Why Linn Energy LLC Remains 1 of America's Top High-Yielding Investments

Since 2013 the MLP Linn Energy  (NASDAQ: LINE  ) and its dividend-paying equivalent Linn Co. (NASDAQ: LNCO  ) have come under heavy attack by Hedgeye, an investment-advisory firm which has been arguing that the partnership has been funding its distribution through debt -- the partnership, like many MLPs, has negative free cash flow. These allegations resulted in a negative article in Barron's magazine (which rehashed the Hedgeye allegations) as well as an informal SEC inquiry into its accounting methods, resulting in a 20% decline in Linn Co. shares. 

This decline in share price caused the price of Linn Energy's most recent acquisition, Berry Petroleum, to increase in price by 34%, since Linn Co. used its shares to fund the acquisition. The extra cost threatened the accretive nature of the purchase, and when management announced distribution coverage guidance of 1.0 for 2014, due to increased maintenance capital costs for new Berry Petroleum resources and the higher purchase price, Wall Street became concerned about the safety of the distribution.

In a previous article, I argued that these concerns were short-sighted and overblown and that they ignored important growth catalysts that would secure the current distribution. LINE yields 10.2% and LNCO yields 10.4%, and the partnership was trading at a 23% discount to the future value of its oil/gas reserves. Linn Energy's most recent quarter confirms these investment hypotheses, so long-term income investors should still consider Linn Energy for their income portfolios.

Solid quarter, solid growth plan
The most recent quarter's financial results support continued confidence in management's growth strategy:

  • Revenue growth of 98% 
  • Production increase of 39%, including a 50% increase in the Rockies, 52% in east Texas, 108% in the Permian basin, and a stunning 1,176% increase in California
However, the partnership did report several negative things as well:
  • Distribution coverage fell to .99 for a $3 million shortfall for $240 million in paid distributions
  • Increased transportation expenses of 21% per Mcfe, or million cubic feet of natural gas equivalent
  • Slight decreases in midland (-7%) and Michigan/Illinois assets (-4%)
  • Guidance for 2014 distributable cashflow, or DCF, down $29 million (from a $12 million surplus to a $17 million deficit) 
This last point may seem alarming to investors, as it seems to support the negative thesis that the distribution is threatened. However, there are several catalysts that serve to protect the distribution and in fact grow it into the future. 
 
First, management guided for a small DCF shortfall, while coverage ratio guidance remained at 0.982, because of higher expected capital expenditures, or capex. This is because some of the assets it purchased from Berry Petroleum (specifically those in the midland basin) require more expensive horizontal drilling to increase production. The partnership is attempting to increase organic production by 3%-4% while cutting capex by 11%, thus increasing profitability and securing the distribution/dividend. How is it possible to accomplish these seemingly incompatible goals?
 
Management is looking into several possible deals involving its midland properties. These properties, in addition to being more expensive to produce, also decline in production quicker than other newly acquired assets. Yet they are still incredibly valuable as they are currently producing 17,000 barrels/day oil equivalent, and Citigroup estimates that they are worth around $2 billion. 
 
Management's plan for these assets, and the strongest reason to remain bullish on Linn Energy, is that the partnership plans to attempt a sale/swap of these properties for lower depleting, already-producing assets. This would result in lower maintenance costs, lower capex (to increase production), and a lower production-decline rate -- this would become immediately accretive to DCF/unit. 
 
During the most recent quarter's conference call, CEO Mark Ellis stated that the MLP was receiving strong interest from potential business partners regarding its midland assets. 
Though no timetable for potential deal(s) was given, 2014 seems a likely time-frame for this beneficial transaction(s).
 
However, increased organic production and smart land-swap deals are only two of three legs in Linn Energy's growth strategy. The third is continued accretive acquisitions, of which management has a long and successful track record of 60 acquisitions since 2006 worth $15 billion. 
 
Management has already bid on 48 properties (with a $5.5 billion value) as of April 2014. While this may seem like a large amount considering the estimated $300 billion of oil/gas assets currently on the market, it's a drop in the bucket and shows the kind of long growth runway Linn Energy has to look forward to in the years to come.

Foolish takeaway
Linn Energy's management team has grown the operation into the largest upstream MLP in America, with a 2,500% enterprise value increase in just eight years. Through a consistent history of accretive acquisitions and wise use of investor capital, the partnership has been able to grow its generous distribution by a 4% CAGR since 2007. It has never had to cut the distribution, not even during the financial crises. Given management's track record and solid growth plan, long-term income investors can be confident in both the safety of the current distribution/dividend and the long-term growth prospects for steadily increasing income. 

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Read/Post Comments (3) | Recommend This Article (8)

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  • Report this Comment On May 27, 2014, at 12:09 PM, m1817 wrote:

    This article is outdated by another MF article that was published on 5/23/14, that discusses the exchange of Permian assets with XOM.

    http://www.fool.com/investing/general/2014/05/23/why-linn-en...

  • Report this Comment On May 27, 2014, at 6:30 PM, AdamGalas wrote:

    Unfortunately this sometimes happens. At the time I wrote the article the deal hadn't been made public. It can take several days for an article to be published and by the time it was the news was out.

    I'll make sure to include an analysis of the deal in my next update.

    Thank you for the link though. Its always good for readers to get the most up to date info.

  • Report this Comment On May 27, 2014, at 6:51 PM, AdamGalas wrote:

    Thank you for the link. Its always good for readers to have as up to date information as possible.

    At the time I wrote the article the news hadn't broken yet. Sometimes it takes several days for a submitted article to be published and this kind of situation can occur.

    I don't believe it invalidates the article, who's point was that Linn Energy represented a safe, double digit yield that was likely to grow, (slowly) over time.

    The fact that the deal is now complete only strengthens the investment thesis.

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