- Some have suggested Linn Energy is paying out too much.
- The Berry deal will likely be dilutive for unitholders.
- With its capital program, production growth should be 10% higher.
- While the distribution is safe for now, increasing debt and equity needs and weak production could threaten the payout.
Over the past year, perhaps no stock has been more of a battleground then Linn Energy (NASDAQ:LINE) along with its sister LLC LinnCo (NASDAQ:LNCO), which owns units of LINE. On the one hand, there have been the bears led by Hedgeye's Kevin Kaiser and Barron's, which question Linn's accounting. They have argued that Linn should consider more of its cap-ex as maintenance and that its distribution is unsustainably high. Even the SEC launched an inquiry into Linn's accounting after the negative criticism. On the other hand, many income oriented investors have remained bullish, often citing Linn's 10.3% current yield, which provides quite a margin of safety. For much of this battle, CNBC host Jim Cramer was also bullish and rather critical of the bears. However, he did sell the position his charitable trust held last month (details available here).
Now on Monday morning, Cramer answered some stock questions for The Street. The final question asked was "Is Linn Energy's dividend safe?" Cramer responded, "It's not clear...I think it's probably safe… Linn bought Berry, and the production growth has not been demonstrated yet…We fled the stock in the low $30's…The failure to execute in the past two quarters has really been pretty dumbfounding to me." Investors can watch the full Q&A here. Can investors count on the distribution or is there risk?
We know where the bears stand on this issue. Ironically, their negativism could be a self-fulfilling prophecy. As LINE's price continued to fall during 2013, some Berry investors thought a merger no longer made sense. As a consequence, Linn increased its offer from 1.25 LNCO per Berry share for 1.68. Now, this new Berry exchange rate increased Linn's unit count by 40%. However, the deal only increased Linn's proved reserves by 34% (all financial and operating details available here). Similarly, production in 2014 should only increase 34%. In other words, production and reserves per unit will actually fall this year. That puts pressure on the distribution per unit. The Berry deal will likely prove dilutive for LINE.
This guidance was very disappointing, and it suggests Linn's non-Berry assets won't provide any production growth. Considering how much money Linn spends on cap-ex and acquisitions; Linn should be growing production far more appreciably on a pro forma basis. Linn will spend $1.6 billion in cap-ex this year, which is down 11% from 2013's program. Still, it is a mighty sum and amounts to $4.83 per unit. The cap-ex program is actually 67% than distributable cash flow. At some point, Linn needs to show appreciable pro forma growth to justify this budget. Moreover at some point, LINE needs to generate free cash flow, not just distributable cash flow.
Maintenance cap-ex should be about $625-$650 million this year; meaning Linn will spend at least $950 million on growth projects. This spending amounts to 10% of Linn's market capitalization. Linn will have to keep issuing debt and equity to fund this. With its 10% distribution, issuing equity is extremely costly. Linn also carries $9.17 billion in debt, which will make issuance increasingly costly. Further if interest rates rise over the next 3-5 years, Linn will be borrowing and rolling over debt at increasing rates, which will be a cash drain.
Last quarter, Linn also took an $828 write-down on assets it bought. Between this and the Berry deal, it does seem that Linn is willing to overpay for production, perhaps to compensate for the fact that Linn's capital program is not generating the production growth it should. I do believe Linn's distribution is safe in 2014 and probably 2015 as production should be able to sustain a $2.90 annual payout and Linn has already hedged out most of the pricing risk. As we look out longer, oil price appreciation may be lackluster thanks to booming US production. Moreover, Linn will be pouring more and more capital to maintain production as legacy wells continue to decline.
Linn has a massive cap-ex budget, and funding the growth projects will lead to more debt issuance and equity issuance, which will threaten the distribution. With its capital program, Linn should be growing production 8-10% faster than it currently is. In 2014 and 2015, I expect Linn to generate DCF of about $2.90, but unless it can show stronger production growth, DCF will likely start slipping in 2016 that could force a cut. Long term investors in LINE need to closely watching production; unless we start to see a meaningful increase over the next 12-18 months, one has to be concerned about the distribution over the next 3-5 years.