Why I'm Buying This Embattled Energy Company

Oil and gas MLP LINN Energy (NASDAQOTH: LINEQ  ) has become a battleground stock this year. Vicious short-sellers have called the company's accounting aggressive, if not erroneous. Further, those who are negative on LINN assess its worth as low as $5.50 a unit. Needless to say, it's been a rough year for investors in LINN, especially after it was disclosed that the SEC would now be looking into its books. 

One of LINN's 19,000 producing oil and natural gas wells. (Photo courtesy of LINN Energy)

I firmly believe that LINN will successfully navigate the SEC inquiry, which once resolved should end the attacks against the company. In anticipation of that happening, I want to take advantage of the weakness created to add to my position in the company. In fact, I can point to two other major reasons why I think LINN and its affiliate LinnCo (UNKNOWN: LNCO.DL  ) are both compelling values worth buying today.

Getting the facts straight
While Jim Cramer has backed off his bullishness, many other investors are staying the course. Among them is none other than Leon Cooperman, the chairman and CEO of Omega Advisors. In a recent letter to the editor of Barron's, which has been particularly bearish on LINN, Cooperman called the negative articles "distortions about LINN". He further states that these articles are "twisting facts to suggest that there is something untoward about" how LINN accounts for its hedges.

What I've found interesting is while short-sellers make a big deal about LINN's use of puts, LINN has already said it's simply not going to buy them anymore because of the commotion they are causing. If LINN's purchase of puts were so important to keeping up its so-called ruse, then the company would likely rigorously defend the action, not decide to simply use another form of hedging. Finally, as Cooperman points out, LINN's accounting for purchased puts does comply with FAS 133; to say the company is miscounting its puts is simply wrong.

Real, tangible value
While short-sellers would have you believe that LINN's worth is just in the single digits, many other highly qualified analysts disagree. In fact, most Wall Street analysts believe LINN is worth about $40 per unit. Even in a worst-case scenario, it's hard to put a value on LINN that's lower than it's currently trading. This is best summed up in a note by Stiefel to its investors:

If the Berry Petroleum/LinnCo deal falls through and the company NEVER makes additional accretive acquisitions (extremely doubtful in our opinion), we believe LINN's units are worth approximately $22 using a discounted cash flow analysis. However, if the Berry/LinnCo acquisition falls through but the company maintains a conservative acquisition program through 2020, we estimate LINN's units to be worth $32 to $35. If we assume the Berry deal is completed in 4Q13, we estimate LINN's units intrinsic value to be $35-$40 based on a future discounted cash flow analysis and assuming a conservative future acquisition program.

Further, internal and third-party valuations of LINN range from $37.34 per unit on the low end and up to $65.74 per unit on the upper end of the scale. These values for LINN standalone without the benefit of adding Berry Petroleum. That's because the company has a substantial unproved drilling inventory that's estimated to hold up to 14 trillion cubic feet equivalent of reserves, which adds significant potential value to LINN:

Source: LINN Energy investor presentation

The only way you can get value for LINN anywhere near where short-sellers have it pegged is if natural gas prices stay at last year's depressed prices... forever. Seeing how natural gas prices are already substantially higher, with potential future demand drivers coming from electrical generation, exports, and natural gas vehicles, I think it's safe to say that there is a lot more value in LINN's asset base than the shorts give it credit for.

My trade
While I already own units of LINN and shares of LinnCo, both combined make up less than 2% of my well-diversified portfolio. That's why I plan to buy shares and write puts striking at $20 on both companies to bring my overall exposure up to 5% of my portfolio. I feel very strongly that the attacks on LINN are unjustified and that its real value will eventually win out. 

That's not to say that I don't expect a bumpy ride, I just have more than enough stability elsewhere in my portfolio so that I can sleep at night. That being said, if you are worried about your LINN position, you might want to balance it out with other solid high-yielding stocks instead of adding to it during this period of turmoil. If you need to help finding a few solid stocks to balance out your portfolio I'd encourage you to check out The Motley Fool's special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.

