Shares of Linn Energy (LINE) rallied over 2.3% on Thursday after investors digested the company's second results. Linn has been a controversial company as analysts like Hedgeye's Kevin Kaiser have suggested the distribution is too high and that a cut is inevitable. Overall, this quarter was a decent one, and Linn is in no danger of a distribution cut in the immediate future. Still, significant fundamental problems remain, and the company announced a confusing and troubling share buyback program that should give investors pause. I continue to suggest long-term investors sell Linn and invest in other energy companies.
In the quarter, Linn energy earned $0.56 per unit compared to expectations of $0.42 (operating and financial data available here). Rightly or wrongly, most investors don't focus on GAAP net income because MLPs are owned mainly for the distribution. As a consequence, investors look for distributable cash flow ("DCF"), which is the amount of cash available for distributions. If the distribution is higher than this, there is a heightened risk of a cut. At its current annualized payout of $2.90, Linn needs to generate $241 million per quarter. Linn actually generated $273 million for a coverage ratio 113%. In the first half of 2014, Linn has generated excess cash of $29 million and expects to generate excess cash of $103 million over the course of the entire year.
Linn increased production by 45% to 1,131 MMcfe/d, but the vast majority of this increase was due to the acquisition of Berry Petroleum. This acquisition has made Linn's production more oriented toward liquids, which are generating superior selling prices. In the quarter, 44% of production was natural gas while oil was 39% and NGLs were 17%. On an organic basis, production grew by a meager 2.4%. Now, this production was better than where management had guided, but 2.4% growth is hardly spectacular. Moreover, Linn's unit count increased by 41% year over year, so on a per unit basis, investors are seeing less than 4% production growth.
Now, the reason why I'm most concerned about slow organic growth, which will be less than 5% this year, is that Linn spends a ton of money on capex. For the year, Linn is still on pace to spend $1.6 billion. 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 it performs well.
Linn is spending over 40% of revenue on capital projects, but organic projects will add less than 5% to revenue. Linn will also be maintaining a relatively large capital program through 2016. With the size of its cap-ex program, Linn should be growing production around 8%. This low growth rate makes me concerned about the efficacy of this spending. Meanwhile, it adds more debt and equity to fund these projects, so if they don't pan out, existing investors will be very diluted. Linn now carries $9.6 billion in debt, which is roughly 9x distributable cash flow. Linn is simply a highly levered company with subpar growth.
Finally, Linn made a very strange announcement in this quarterly report. First, it announced the board authorized Linn Energy to repurchase $250 million in units, and LinnCo (LNCO), which is an LLC that owns LINE units, can also buy back $250 million in stock. At the same time, the Linn board authorized a $500 million LINE at the market secondary program while LNCO can also sell $500 million in stock. Why would a company authorize both issuance and repurchases of equity? Moreover with high leverage and an outsized distribution, it is unclear how Linn could fund such a buyback. At the end of the day, I expect Linn to issue stock but to buy back far less than authorized.
Linn continues to accrue debt and increase the unit count at a fast pace while organic growth remains slow. While Linn's 9% yield might be appealing, Linn will struggle to maintain that dividend in late 2015 to early 2016 as debt grows, the unit count increases, and production growth is minimal. I encourage investors to sell LINE now that it is above $30 and look for energy companies with superior growth like ConocoPhillips (NYSE:COP) and Anadarko (NYSE:APC).
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