- Current valuation has only priced in slightly negative to zero distribution growth.
- Continued high-grading of asset portfolio should notably improve distribution coverage driven by significant capex savings.
- Potential swap of the remaining Permian assets would lift distribution coverage to about 1.15x.
Unit price of Linn Energy (NASDAQ:LINE) has risen by 4.5% over the past 3 months, which is slightly better than 4% return for S&P 500 Index. Based on current annualized distribution of $2.90 and 10% cost of equity (the CAPM model would result in 7.8% cost of equity based on 3% risk-free rate, 6% equity risk premium, and LINE's 5-year beta of 0.81), the Gordon Growth Dividend Discount Model suggests that the current unit price of $30.70 implies a slightly negative distribution growth rate (see chart below). In my view, the current valuation is somewhat conservative as the likelihood of a distribution cut is very low given my view that LINE is able to maintain a solid distribution coverage ratio at north of 1.0x in the next few years.
LINE recently announced a transaction to swap a portion of its Permian assets (26,000 net acres) for an interest in the Hugoton assets from Exxon Mobil (NYSE:XOM). The deal demonstrates management's commitment to restructuring LINE's asset portfolio towards assets with low decline rates and higher capital efficiency (i.e. requiring less upfront spending). Management expects the deal to be DCF (distributable cash flow) accretive, which is amounted to be about $30M-$40M per annum. Given that a majority of production is generated from the remaining Permian assets (29,700 net acres) and the capex requirement is very high, I believe continued swap-in of low-declining and capital efficient producing assets would have even greater accretive impact on DCF.
I have performed an illustrative asset swap analysis for the remaining Permian acreage. First of all, I assigned a $1.0B value for LINE's 29,700 net acres, implying a valuation of $34K per acre. This valuation is slightly below a $37K per acre valuation from the recent Athlon Energy/Permian transaction, which is deemed to be the most comparable transaction to LINE's Permian assets. Assuming a 7.5x EBITDA multiple for the new asset valuation, EBITDA from new assets would be about $133M. Based on Raymond James' estimate of $36M EBITDA for the swapped Permian assets with daily production of 2K BOE, I estimated that the remaining Permian assets should generate approximately $263M EBITDA given that the daily production is about 15K BOE. Now one should have noticed that the incremental EBITDA from a potential swap transaction would likely be negative. Based on my calculated incremental EBITDA of -$129M and consensus EBITDA estimate of $2,310M for 2015, the pro forma EBITDA would be $2,181 for the year (see chart below).
As management's goal is to swap in assets with higher capital efficiency, I estimated maintenance capex from the new assets to be 35% of EBITDA, which represents about $47M based on my EBITDA estimate of $133M from new assets. For the existing Permian assets, I assumed a maintenance capex of $250M, which is based on management's original capex budget of $275M for the entire acreage and has factored in the sold portion. As a result, incremental capex for the hypothetical transaction would be -$203M. As consensus estimated capex for 2015 generally ranges from $750M to $800M with a mid-point of $775M, my pro forma capex for the year was calculated to be $572M. After subtracting interest expense of $500M in 2015, I estimated distributable cash flow in 2015 to be $1,109M, or $3.34 per unit based on ~332M unit count. Given the $2.90 distribution per unit, my analysis implies a solid distribution coverage of 1.15x. As illustrated by the analysis, the whole idea of an asset swap is to achieve greater capex savings than loss in EBITDA (see chart above).
I have also presented a scenario without any asset swaps. In this case, distributable cash flow would be about $1,035M in 2015, or $3.12 per unit, representing 1.08x distribution coverage (see chart below).
In conclusion, the recent Permian transaction has proved management's ability to pursue its asset high-grading plan. With some fair assumptions, the full execution of the plan would notably improve distribution coverage. Given that LINE's current valuation remains fairly conservative, a buy rating is warranted.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.