Over the past fifteen months, Linn Energy (LINE) has been the ultimate battleground stock. Over this time frame, the bears have been winning as units have fallen more than 25% from their highs. However, some bulls have probably used the pullback to add to their position at what they consider to be an attractive price. Bulls, including many retail investors, love Linn's distribution. At current prices, Linn yields around 10%, which is hard to beat. However, bears like Hedgeye and Barron's have suggested this distribution may not be sustainable over the long term. While bears have been winning, one might think LINE is cheap enough to safely buy now. I would disagree. As a side note, this analysis also applies to LinnCo (LNCO), an LLC that solely owns LINE units.
Given the decline in shares, there may be some temptation for the bears to declare victory and move on. Instead, Hedgeye's Kevin Kaiser reaffirmed his view that Linn must be sold in a note sent to clients (details available here). It can be dangerous to be greedy when investing and taking profits never bankrupted anyone. However in this case, I think the prudent strategy is to be a seller of Linn because its capital allocation strategy will erode investor value while leaving the firm deeply indebted. Linn is not generating sufficient organic production growth to justify its massive cap-ex budget.
In 2014, Linn will spend about $1.6 billion in cap-ex (all financial and operating data available here). For perspective, Linn's cap-ex budget will consume over 40% of this year's revenue. With this spending, Linn will generate organic growth of roughly 3% this year. Moreover, there will be a sequential production decline in the second quarter despite the bad weather in the first quarter. While an imperfect comparison, ConocoPhillips (NYSE:COP), which is also focusing on North American oil and gas, will spend only 27% of revenue on cap-ex and generate slightly faster production growth. With Linn's cap-ex budget, 3-4% organic production growth is anemic.
Now as an MLP, Linn has to break its cap-ex spending into two categories: maintenance and growth. Maintenance cap-ex is the spending needed to maintain the current level of production while growth cap-ex is spending to grow production. This year, LINE will classify about $700-$800 million as maintenance and $800-$900 million as growth spending. This distinction is critical for investors. Distributable cash flow, which the company uses to determine its distribution, is essentially operating cash flow less maintenance cap-ex. In this sense, it is analogous to sustaining free cash flow.
As a consequence while Linn's distributable cash flow covers the distribution, the company is free cash flow negative. For the full year, Linn will generate virtually no free cash flow and could even be slightly free cash flow negative. As a consequence, Linn issues equity and debt to fund its growth cap-ex. When a company uses the cash it generates to fund growth projects, there is limited downside. At the very worst, it wastes the money. In Linn's case, there is more downside as it issues equity and debt. It has to pay interest and dividends, so growth projects are more expensive. If they fail to achieve expected outcomes, Linn's cap-ex spending will in fact dilute shareholders and lead to a net cash outflow.
This year, Linn will generate a meager $150 million of organic revenue growth. With Linn consistently spending over $800 million per year on growth projects, $150 million of annual organic revenue growth is deeply disappointing. At the very least, Linn should be generating production growth of 8-10% given its massive cap-ex budget. Instead, Linn is growing at half that pace. Investors see Linn's growth cap-ex spending as a positive because in theory it should drive future distribution growth. Instead, this spending is really a negative because Linn is adding debt and equity without generating adequate production growth.
Yes, Linn pays a nice 10% distribution, but the company has no free cash flow generation. Instead, the company continues to add debt and equity. Without an acceleration in production growth, this could end badly with existing holders diluted. With rising maintenance cap-ex and disappointing growth coupled with a larger debt load, Linn will likely be forced to cut its distribution sometime in 2015. I expect units to head back to the low $20's in the next twelve months as weak production pulls down results. Until and unless LINE can better execute on production growth, the path of least resistance is lower.
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.