Shares of Linn Energy (NASDAQ:LINE) are trading near their low at $0.32 apiece on while shares of LinnCo (NASDAQ:LNCO) is behaving similarly. The main reason appears to be that, despite a nice uptick in oil prices recently, investors are afraid the business may go under. For this very reason, it is my opinion that we should start thinking of what the picture looks like should matters worsen and the company go through bankruptcy.
What would investors get in a bankruptcy?
There is no denying that cash flow for Linn this year should be very positive, even with management expected to allocate a great deal of capital toward capital expenditures to keep production from declining significantly. In the image below, you can see what the picture looks like with oil prices averaging $40.39 per barrel and natural gas going for $1.924 per Mcf. After this year, however, things start to take a turn for the worse, with the business expected to see massive cash outflows in 2018 and 2019.
Unfortunately, Linn may not make it that long regardless. In February, management drew down the rest of its credit facility and recently announced that it would stop making payments on certain types of debt because it was risking a covenant breach, a situation that would push it into default due to the acceleration of debt. Since then, the cash has been placed into an unencumbered account that will afford it some protection in the event that the company faces a debtor-in-possession situation. Management has also stated that it will allow investors the opportunity to exchange their Linn shares for shares in LinnCo in an attempt to avoid massive tax gains should the business buy back or otherwise reduce its debt meaningfully.
Because of this turn of events, it's clear that LinnCo shares are more appealing than Linn's shares since those would shield investors from the tax hit. However, none of this will do much good if the company happens to go under unless a tremendous amount of value is left over for investors to grab hold of. This has led me to look into Linn and see what kind of value would exist should the company go through a Chapter 11 restructuring. As a note of caution, any discussion on this topic is highly subjective because it's impossible to know what various assets will be valued at for a company that is trying to restructure and because there's an incentive for senior debtholders to push for a lower valuation on those assets while more junior debtholders (and shareholders) have an incentive to push for a higher estimated valuation on the business.
Looking through Linn's balance sheet, which you can see in the image above, it's clear that (using fiscal year end 2015 for all this work) the company has $2.17 million in cash and cash equivalents and $215.56 million in accounts receivable. Cash is always worth par and accounts receivable would likely be discounted modestly (perhaps 5% to 10% unless customers are deemd to be risky). So let's say that receivables would be worth, say, $204.78 million. Derivatives as of the end of last year should be worth $1.79 billion but this number can change significantly as energy prices fluctuate.
Although Linn has some deferred tax assets on its books, these are small and can be subject to restrictions under Section 382 of the Internal Revenue Code in the event of a change of control and other uncategorized assets are also uncertain in terms of value so I can't see assigning any real value to those. The rights to oil properties on a PV-10 basis was estimated to be $3.03 billion but that's assuming oil prices of $50.16 per barrel and natural gas prices of $2.59 per Mcf. I personally believe that both products will see prices rise in the months to come and this is probably a fair or perhaps even a conservative estimate for the long run. Restricted cash totaling $257.36 million would go to Linn's Berry Credit Facility so that can serve as a direct reduction to the relevant debt outstanding. Similarly, the $919 million in cash the company put into an unencumbered account from its LINN Credit Facility would likely go to pay down the company's increase in said credit facility but could be split up amongst both facilities. Either way, that's a wash on a net basis.
On the liability side, things become a lot more complicated because the disclosures provided by Linn aren't all that great. As a rule of thumb, employee salaries that are due and taxes (and other obligations) to the government are paid off first, but these are not specified in Linn's annual report to a significant degree so they are likely small enough to say that the deferred assets I mentioned above are probably large enough to satisfy said claims, if any. All other liabilities should be washed away except for debts due to creditors. As the first in line, the company's credit facility lenders should be paid before anybody else. After factoring in the restricted cash issue and assuming that the $919 million in Linn's unencumbered account goes back to the company's credit facility lenders, this leave debt of $3.33 billion due to said lenders.
By my own calculations, the value of Linn's assets (making the very volatile assumption that the company's PV-10 value is appropriate) should be worth about $5.02 billion. Should the company's credit facility lenders be made whole (which they should), this would leave $1.69 billion in extra value. The next lenders in line would be the owners of the company's Second Lien Notes, which have debt outstanding of $1 billion.
Interest of over $600 million is factored into long-term debt but I cannot see why a judge would allow interest to be paid before the principal of other debtholders. Given that my assessment here is accurate, this would leave excess value of $692.78 million to be divvied up between Senior Notes investors with debt outstanding of $4.46 billion. In a world where all such creditors are paid proportionately, this implies that they would recover about $0.155 on the dollar for debt, suggesting that some classes of debt might be undervalued right now.
Of course, this isn't cash that lenders would receive but is, instead, likely ownership in a revived Linn. Furthermore, should Linn truly be restructured, the self-interests of different debtholders will likely create a war in the process in the hopes of extracting the greatest amount of value from each side. For instance, it would be in the best interests of credit facility lenders to try and downplay the value of assets while it would be in the best interests of Senior Notes investors to say that asset values are much higher than they might actually be. On top of this, you have a complex legal system and the likelihood that some of the debt will stay on Linn's books as debt should it be restructured, which will drastically change ownership compositions.
Moving forward, it will be interesting to see what happens with Linn. At the moment, I am more cautious on the business than I have been but I'm also not sure there's a guarantee the business is going toward bankruptcy since there may be other ways out of the mess. What I am quite certain of, however, is that there appears to be a chance for Senior Noteholders to see some value salvaged in the event of a restructuring but any such move would certainly leave shareholders with nothing or very next to nothing.
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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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