Linn Energy (LINE) shares dropped nearly 4% on Tuesday as Jim Cramer sold his position in the upstream master limited partnership ("MLP"). He also recommended investors rotate out of LINE and into Kinder Morgan Energy Partners (NYSE:KMP), which has underperformed lately (details available here). The drop in LINE also pushed LinnCo (NASDAQ:LNCO) down over 3%. LinnCo is an LLC that solely owns LINE units and functions as a tracking stock for investors who prefer not to deal with K-1's when they file taxes. Should investors follow Cramer's recommendation or stick with LINE and its 9% yield?
Over the past twelve months, Linn Energy has been one of the most hotly debated stocks in the market. Kevin Kaiser and Barron's have been the leading voices on the bear side, raising concerns about maintenance cap-ex accounting and the efficacy of the capital program. Mr. Kaiser's research also played a role in the SEC's inquiry into Linn's accounting, though no actions were taken against the firm. Last year, Linn also completed its acquisition of Berry Petroleum, though it did raise its offer by 34% during the year. By paying more for Berry, the deal is appreciable less accretive.
In 2014, Linn expects to grow production by 34% to 1070-1140 MMcfe/d (guidance and financial data available here). Thanks to the Berry deal which resulted in the issuance of 94 million units, Linn's unit count is up 40% year over year. In other words, production per unit will decline in 2014, though it will be tilted more towards oil, which is positive. Similarly, proved reserves are up 34% to 6.4 Tcfe, which also lags the unit count. Under the original terms of the deal, Linn would only have increased its unit count by 30%. Berry was touted as a transformational acquisition, but it looks like Linn overpaid. It is no wonder bulls are exiting the stock.
There is further evidence Linn overpays for production growth as it was forced to take an impairment of $790 million last quarter on assets that cost $1.8 billion, meaning Linn paid nearly twice what they were worth. Linn has been focusing on growing production primarily and in its quest to do so has been unafraid to pay high prices. If energy prices rise dramatically, these deals may prove accretive, but in the current environment, they look like losers. Linn's deal-making is having a dilutive impact on unitholder value.
Based on its guidance, Linn will also be unable to increase its distribution beyond $2.90 this year. The company will generate about $2.93 of distributable cash flow, so it has little margin for error and cannot sustain an increase to the distribution. Given the Berry deal, I also do not expect room for much, if any, growth in 2015. MLPs are owned primarily for their yield, and without an increase to the distribution, there is no clear catalyst to push LINE higher especially as its non-Berry assets will not generate appreciable production growth in 2014.
After a strategic error with the Berry deal and lackluster distribution coverage, it makes sense for the bulls to rethink their thesis. 2014's production growth is driven by an acquisition and not organic factors, which gives credence to criticisms of the capital program. Distribution growth in 2014 is exceedingly unlikely, and unless production results improve, investors should not expect an increase in 2015 while rising interest and maintenance expenses create downside risk. While Linn's 9% yield is certainly enticing, investors should look elsewhere.
Kinder Morgan offers a 7% yield that is growing 5% annually, and it has $14 billion of growth projects under development (financial and operating data available here). As a pipeline operator, it is also far less exposed to commodity prices than Linn is. While the current yield is lower, future distribution growth will be superior. Investors would be wise to follow Cramer's advice. With no distribution growth, there is no catalyst for LINE to move higher. Investors in LINE and LNCO should sell and rotate into other MLPs like KMP.
Disclosure: I am long KMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.