Votes for approval of the LINN Energy (NASDAQ: LINE ) and Berry Petroleum (UNKNOWN: BRY.DL ) merger are finally set for December 16. After LINN Energy bumped compensation from 1.25 to 1.68 LinnCo (NASDAQ: LNCO ) shares per Berry share, LINN shareholders have expressed some anxiety. Even after the raise, the deal is still fairly priced. Here are three good reasons I think the merger should be approved.
The LINN-Berry merger has come full circle. Not long ago, the Internet was littered with angry message board posts penned by Berry holders, lamenting the poor terms and angrily vowing to vote the merger down. With LINN raising the stakes, it's now LINN holders spamming message boards with vitriolic words for management.
With LNCO shares pressured downward by short sellers, is this deal still worth the price? I think so. Here are three big reasons the deal makes sense.
These two are stronger together
LINN Energy has more organic potential than most people acknowledge. The problem really is that much of that potential is locked up in natural gas assets that were acquired from BP in the heart of the crisis. These Green River and Hugoton assets were good buys, but natural gas prices limit the current impact they can provide.
LINN Energy listed 799 MMBOE (million barrels of oil equivalent) of proved reserves year-end 2012. While the bulk of those are developed, 35% of LINN's proved reserves remain undeveloped. That PUD level is much higher than typical for MLPs.
The issue for LINN Energy is really the product mix of its reserves. Over half of its proved reserves are natural gas. Only 24% are oil, with NGLs comprising the remainder. One current problem for LINN Energy is that it had been living off its rich gas targets in the Granite Wash. With NGL prices deflated, those projects are less profitable.
Berry's the Yin to LINN's Yang. Berry adds another 275 MMBOE of proved reserves. Three quarters of those reserves are liquids. More importantly, unlike LINN Energy, Berry's liquids are black oil rich. Two thirds of Berry's proved reserves are oil. Only 7% are NGLs. In this pricing environment, Berry's product mix is ideal.
With a more balanced development portfolio, LINN can focus its development on oil, forgoing its rich gas opportunities until NGL prices improve.
It's not as dilutive as it appears
Sticker shock is a big component of the angst. The $4.9 billion price tag works out to $17.75 per BOE. That's in line with LINN's typical oil-rich purchases. LINN's most recent Permian acquisition priced at $17.50 per BOE. It's the direct use of equity in the purchase that's producing the knee-jerk reaction by some investors. Don't kid yourself, the price you're paying for that half billion dollar Permian Clearfork acquisition is identical in every way.
It is unusual for LINN Energy to use equity in a transaction, but it's far from unusual for LINN Energy to pay for an acquisition with dilutive equity raises. In fact, it's standard operating procedure. Dilutive secondaries are a fact of life.
There were $1.9 billion in dilutive equity raises in fiscal 2012, to defray some $2.6 billion in acquisitions. LINN Energy's acquisitions are usually cash funded using its revolver. Since the acquisitions are accretive, no one questions the follow on equity dilution that later wipes the revolver clean. The bill is still ultimately paid in equity. It's just that the two-piece nature of the transaction usually obscures the dilutive cost of acquisition.
The fact that the dilution is up front in the Berry deal, rather than after the fact is immaterial. From a cost of capital perspective, anyone opposed to the Berry deal, should in principle be opposed to the recently closed Permian acquisition. The problem is neither the price agreed to, nor the dilution. It's the weakness of LinnCo's share price.
Danger of downside
Vote this merger down and you'll see real weakness. This transaction is proof of concept for LINN Energy's ability to acquire C-corps going forward. Failure validates a big piece of the shorts' thesis. The biggest piece of their argument is that LINN won't be able to find big enough chunks to keep the acquisition ball rolling.
This is a $4.9 billion acquisition that increases LINN Energy's reserve base by a third. The universally celebrated half billion dollar Permian acquisition provided a minuscule 3.8% increase in reserves. Without the potential to add in big chunks that this merger validates, there is legitimate reason to question the outlook for future growth.
Feeling vindicated, the shorts could reload. They can point to the rocky merger process, continuing SEC oversight, and ultimately the failure of the merger as evidence that LINN's growth model is flawed. Shoot this down and we may retest the $23 lows. If you remove LINN Energy's growth potential, you remove its premium to peers. There's no divorcing the two.
Vote 'Yes' for progress
Vote early and vote often. This is a critical step for LINN Energy's evolution into a company that's beginning to look less like an MLP and more like its Independent peers. This can't be and isn't a company shackled to declining assets, that's simply intent on running them off for the sake of income. It's been a company defined by its growth. To continue that growth, it needs this acquisition. The price is fair. Berry's asset set is highly complementary and affords LINN Energy an opportunity to optimize its development to fit market conditions. This is a merger that's in the best interest of all parties and it deserves support.
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