Can LINN Energy Cover Its Distribution?

It's hard to be unloved. LINN Energy (NASDAQ: LINE  ) exited a tough year with an excellent quarter. Yet investors were singularly unimpressed, selling off LINE and its sister security LinnCo (NASDAQ: LNCO  ) . The unloved pair were already twisting in the wind despite finally closing the long-delayed Berry Petroleum acquisition. Then on Monday, JPMorgan ratcheted up the pressure with a downgrade that sent shares into a complete tailspin.

At some level, guessing about market moves is a fool's game. But when you're holding a stock that's under pressure—especially a public short attack – at some level, you must listen to the market. At the very least you need to be certain that you disagree. How bad is it and what will it take to turn it around?

The company has to be relieved that 2013 is gone. Slumping NGL prices hurt cash flow and squeezed DCF coverage uncomfortably. NGL differentials are critical to LINN's success. They're a large proportion of LINN's liquids production. More importantly, hedging them effectively is nearly impossible.

Ironically, the same NGLs that wrecked the year ended up saving LINN's bacon in the fourth quarter as prices stabilized, especially for propane as a result of the harsh winter weather. Coverage ratios improved substantially on improving revenue, reaching 1.19 times DCF in Q4.

That's the good. How about the bad?
So why the worry? Even management confessed to being confused about the market's initial response when quizzed on the quarter's call. While last quarter was nice, investing is about the future. Investors need to worry about next quarter's coverage, and guidance was not exactly comforting.

LINN Energy forecasts only a $12 million distribution excess year-end 2014 with a scant $1 million distribution increase. That $1 million works out to a 0.1% increase. Needless to say, holders seemed less than thrilled. Monday, JPMorgan made it that much worse when it declared that even that distribution level is not safe.

Can LINN avoid a cut?
The poor guidance comes paired with a looming distribution increase in the first quarter. The Berry deal closed so late in December that no payments were made to former Berry shareholders in Q4, so that comfortable fourth quarter coverage ratio may be tighter than it appears considering dilution from the merger.

Unit count popped 40% as a result of the Berry merger. Yet, LINN's low-end forecast projects only a 20% increase in production to offset that dilution. With equity holders already spooked by the drawn-out acquisition process and swirling short attacks, that's the kind of math that breeds uncertainty—maybe even panic. According to management, this will be an accretive deal. How can that math work?

Follow the cash
Focusing on production is misleading. Ultimately, we don't care how much oil and gas LINN produces. Heck, we don't even care what LINN produces. It could be oil, gas, cell phones, or razor blades. We care how much money LINN produces.

What's missing from the analysis above is accurate consideration of how significantly LINN's production mix is altered by Berry. That incremental production provided by Berry's operations is 80% oil, and at these oil and gas prices, oil is the lion's share of any company's revenue.

Oil companies all produce a mix of oil and gas. To make production numbers easier to follow, headline numbers are reported collectively in equivalents based on the relative energy content of oil and gas. LINN converts all its oil production to 'mcf equivalents' or Mcfe when it reports its headline number.

At these prices, all that oil makes Berry significantly more valuable per Mcfe than LINN's current gas production. One Mcfe of oil—one sixth of a barrel – is worth roughly $16.50 compared to an Mcf of gas at $5. That's the equalizer in the deal.

It's all about the oil
A quick back of the envelope calculation illustrates this. LINN's Q4 production was 889 MMcfed (million cubic feet equivalent per day), and 44 MMcfed came from Berry at quarter's end. So, LINN ex-Berry averaged 845 MMcfed in Q4 of 2013. The low end of Q1 guidance is 1,070 MMcfed for an incremental boost of 225 MMcfed due to Berry's expected production.

With Berry producing 80% oil, that works out to 180 MMcfed or 30 MBbld (thousand barrels per day) of incremental oil production. At the $93 per barrel realized in Q4, Berry will add $251 million in oil revenue over a 90-day quarter.

Add in the little bit of gas revenue and Berry's $265 million boost to revenue is far more appealing. The 42% revenue increase Berry brings over Q4 can in fact offset the deal's 40% dilution. Oil is simply much more valuable economically, and that's exactly why LINN snatched up Berry. Its strong oil project inventory adjusts LINN's portfolio favorably—both now and in the future.

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Read/Post Comments (7) | Recommend This Article (8)

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  • Report this Comment On March 25, 2014, at 2:34 PM, zorro6204 wrote:

    And, the reason they cut back maintenance capex is they figured they didn't need it. Coverage can be managed (not in a quarter or two, but over a year), simple by tapping more reserves.

    Plus, by one calc the coming asset reallocation could add 30-60 cents to DCF. Of course, they can't include something that hasn't happened in guidance, but . . . it will happen.

