If you are reading this article you are quite possibly in one of the five stages of grief: denial, anger, bargaining, depression, or acceptance. I am somewhere in the last two. I accepted my poor investment decision and want to determine what I may have missed and how to avoid it in the future. I appreciate Seeking Alpha comments as a good place to blow off a little steam and throw some blame around, but I don't think it typically belongs in the articles. As investors, we make the best decision possible at the time with what we know at the time. We try to predict the future within reason but are often wrong. Looking back, it is easy to see that I made a poor decision.
Consider calculating a weighted average debt maturity to determine how much the company needs to save per quarter to meet future repayment obligations and determine a more accurate EPS. Companies that are dependent on rolling their debt and are tied to a volatile commodity need extra attention. Depreciation is a very real expense that capital must be planned to replace depleted assets. The company needs to maintain a reasonable level of debt, provide a fund for repaying the debt, or have truly substantial resources to weather a downturn.
Other considerations are buying insurance in the form of puts, or only purchasing in a non-tax-sheltered account so that any losses can be realized against taxes. Even though you have a long term outlook and are value driven, your capital investment may not survive the market cycle. Would you buy the company's bonds or are they operating on the greater fool theory? Is the company a price maker or a price taker? Price maker's have far greater control of their own destiny. How does the price of the dollar affect the company?
Bankruptcies and other companies:
I have had three different experiences with companies that have gone bankrupt or possibly will. Those are General Growth Properties (NYSE:GGP), Genco Shipping (NYSE:GNK), and now Linn Energy (NASDAQ:LINE)(NASDAQ:LNCO).
General Growth Properties
GGP is one of the largest mall owners in the country. Malls are expensive propositions and provide a unique shopping experience. Lease rates at malls are generally higher than other commercial properties so GGP is more of a price maker than taker. GGP had a high level of debt and due the recession many of their retailers closed their doors, and GGP was unable to pay their bills for a brief period of time and of course the bond and equity markets were closed to them. GGP during the financial crisis filed for bankruptcy but Bill Ackman saw the value in it through his Pershing Square fund and clearly demonstrated that it's assets were of substantial value to the shareholder's, easily $4 per share. I was not an investor before and bought in under $1. Luckily, they had sizeable assets in commercial property that was not subject to large volatility. This story turned out very well for GGP shareholders who held on.
Genco is a dry bulk shipper. It operates primarily on spot market prices compared to others who operated on contracts. Therefore GNK is a price taker. The spot market price was based on the Baltic Dry Index (BDI). Many of their competitors locked in contracts near the peak of the market. This would be similar to Linn's hedges. The dry bulk market overbuilt capacity and day rates tanked. Genco was in my opinion one of the more share holder friendly operators. It should be noted that a lot of the dry bulk shippers are Greek companies. Genco was paying healthy dividends and had a very large book value. Ships were expensive due to the large backlog of orders at shipyards, which of course Genco had plenty on order as well. Genco was very similar to Linn in that they expanded at the peak, except Linn had the forethought to hedge superior prices. Ships are scrapped over time and new ones built and Genco argued that eventually the market would come into balance. My opinion is that the oil market can come into balance a lot quicker than the shipping market.
The process for Genco entering bankruptcy was long and drawn out, with occasional spikes in the BDI. This enabled me to sell covered calls, recoup my money, and even sell out at a profit. In the end, the shareholders got massively diluted. Recovery for shareholders primarily depends on what the company is worth. Shareholders argued that because billions of dollars were recently invested in the shipping industry, that GNK was worth more than the other parties were valuing it at. I wonder if that court case would have any bearing on a value for Linn if it files for bankruptcy. I do not want to create any false hope for equity holders out there like myself. The odds of recovering anything in a Linn bankruptcy are very small.
Linn energy is an oil and gas producer, the definition of a price taker. In my opinion they tried their best to overcome this liability by hedging their production. We all know Linn's troubled tale. Some predicted the current situation. I did not think the end would come so soon or that the market would primarily go in one direction unabated. After all, GGP couldn't pay its bills, and Genco waited till the very end. Linn still has lots of cash and can meet it's obligations for the current year and probably next year as well. They appear to be forcing this bankruptcy. To me the only thing that makes sense is that the second lien holders do not want any more interest payments going to the other unsecured debt holders so that they can recover more, but that is pure speculation which as it turns out investing in this company was.
Kinder Morgan (NYSE:KMI)
As primarily a pipeline company, they are a price maker. If you want to ship your product to market, there are often no other pipelines to put it in. Like the other companies mentioned here, they have run up massive amounts of debt and been paying out large portions of their cash flows to share holders. I was admittedly doubtful of Kinder Morgan for a long time due to the Enron association. I was wrong, it's a great company. Regardless of whether you needed the dividends, we can all see that in the long term interest of the shareholders, it was the right thing to do. Cutting the dividends doesn't mean the money is gone, it goes to the balance sheet. A properly run business should use the cheapest source of capital as I think KMI has done and shareholders will reap the benefits in the future. KMI controls it's own destiny by not needing the bond market, being able to eliminate or put projects on hold while receiving substantial cash flows from an operation that has a deep moat.
How do I avoid the next Linn?
I bought my first shares in October 2013. The merger with Berry was pending and in all honesty I did not do my due diligence as I thought it was roughly a merger of equals. At the time here is what I knew (based off the August 10-Q):
|Linn Balance sheet||June 2013|
|BV per share||21.30|
|Linn Cash flow statement||Six months ended June 2013|
|Cash from operations||561,356,000|
|Cash from investing||(404,528,000)|
|Cash from financing||(156,919,000)|
|Net change in cash||(91,000)|
|Dividends per share||1.45|
|Debt schedule (dates are approx.)||Amount in millions|
Linn had a high book value, shares were around $31-32 at this time so the book value was a substantial part of that price. Dividends were substantial, $170 million per quarter. No substantial debt was due for five and a half years. Cash flow at -$91,000 is as close to even as it gets. They just bought back $41 million of their 2017 notes. They have a credit facility of $4 billion with about $1.4 billion used. What's not to like?
Knowing what I know now, let's look a lot harder at the debt:
Let's go a little further into their debt schedule. The weighted average maturity is January of 2020. Between October 2013 and January of 2020, let's just call it six years, Linn needs to be able to pay back $3,864 million, an average $644 million of debt per year, all the while paying the interest. This is approximately $161 million per quarter. Why do they need to pay it off? Because oil fields are depreciating assets. They deplete and must be replaced to continue operations. Linn is realizing depreciation on their income statement, but doing little to prepare for the cash flow reality. You could look further into their investing and financing portions of their income and cash flow statement, but I will stick with the dividend portion as I believe it is representative. At this time the dividend was around 9%.
In hindsight (and in foresight for those of you out there smarter than me), this $161 million needed versus $170 million which is essentially all excess cash paid in dividends is a red flag. Essentially giving the bond holders their due, leaves $9 million per quarter for common share holders. This results in an EPS of $0.15 per year. At a PE of 20x, puts Linn in October 2013 worth $3.06 based solely on earnings and not taking into account their assets which at the time, were substantial.
Couple this with a volatile commodity and we have a value trap. If oil goes up, all is well, heaven forbid the oil price drop. Even with their hedges maintaining current prices does not make up the difference. Completely cutting the dividend in hindsight along with cost cutting measures could have kept Linn a viable company.
Disclosure: I am/we are long LNCO, KYE, BP.
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.
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