Is The Linn-Berry Merger in Trouble?

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Note: This article incorrectly referenced June 2 as the date of the sell-off of Linn Energy's stock. The actual date was July 2. This has been corrected below.

The planned merger between Linn Energy (NASDAQ: LINE) and Berry Petroleum (NYSE: BRY) has been eagerly anticipated by investors for many months. Berry Petroleum shareholders will receive a healthy premium for their shares, and Linn investors get to see their company advance its major strategic priorities.

Unfortunately, when the Securities and Exchange Commission gets involved in a deal, it’s rarely good news. That's exactly what happened on July 2, and investors need to sift through the rubble to determine if they want to stick around for the conclusion.

The SEC comes calling

Linn said it had agreed to voluntarily disclose information to the SEC’s informal review. The SEC had previously requested this information pertaining to the Berry deal, the non-GAAP financial reporting measures provided to investors, and the company’s internal hedging strategies.

Linn Energy and LinnCo (NASDAQ: LNCO), essentially a holding company for Linn Energy, both declined more than 12% on the day of the announcement. Berry Petroleum didn’t escape unscathed, falling 5%.

Berry wasn’t hit nearly as hard as the two Linn-related stocks, likely because Berry’s accounting practices aren’t in doubt, and the company is successful with or without the merger. Berry’s discretionary cash flow rose 6% in its most recent quarter, and the company’s operating margin increased 2 percentage points during the first three months of the year.

Linn, meanwhile, has been under heavy scrutiny in recent months from a variety of outlets. A negative article in Barron’s and a presentation by hedge fund Hedgeye Risk Management put a spotlight on the company’s accounting practices. In addition, analysts were quick to downgrade Linn in the wake of the SEC inquiry.

At the same time, Linn is getting a boost from noted investor Leon Cooperman, whose firm Omega Advisors is the largest outside investor of Linn Energy. All told, Omega holds more than $200 million of Linn.

Is the deal dead?

Fundamentally, investors need to know whether or not the Linn-Berry deal will proceed as planned. If you believe the market reaction on the day of the SEC inquiry, it doesn’t look good. The market is clearly betting that this won’t end well.

At the same time, Linn Energy maintained its commitment to the deal, saying in a corporate statement that the SEC does not view negatively any entity, individual, or security regarding the companies involved. Furthermore, all parties involved remain fully committed to seeing the deal done.

Moreover, investors are paying close attention to Linn’s dividend, which is one of the highest in the oil and gas partnership space. Since the SEC inquiry pertains to Linn’s hedging strategies and financial reporting measures, the dividend may be at risk.

Fortunately, on the same day of the announcement, Linn and LinnCo both declared their expected monthly distributions. Each company will pay $0.2416 per share, or $2.90 annualized, on July 16 to shareholders as of the close of business on July 10.

Whether Linn and LinnCo are value traps or screaming bargains depends heavily on the result of the SEC inquiry. Should the SEC find no wrongdoing, investors should view the July 2 shellacking as a major buying opportunity.

Linn and LinnCo now yield 10% and 9%, respectively, and their yields are even greater if you account for the 6% distribution increase planned for later this year.

I initiated a position in LinnCo during the past couple of months, to avoid the headaches of a K-1. While a 13% haircut is never good, I’m a Foolish enough investor to understand a long-term opportunity when I see it. I can’t definitively say that the deal will go through, and it’s obvious that Linn needs this inquiry to end without fanfare.

At the present time, Linn seems much closer to a screaming buy than a house of cards. I’ll be waiting for the dust to settle a bit, but over the coming weeks, should LinnCo continue to trade lower, I’ll be adding to my position.

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Robert Ciura owns shares of Linn Co, LLC . 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!

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