  • Report this Comment On March 26, 2014, at 2:36 PM, dsandman999 wrote:

    " At the $93 per barrel realized in Q4, Berry will add $251 million in oil revenue over a 90-day quarter"

    I am not sure where you got this number, or if it is the rate that LINE got. But a large part of the new oil will be in California and they get the Brent prices there. The difference whould be enough to fully cover the $272M/yr in additional distributions for the 93.8M units issued to cover the same count of LNCO shares. New CAPEX will increase this margin. And because of the way LINE calculates DCF, that $12M is actually larger than it seems because they have been running in the negitvie numbers for several qtrs because they subtract out "discretionary adjustments" which drives some with accounting backgrounds nuts.

    There are also a number of pipelines comming online in the 2nd half of the year that will improve pricing as well as reduce costs. The Permean/Texas area has a current Oil glut because of delivery issues and prices are below WTI. There are also horizontal drilling play areas in the midlands that are likely to be sold this year reducing debt, which should add to DCF as well.

  • Report this Comment On March 26, 2014, at 4:07 PM, JustMee01 wrote:

    Dsandman,

    The $93 per barrel used is based on LINN's Q4 pricing. The gas price used is also what they received in Q4. Rather than try to guess what LINN will get, I felt it best to anchor the analysis on last quarter's pricing. Keep it simple... You're certainly correct that Berry's Cali oil pricing will be higher, closer in line with Brent.

    The purpose was to illustrate that Berry's oil should cover the dilution, using as conservative an estimate as possible. That's why I used the low end of guidance and avoided as many uncertainties as possible with respect to pricing.

  • Report this Comment On March 26, 2014, at 4:24 PM, SkepikI wrote:

    <Focusing on production is misleading. Ultimately, we don't care how much oil and gas LINN produces. Heck, we don't even care what LINN produces. It could be oil, gas, cell phones, or razor blades. We care how much money LINN produces.>

    This is misleading.....if they are a PRODUCTION company you BETTER care how much oil and gas they are producing, otherwise, ENRON like you are subject to being scammed. And Enron-like you will deserve what you get..... I certainly agree money is the measure of effectiveness, but not the only one. Bernie Madoff produced "money" without really producing anything...until he couldn't produce anything like the investments purported to be producing the money....

    I don't purport to be an oil patch expert, but this bears so many resemblances to oil patch darlings that turned into witches, its sobering. I neither invest in LINE nor short it, but this has all the fascination of a horror movie

  • Report this Comment On March 26, 2014, at 5:11 PM, dsandman999 wrote:

    @JustMe01 - Ok. Only problem I saw was that you ended up with a number below requirements which is a cargo door opening for the bashers. Can't you just see Barron's quoting that one line and saying that your article proves they can't cover. Those folks do not give you the benifit of the doubt if they can misquote or quote out of context.

    The JP Morgan analyst used High CAPEX as a reason for his downgrade. That inspite of the CAPEX will be significantly less than last year and targeted towards high priced Oil like California.

    Thankx

  • Report this Comment On March 26, 2014, at 5:23 PM, JustMee01 wrote:

    Skepik,

    The point is not that production growth is irrelevant. It certainly is, and LINN will grow production in 2014. The point is that focusing on raw production headlines can be misleading since they blend gas and oil volumes with no consideration of their economic value.

    Oil has considerably higher impact on revenue than gas. It's no different than Ford selling an F-150 versus a Focus. Those high margin F-150 sales are disproportionately more important to Ford's success.

    Growth in the higher margin category has more impact. For LINN that's oil. That's what Berry brings to LINN: growth in its higher margin oil production.

  • Report this Comment On March 26, 2014, at 5:44 PM, JustMee01 wrote:

    Dsandman,

    I read that capex line from the JP Morgan report second hand. I haven't found the report on line. Sometimes people sneak them on to file sharers, but I haven't been able to google a copy up.

    From the second-hand Barron's account, it sounded to me that the JP Morgan complaint was about *maintenance* capex, not capex itself. Yes, capex is up, but it has to be: LINN is bigger! (I understand your point about the pro-forma spend actually being down and agree, but that's a different issue...)

    Maintenance capex IS up as a percentage of total capex. I suspect that's what he's upset about. It tightens the coverage ratio. It's actually been rising as a percentage of total capex for a little while now.

    I just don't see this as a bad thing however. All it really means is that LINN is retaining a higher percentage of its cash flow. That's not necessarily a bad thing. It means that LINN is funding more of its capex from operating cash flows. That strengthens the company, not weakens it.

    I see it as not unlike retained earnings for a C-corp. Holding back some of that cash by hiking the maintenance component of capex seems prudent to me.

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