As I write this units of LINN Energy (NASDAQ: LINE ) are heading lower while shares of affiliate LinnCo (NASDAQ: LNCO ) are following suit. The culprit is an article in Barron's on the company that is highlighting comments from a recent presentation by a hedge fund that's short the company. The article, "Twilight of a Stock-Market Darling", is one of the many recent publications on the company that have highlighted some areas of concern. Let's dig into the thesis of the recent concerns and see if we can glean some insight into what's going on.
What's being said
The article starts out by saying that LINN Energy "may be the country's most overpriced large energy producer" and goes on to say that the company had "for years used aggressive accounting to prettify its financial statements." The crux of the article is that LINN's fundamentals are now deteriorating and the company's yield, which had been supporting its high unit price, might not be sustainable.
There's no doubt about it that last quarter wasn't a barn burner. LINN pointed out a number of reasons why it missed its quarterly production guidance which caused it to miss earnings this quarter. What would be most worrisome is that LINN's distribution coverage ratio slipped to 0.88 times, meaning LINN paid out more than it should on the quarter; however, that concern will soon abate. Further, LINN is not the only upstream MLP that had trouble in the quarter, as BreitBurn's (NASDAQ: BBEP ) coverage ratio slipped all the way to 0.67 times, which was well below its target ratio of 1.1-1.2 times. LINN and its peers face a real uphill battle in keeping that distribution stable, let alone growing it.
A wellspring of problems
The natural decline of an oil and gas well requires constant capital investments just to keep production stable. This maintenance capital issue has been a recent sore spot for the company, and bears question how LINN accounts for this spending. The worry is that LINN is aggressive in how it accounts for this spending and is therefore paying out more than it should; at some point its cash flows will dry up, and therefore so will its distribution.
LINN operates a unique business: It acquires mature oil and gas assets and then attempts to squeeze out every drop it can to produce income for its investors. Yet, these assets don't produce a steady amount of oil and gas each year until they run dry. Instead, production rates decline, a fact made even more difficult due to volatile commodity prices. LINN's reserve base has decline rates all over the map, with its Jonah Field declining by 14% per year and its California assets only declining by 3% annually. While its understandable to be concerned here, this isn't a new issue for LINN; it's been battling production declines since day one.
Don't forget the business model
Short sellers see this decline rate as being an insurmountable burden that will eventually lead to LINN's demise. Given the perfect storm, that's entirely possible, just as it is for any other company. Yet, LINN's business model is designed to combat the decline – it is constantly purchasing additional assets to not only replace the decline but to grow its production and reserves. Earlier this year the company made its largest transaction ever as it announced a deal to buy Berry Petroleum (NYSE: BRY ) .
The Berry deal was so accretive to cash flow that it enabled LINN to announce a distribution boost. Once the deal closes, LINN's expected distribution coverage ratio will be on safer ground at 1.07 times for the second half of the year. LINN's ability to continue to acquire assets is showing no signs of slowing down – the company believes its activity will only increase. Further, its opportunities will continue to evolve as today's hot play will become tomorrow's mature asset that's ripe for consolidation under LINN's business model. LINN is very selective in which assets it acquires, a business model that leaves its future open to so many possibilities. Finally, rising natural gas prices are currently a weight that could be lightened if gas heads higher, a distinct possibility given the demand outlook. So, while I understand the concern, LINN has a long runway of upside opportunities ahead and I see no reason to worry.
Foolish bottom line
Short sellers are going to continue to attack LINN, if for no other reason than that it's large yield has attracted heavy interest from retail investors. Savvy Wall Street investors know that it's possible to worry these investors enough to entice them to part with their investments en masse. Don't think that these attacks are about exposing some weakness in LINN's business model to enlighten the average investor. Unfortunately, you're best interests are not what's being guarded here; instead, this is a pursuit of profits at your expense.
As an investor you need to trust LINN's management team and believe that they have your best interests in mind, otherwise it's time to move on. So far the team has done admirably in pursuing value-creating opportunities, which is even why LINN's in the spotlight today. Personally, I'm going to continue holding on to LINN and allowing the team to continue to create value. In fact, I plan on adding to my position as soon as the move is practical.
If the negative sentiment has you thinking about moving your money out of LINN, you might want to look at the midstream sector. The growing production of natural gas from hydraulic fracturing and horizontal drilling is flooding the North American market and resulting in low prices for natural gas. Enterprise Products Partners, with its superior integrated asset base, can profit from the massive bottlenecks in takeaway capacity by taking on large-scale projects. To help investors decide whether Enterprise Products Partners is a buy or a sell today, click here now to check out The Motley Fool's brand-new premium research report on the company.