There aren't a whole lot of places in the investment universe where you can look to find companies yielding nearly 9% which pay out distributions monthly and have raised their distribution nearly every year in their corporate trading existence. With the exception of a distribution freeze at $2.52 per unit from 2008 to 2009, Linn (LINE) (LNCO) is the company that fits such a billing.
I have been reluctant to write an article dealing exclusively with Linn because I had one principal concern: I could not determine the safety of the distribution because the distribution payout always seemed dangerously close to engulfing the full amount of cash flow that Linn was generating. For example, Linn generated cash flow per unit of $2.88 in 2010 and paid out a distribution of $2.55, for a payout ratio of 88.5%.
Even in 2013, the reported figures were largely more of the same. After posting $3.21 per unit in cash flow, Linn paid out a distribution of $2.90 per unit, for a payout ratio of 90.34%. This shouldn't necessarily be read as a criticism of Linn (many energy MLPs that own and develop long-life natural gas and oil properties tend to have payout that come close to fully encapsulating cash flow). Nevertheless, it emphasizes that when a company's payout ratio almost equals its cash flow, you will find yourself in a position where a meaningful but not significant downtick in the commodities cycle would force the firm to access the credit markets to issue new units or take on new debt to keep the distribution coming to unitholders.
What makes Linn interesting, though, is the recent maneuvers aimed at boosting production, and consequently, cash flow per unit, as the Wall Street Journal reports:
Devon Energy agreed to sell all its noncore U.S. oil and gas properties to Linn Energy for $2.3 billion as the Oklahoma City-based energy producer continues to shift its focus to oil from natural gas. The deal covers the remaining assets that Devon had planned to divest, including properties in the Rocky Mountains, Texas, Louisiana, Wyoming, Utah, Oklahoma and Kansas, Devon said. These assets currently produce 275 million cubic feet of gas equivalent a day, about 80% of which is gas.
This move, in addition to its recent trade with Exxon Mobil (NYSE:XOM) to more than double production in the Hugoton Field, puts Linn in a position to substantially increase its cash flow per share, setting the stage for future distribution increases and more distribution coverage safety in the event that business conditions for commodities in its long-life properties encounter some hiccups. With analysts currently expecting cash flow per share figures in the $4.50-$4.70 range for 2014 (compared to $3.21 per share in 2013), giving the distribution payout of $2.90 per share some nice breathing room. Before its acquisitions, the Linn distribution payout ratio was around the 90.34% mark, but adjusted for the current 2014 expectations, the distribution payout ratio falls to 63.04% (assuming Linn hits the midpoint of cash flow expectations at $4.60 per share). That gives room for future distribution growth, and until that growth materializes, offers current Linn holders a meaningful margin of safety inherent in the payout.
Furthermore, Linn's core metrics of profitability appear to be on the rise. Operating margins are increasing from 50% to 55% (2013 to expected 2014 comparison). Net profit margins are increasing from 10.7% to 14.2%. Return on total capital is increasing from 2.9% to over 4.8%. Really, the only concern with Linn's fundamentals might be its balance sheet, which does contain over $9.4 billion in debt with interest now amounting to over $500 million (which, judging by management's actions in regard to acquisitions, could indicate that lowering the debt load is not a priority for this company).
Even if Linn froze its payout for the next five years (this is a super conservative estimate used to make a point, and does not reflect Linn's habit of raising distributions coming out of the financial crisis), you would stand to collect $14.50 per unit in cash, amounting to a total cash return of 45% of your initial investment. Factoring in anticipating distribution raises would make that figure even higher. That's why, if you want lots of income over the next few years, Linn is an interesting place to look.
The thesis for income investors regarding Linn amounts to this: You get a current distribution yield of 9%. Usually, most firms offering a starting yield in that range come with payouts that rely on prayer to remain sustainable for a five-year stretch. But when you look out over the next five years, it seems that Linn should only be able to maintain its current distribution payout, but it ought to be able to increase it as well, because the gap between the $2.90 per unit distribution rate and cash flow per unit in the $4.60 ballpark this year should give income investors a margin of safety for the next few years. The combination of a high starting yield and a payout ratio that is only sixty percent of this year's cash flow make Linn fertile soil for further research among long-term investors.
Disclosure: The author is long XOM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.