valuation and management's near-term plan to monetize Wolfcamp acreage.
The company made $2.90 per unit distribution in 2013. Based on a Gordon growth dividend discount model, the following table shows different mix of dividend growth rate in 2014 and cost of equity for LINE corresponding to various unit prices as of now:
Based on the above, the current unit price of $30.9 has baked in an assumption of 0% dividend growth in 2014 and cost of equity at approximately 9.5%. Based on a CAPM model with a 2.5% alpha to account for additional company-specific risk as shown below, the 9.5% cost of equity for LINE is completely fair and reasonable.
As such, it can be concluded that LINE's current valuation implies a flat distribution growth scenario. Given that 1) management guided a distribution coverage ratio of 1.0x for 2014; 2) management's plan to monetize Wolfcamp and use of the proceeds to acquire producing assets should provide meaningful near-term distributable cash flow ("DCF") growth; and 3) the company's ongoing effort to lower production decline rate and diversify asset portfolio would further support DCF growth, I view LINE's current valuation to be conservative as there is fair chance of distribution growth in 2014 or 2015. Hence, an announcement of distribution growth down the road would be an upside surprise to the unit price.
Here is how the Wolfcamp monetization would drive near-term DCF growth. Based on various estimates from sell-side analysts, the divestiture should generate cash proceeds ranging from $1B to $2B. Based on a total acreage of 55K, this implies a per acre price range from $18K to $36K, which is in line with the region's recent transactions. Assuming that LINE is able to acquire production properties at 6.8x EBITDA, which is the same as the acquisition price for Berry, this would translate into an incremental EBITDA range from $147M to $294M. Assuming a 30% maintenance capital expenditure requirement, incremental DCF would range from $103M to $206M, representing an incremental DCF per unit range from $0.30 to $0.61. This would mean a material upside of 11% to 21% from the actual DCF per unit of $2.88 in 2013 (see chart below).
In addition, the completion of Berry acquisition should provide meaningful benefits to LINE through lowering production decline rate (i.e. management expects the decline rate to trend down in 2014) and helping the company diversify its asset portfolio so as to achieve a more stable production profile.
In summary, I believe now is a great opportunity to buy LINE as the units trade at the assumption of no distribution growth. Given the chance of distribution hike is fairly high in near to medium term, the unit is poised for a meaningful price upside. It should be noted that my above analysis does not even consider the compelling 9.5% yield.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.