Linn Energy: Production Imperils The Distribution

| About: Linn Energy, (LINEQ)


Linn is trading slightly higher after reporting a roughly in-line quarter.

Production growth of 39% was driven by the Berry deal, and the unit count is up slightly more.

Organic growth will be only 3-4%, despite a massive capex budget that totals nearly $900 million.

Without an improvement in organic growth, the cap-ex program will imperil the distribution as Linn continues to issue debt and equity.

On Thursday morning, Linn Energy (LINE) reported quarterly results, and the market seems to be breathing a sigh of relief, with units up over 1%. However, it is worth noting that LINE came into the quarter near its 2014 low. Investors had been selling units for weeks prior to this report, and it probably would have taken a distribution cut to push LINE lower in the immediate term. However, these results continue to point to long-term problems for this upstream MLP. It should also be noted that this analysis applies fully to LinnCo (LNCO), an LLC that solely owns LINE units.

Unsurprisingly, Linn reported a net loss of $0.27, but if you exclude a non-cash loss resulting from the reduction in put option premiums, EPS was $0.40, which was exactly what analysts expected (all financial and operating details available here). Oil and natural gas sales totaled a solid $939 million. Most MLP investors are investing primarily for the distribution, and as a consequence, de-emphasize earnings in favor of distributable cash flow. While Linn is maintaining its distribution, it paid out $3 million more cash than it generated. In other words, operations covered about 98.75% of the distribution. A coverage ratio below 100% is definitely troublesome, but this figure is so close, a cut to the distribution in the next six months is highly unlikely.

Investors need to ask whether this coverage ratio will improve or get worse over the next 6-12 months. If it improves, the current distribution is safe, but if not, an eventual cut is inevitable. LINE currently yields 10.2%, which suggests some investors are skeptically about the sustainability of the distribution. After looking through these results, I do not foresee an improvement in the coverage ratio going forward. While I do not expect a cut in 2014, I would not be surprised by one in 2015 and expect LINE to continue to languish below $30.

At first glance, daily production of 1,104 MMcfe/d seems fantastic; after all, it is up 39% year-over-year. However, this gain is almost due entirely to the acquisition of Berry Petroleum. This deal increased Linn's unit count by 40%, so production per unit actually fell slightly in the quarter. This is further evidence that Linn had to overpay to buy Berry. For the full year, I expect production growth of about 35%, driven almost exclusively by Berry.

Linn's current guidance forecasts production of 1,075 to 1,110 MMcfe/d in the second quarter and 1,075 to 1,135 for the full year. We are actually going to see a sequential decline in the second quarter, which is concerning. While downtime will cut production by 1% in the second quarter, terrible weather made production a bit more difficult in the first quarter. A sequential production decline is troubling.

This sequential decline is even more worrying when you consider how much Linn spends to grow production every year. In total, Linn will spend about $1.6 billion in capex this year. Of this sum, $700-$800 million is maintenance capex, spending that keeps production flat. The remaining $800-$900 million is growth capex, spending to increase production. It should be noted that maintenance, but not growth capex, is subtracted from operating cash flow to determine how much cash is available to distribute. Linn therefore funds growth projects with debt and equity, making it absolutely critical that they perform well.

Unfortunately, growth efforts are underwhelming. Linn's growth budget is 8-10% of its market capitalization, and will equate to over 20% of 2014 revenues. Simply put, Linn is spending a ton of money, so one would expect quite a bit of organic growth. For the full year, Linn expects an organic growth rate of 3-4%. Linn consistently spends several hundred million dollars on growth projects, but organic growth is meager. This implies that either growth projects are underperforming or some growth capex should be classified as maintenance capex, which would make the coverage ratio worse. Organic growth will contribute less than $150 million in sales this year. To be blunt, Linn's organic growth is terrible when we consider how much it spends. If Linn cannot improve production figures, it will be more difficult to pay back the debt it has added to fund growth projects, meaning further dilution for equity holders as Linn sells equity to pay back debt. With its budget, organic growth should be at least 10%.

This quarter was not disastrous, but there are warnings signs that there are problems ahead. Production growth lags unit growth, which means that per unit production was lower in the quarter. There will be a sequential decline in production, and annual organic growth will be a measly 3-4%. At the same time, expenses, like lease and cost of production, continue to increase, which will pressure margins. Moreover, growth projects seem to be underperforming, which will pose problems in the next three years. I don't expect a cut in 2014, but Linn's distribution is in a precarious position given weak organic growth. A cut in 2015-2016 is quite possible, and I would not be an owner of LINE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.