A Perfect Storm Sinks Linn Energy
J.A. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It has been an ugly week for energy companies with the letters LP or LLC after their name. Limited liability corporations (LLC) and master limited partnerships (MLP) are structured to give companies a tax advantaged business if it distributes income to unit-holders who in turn will pay the taxes on that distribution. The company does not pay taxes on this income.
The best MLP?
Historically, master limited partnerships have been largely the province of pipeline companies – Kinder Morgan (NYSE: KMP) is a good example. Kinder Morgan runs gasoline and other fuel through 8600 miles of pipe and 33,000 miles of natural gas pipelines. It has a $32.5 billion market cap and is capable of distributing a decent yield to investors through reliable high cash flow. Its dividend yield is right around 6%. Kinder Morgan is one of the best run MLP's.
Over the past few years, the tax-advantaged structure has been invaded by a different breed of energy company –the small to mid-cap independent energy producer. Most of them fly under the radar, generating little controversy -- that is until Linn Energy (NASDAQ: LINE) became the focus of a series of scathing articles in Barron’s.
Barron’s has been running articles since February 2013 detailing what it believes to be misleading accounting that will lead the company and its investors to ruin. The stock is also the target of significant short interest and an investigation by the U.S. Securities and Exchange Commission, all of which have crumpled the stocks price. Linn Energy lost about 40% over a couple of trading sessions.
Linn's ugly chart
The berry deal
It was not just the Barron’s stuff that crushed Linn –- the SEC announced an informal inquiry into its pending acquisition of Berry Petroleum (NYSE: BRY) and the hedging strategy that uses non-GAAP (generally accepted accounting principles) measures when calculating the distribution to investors. It was a perfect storm of Barron’s investigative journalism, a threat to the important Berry acquisition, and the SEC’s informal investigation that has effectively sunk Linn Energy.
There is no question Berry Petroleum is a key acquisition for Linn, as it adds proved reserves of 204 million barrels of oil equivalent and production or 27,400 barrels of oil per day. Oil is an important piece of the growth puzzle for Linn Energy. Its current oil production is 29,000 barrels per day and the deal would nearly double that.
Berry also brings 54,000 million cubic feet of gas per day and some natural gas liquids. These last two are far less profitable at present, but should yield growth when prices recover. Berry’s estimated 204 million barrel reserve will more than double Linn’s 191 million barrels.
Add to that $500 million in cash flow from Berry’s cash flow statement and it’s easy to see why any hint of this pivotal deal not closing is enough to shock Linn's stock. The SEC investigation and the Barron’s articles weigh on Linn, but missing out on the Berry deal is the overriding concern for most investors.
Without the influx of cash and oil, Linn may have to make the hard choice to ease back on their generous distribution to investors, now around 9.3%. In fact, that was the gist of the Barron’s series of exposés –- accounting for the distribution was at least erroneous if not fraudulent and overstating available cash.
What has Barron’s knickers in a twist?
The energy companies organized as limited partnerships and LLCs distribute “dividends” called distributions to unit-holders based on a formula that starts with adjusted EBITDA. EBITDA is earnings before interest, taxes and depreciation/amortization. Companies then subtract interest expense and maintenance capital spending to calculate distributable cash flow.
If the ratio of distribution to distributable cash is greater than one, then theoretically the company can pay the distribution from the cash flow. Linn’s most recent coverage ratio was 0.88 times and BreitBurn was 0.67 times both falling short of comfortable coverage. Linn historically runs a ratio above 1, and the higher the ratio, the better the coverage and the more confident investors are the company’s payout is sustainable.
Barron’s contends Linn is artificially boosting cash flow by failing to account for the expense of hedging contracts while recognizing all the profits from the contracts. They imply Linn is aggressive in the accounting treatment, if not fraudulent.
Barron’s also notes that all the companies they looked at recognize the expense and Linn was alone in its deceptive cash flow calculation. But most of the companies I checked, including BreitBurn, use the same calculation with no deduction for the cost of hedging in calculating non-GAAP EBITDA.
The Barron's gist
Barron’s argument that hedges should be expensed is misguided at best. Since hedges are settled and gains recognized months after the costs are incurred, using current costs as a proxy for the past expense would be completely meaningless if distributable cash flow is supposed to be a measure of the current cash flow. The applicable cash costs are long gone.
That’s probably why no company I looked at does it. This is a non-GAAP metric and is not intended to be a GAAP-compliant measure of free cash flow available to pay shareholders. If Barron’s wants the SEC to step in and overhaul the non-GAAP distributable cash flow convention, it probably won't happen anytime soon.
The SEC investigation of Linn is informal and unlikely to result in a change in non-GAAP accounting conventions before the Berry deal is slated to be consummated. The SEC moves in a geologic timeframe.
Foolish bottom line
Of more concern is the likelihood the Berry deal will fall apart as Berry shareholders see Linn as a weak partner and nix the deal when the vote comes up. If so, Linn will survive, but far less profitably. Linn evaluates hundreds of acquisition per year and life will go on.
However, without the sterling assets of Berry and the much needed cash flow and production, unit-holders may have to take less. Today's price per share is a reflection of the worst-case scenario -— no deal.
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jean graham has a position in Linn Energy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!