Investors aren't too happy with LINN Energy's (NASDAQ:LINE) guidance for 2014, and it shows in both corporate shares and partnership units.
As we can see from the chart above, both LINN Energy and Linn Co (NASDAQ:LNCO) have dropped by high single digits in just the last month. Investors are disappointed by a few things, including a very thin coverage ratio, a drag from increased share count as a result of the acquisition of Berry Petroleum, and a fairly light capital program for 2014. All of these points stem from LINN's acquisition of Berry last year, which was an acquisition that faced unexpected challenges due to a regulatory inquiry and a falling stock price in the latter part of last year.
Last year LINN Energy faced an informal inquiry from the SEC, part of which was in regards to the Berry Petroleum acquisition. In addition, the fallout in the company's stock price, which followed in the wake of several negative media articles, jeopardized the acquisition because the transaction was done by issuing new shares of Linn Co. In response to the market volatility, LINN upped its offer for Berry Petroleum from 1.25 shares of Linn Co for each share of Berry, to 1.69 shares of Linn Co for each share of Berry. This higher share count resulted in a much higher obligation for dividends and distributions, and while the Berry acquisition has certainly added production, it has not thus far been enough to increase per share cash flow in excess of distributions or dividends. In other words, the Berry transaction has not thus far been accretive; it doesn't look like the deal will be accretive for at least this year.
In the company's guidance for this year, management expects to have only $12 million of cash in excess of distributions paid, putting LINN's effective coverage ratio at only 1.01 times for this year. Just to clarify, I do believe that LINN's distribution is secure in 2014, despite the thin coverage ratio, thanks to the company's hedging policy. One hundred percent of both gas and oil are hedged for 2014, and so only a substantial production shortfall could jeopardize the distributions.
However, one of management's goals is to raise the distribution by at least mid single-digits every year. That 1.01 times coverage ratio is actually based on the current distribution. Therefore, I struggle to see how management will be able to raise the distribution this year without making an accretive acquisition.
Possible asset swap
LINN is primarily a driller for high-margin oil and gas located on mature acreage. While the acquisition of Berry Petroleum was largely of this type of acreage, some of the acreage was for horizontal drilling. LINN now holds significant horizontal drilling inventory in the Midland Basin in west Texas. This acreage could provide significant growth but requires lots of capital to develop, something that is not LINN's specialty. As a result, it is looking to possibly sell or swap this chunk of acreage. In doing so, LINN may lower its overall capital intensity and free up precious capital to drill higher-margin, lower-maintenance acreage. Such a sale could be one way to make the Berry acquisition more immediately accretive.
LINN had a tough time closing up the Berry acquisition, and it had to substantially increase its offer to do so. This has made Berry that much harder to "digest." This has resulted in a very tight coverage ratio this year, which will most likely lead to a flat distribution as well. In addition, LINN now has a substantial amount of west Texas acreage, which doesn't fit the company's core competency. After a flurry of intense and often dramatic activity in 2013, I believe we should give LINN at least one year in which to recuperate. By 2015, I believe LINN will be boosted by solid organic production growth and will continue to steadily increase that distribution once again. In the meantime, yes, the current distribution is safe.
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Casey Hoerth owns shares of Linn Energy, 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.