Read/Post Comments (9) | Recommend This Article (11)

Comments from our Foolish Readers

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  • Report this Comment On July 08, 2013, at 12:22 PM, lildimsum7 wrote:

    What do you think about the non-GAAP accounting issues? They back out the cost of derivatives from their adj. EBITDA and DCF calculations; in effect, realized gains = cash settlements. I think their reasons for excluding this cost are weak, but I could use a 2nd opinion.

  • Report this Comment On July 08, 2013, at 1:12 PM, sept2749 wrote:

    I think that we may find new valuations on LINE and LNCO based on their accounting issues. However, they may have a perfectly good explanation for any departures from GAAP and the SEC could agree. I'm on hold -with a paper loss of about 10k between LINE and LNCO in my IRA. Still undecided on what to do as far as selling and taking the loss or hanging in there and risking about 30k.

  • Report this Comment On July 08, 2013, at 1:16 PM, gschneid wrote:

    Thanks for the historical perspective, which helps to highlight why these situations rife with hysteria are indeed great opportunities to accumulate solid companies at lower prices. I did just that, buying more LINE last week at $25.12. we didn't have to wait too long for the snapback, as B of A analysts today endorsed the long theme:

    "NEW YORK (TheStreet) -- Bank of America Merrill Lynch analysts on Monday said they don't believe the accounting practices of Linn Energy (LINE_) have inflated or distorted the cash flow the embattled oil and gas driller pays to its investors through dividends.

    In a Monday upgrade of Linn Energy, the BAML analysts said Linn Energy's accounting for derivatives used to hedge its oil and gas production and the capital expenditure it sets aside to maintain energy output haven't misled investors or put the company's high dividend at risk."

    This report, plus short covering led to a 15% uptick so far today. On top of Friday's 3%, we may have the beginning of real base building and restoration of investor cnfidence. Payment of the dividend this week should additionally bolster confidence.

    Thanks again for writing this prescient piece.



  • Report this Comment On July 08, 2013, at 1:37 PM, TMFmd19 wrote:

    @lildimsum7 - I think the non-GAAP accounting issue will turn out to be much ado about nothing. As I mentioned in the article, if LINN needed to massage the books in how it accounted for puts then it wouldn't have made the decision to stop buying them. Further, LINN's been very upfront in the fact that its distributable cash flow has been weak, and under 1.0 so its not like its been covering that up. I find it highly unlikely that the SEC finds anything amiss.


  • Report this Comment On July 08, 2013, at 7:15 PM, neamakri wrote:

    I buy stock for dividends. LINE is at 281% payout, so I will pass.

  • Report this Comment On July 08, 2013, at 9:12 PM, ackxhpaez wrote:

    maybe a silly question--Isn't Linn's production hedged out until 2016? Since they've fully hedged their production, won't they lose money if oil and gas prices go up?

  • Report this Comment On July 17, 2013, at 6:29 PM, BarnumNBailey wrote:

    A full hedge would have an opportunity cost but the margins would be guaranteed. Linn employed, however, a substantial volume of Puts, which is one reason their hedge was relatively expensive, so hedged against price decreases while remaining positioned to take advantage of price increases.

  • Report this Comment On July 17, 2013, at 6:34 PM, BarnumNBailey wrote:

    Some analysts have mischaracterized the depletive characteristics of Linn's cash flows as being dilutive and this egregious error is about to hurt Linn's short interests, right on the heels of the pain inflicted on the longs, who sold in panic. It is a sad set of circumstances, maybe not entirely innocent?

  • Report this Comment On July 26, 2013, at 12:32 PM, beetom41 wrote:

    Linn's profits should jump this Qtr. It was a bad winter in N. Dakota. That production should jump a lot. Working in west Texas Linn is making some good wells. I believe profits should be up 20-25% this Qtr.

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