On Saturday, Seeking Alpha published an article of mine, which argued that investors should still sell Linn Energy (LINE) and LinnCo (LNCO) despite the severity of the sell-off this year (you can read the article here). This article received a tremendous response with far more comments (both in agreement and disagreement) and readers than I ever anticipated. Either by coincidence or in part due to my article, LINE shares plummeted 18% to $9.82 on Monday, reaching single digits earlier than I had thought they would. Given the drop in shares and news the company announced Monday, I felt it important to update readers in this article.
After the bell, Linn announced it closed its sale of properties in the Granite Wash and Permian Basin for a total of $2.3 billion (press release available here). These sales were announced months ago, and it was simply a matter of finishing up the paperwork to close the deal. A failure to close the sales would have been catastrophic but never likely. In that sense, this report is not good news, just as waking up in the morning does not constitute as a positive surprise. An expected announcement is not a positive surprise; it was expected after all. Linn needed to close these deals as the proceeds will fund the debt Linn took on to acquire properties from Devon Energy Corporation (NYSE:DVN). Linn took out a $1.3 billion term loan and borrowed about $1 billion on its revolving credit facility. Now, Linn can pay this back.
This leaves LINE with $2.4 billion in liquidity, which is absolutely critical (all financial and operating data available here). Liquidity crises are what get companies into trouble, and heading into this slump in oil prices, Linn absolutely must maintain liquidity. Linn is entering this downturn extremely levered. By funding its expansion activity and acquisitions with debt, Linn has levered its balance sheet. Assuming oil averages $60-$65 next year (above current spot prices), Linn's leverage (debt/EBITDA) will be an extremely high 6x. At this leverage level, Linn cannot safely borrow more in the debt markets.
Moreover, the bond markets seem to be shutting to Linn and other high yield energy names with its bonds trading at about 80 cents on the dollar for a yield of 10%. At this prohibitive interest rate, Linn cannot accretively borrow, and if things get worse, I anticipate the yields will only rise. Equity investors love the MLP (master limited partnership) model because an MLP like LINE pays out all of its distributable cash flow (essentially operating cash flow less maintenance cap-ex) to investors. However as MLPs like LINE don't retain much cash, all growth opportunities are funded via the capital markets rather than through retained earnings. LINE needs to issue debt and equity to fund growth projects.
As a consequence as Linn's stock and debt fall, it becomes harder, if not impossible, to accretively grow. A falling stock can create a vicious circle as the MLP is no longer able to fund growth projects, shutting off growth, and leading to an even lower stock price. Now, given unreceptive capital markets, Linn could tap some of that $2.4 billion in liquidity, but this would be a dangerous move. At its current distribution and cap-ex pace, Linn's cash burn will be $1.3-$1.4 billion in 2015. Linn would burn through over half of its available liquidity in 2015, and Linn will likely burn another $950 million to $1.1 billion in 2016 even if oil were to average $90.
That would exhaust all of the company's current liquidity. Moreover, Linn's borrowing base (which determines the size of the revolver) could be cut next year or in 2016 as it is determined by the present value of reserves. Lower oil prices lowers the value of reserves. Now perhaps by then, Linn's stock or debt will have recovered, and it can issue debt and equity to rebuild liquidity. This though seems like a risky strategy. Instead, Linn needs to seriously slash its distribution, by at least 50%, to preserve $1 billion in cash over two years, and it also should postpone some growth cap-ex to hoard as much cash as possible. With high leverage, the best decision LINE can make would be to make these cuts and use the cash to pay down debt. Linn's falling stock price is a sign of how risky it has become.
Sadly with every distribution it pays, LINE gets even riskier as it is sending out cash that would be better used shoring up liquidity. Linn's failure to fully hedge 2015 oil production (about 25,000 barrels a day of production are unhedged) are only exacerbating its levered position as lower prices eat into cash flow. To maintain the distribution and growth plan, Linn has to essentially exhaust its current liquidity, which I consider a financially imprudent strategy. Instead, the company should slash or suspend its distribution, rationalize its cap-ex spending back to maintenance levels, and use excess cash to buy back debt at distressed levels. I expect the decision to suspend the payout would send shares lower as we saw with Seadrill (NYSE:SDRL) several weeks ago, but shareholders would be better off in the longer term. Until then, Linn's cash burn is too concerning, and shares will likely go lower especially as investors recognize the Granite Wash sale proceeds only pay down existing debt rather than raising cash. Investors should use any rally as an opportunity to sell.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.