LINN Energy LLC (OTC:LINEQ) and its affiliate LinnCo LLC (UNKNOWN:LNCO.DL) have been on my radar for a while. While the companies have always been intriguing, I've passed on them due to long-run concerns over their business models. A recent advantageous acquisition and attractive valuations, compared to peers like Denbury Resources (NYSE:DNR) and Cimarex Energy (NYSE:XEC), have made me more positive on LINN and LinnCo, however. Will this bullish change of heart eventually pay off?
A smart acquisition bolsters the short-term
LINN Energy's near-term prospects appear pretty good, helped by the acquisition of Berry Petroleum. Berry, holding long-life reserves, is a good fit for LINN. Its assets, mostly located in California, the Permian Basin, and Utah, add a steady production source that will help support LINN's generous unitholder distribution.
While Berry's major properties are mature and in slight decline, its promising discoveries in Utah's Uinta play and the Wolfberry trend in the Permian Basin, along with the company's experience in enhanced oil recovery techniques, should offset any meaningful drop from the older reserve base.
LINN seemed to make a good deal in acquiring the assets. Costing about $2.8 billion, LINN paid around $189 per barrel of oil equivalent (BOE) based on Berry's average 2013 production of 40,600 BOE per day -- a relatively inexpensive price compared to peer valuations.
A comparison with Denbury Resources confirms the bargain. A company somewhat similar to Berry, Denbury also relies on enhanced recovery techniques and produces mostly oil. Petroleum makes up around 95% of the company's deliveries, compared to around 80% of Berry's performance.
One difference is valuation, however. Denbury shares look to be currently priced around $230 per BOE produced, based on 2013 average deliveries of 70,243 BOE per day -- a meaningful difference to Berry's takeout worth.
At a robust but reasonable per BOE amount, Denbury's value is defended by the its shareholder friendly disposition. The company has reduced its outstanding share base by 14% since 2011 with buybacks and recently initiated its first cash dividend.
Currently undervalued by the market
LINN Energy has its own valuable energy reserves. Producing roughly 811 million cubic feet equivalent of natural gas (MMcfe) per day in 2013, excluding any Berry contribution, LINN's legacy business alone could be worth around $8.9 billion to $11.5 billion on a fair market basis, assuming a value of between $0.030 and $0.039 per cubic feet equivalent (cfe) of production. But is the $0.030 to $0.039 per cfe a reasonable valuation assumption?
A comparison to oil and gas producer Cimarex Energy suggests it is. With principal operations in the U.S. Mid-Continent and Permian Basin regions, Cimarex produced a record 692.6 MMcfe of per day last year, an 11% jump from the prior year led by 21% growth in volumes from the Permian, the company's growth driver. Aiming to further boost production in the area, over 65% of total exploration funding will be allocated there.
Based on impressive 2013 results, Cimarex shares currently trade at around $0.039 per cfe, a slight industry premium. Due to its conservative use of borrowing, Cimarex has only $924 million in long-term debt compared to over $4.0 billion of equity, and oil production potential, 17% to 19% petroleum growth is expected in 2014, investors appear willing to pay up for the company.
With a total fair business value of around $12.3 billion to $14.9 billion, or $38 to $46 per unit, LINN Energy looks to be priced at a noticeable discount. LinnCo, a publicly traded affiliate that holds a 39% share of LINN Energy, looks similarly inexpensive, trading well below its $37 to $45 per share worth.
A troubling longer-term view
As attractive as LINN's near-term traits may be, there are some serious longer-term concerns, however. The company's apparent need for complex financial maneuvering to move the business ahead is far from comforting. LinnCo is a good example. LinnCo appears solely a vehicle that allows LINN Energy to make acquisitions without using its own units, which would be severely price pressured on any declared dilutive activity.
The Berry Petroleum purchase demonstrates how LinnCo can be used. LinnCo took over Berry in exchange for LinnCo shares. Afterward, LinnCo then passed Berry along to LINN Energy in exchange for LINN Energy units. Though a clever way to get the acquisition done with minimal LINN Energy price disruption, the apparent need to use such a process doesn't engender much confidence in the participants.
The long-term stability of LINN's business model may be a greater concern. LINN, a limited liability company, is required to make substantial distributions to unitholders. Unfortunately, these sizable cash disbursements weaken the company's finances significantly. LINN's SEC annual filings show that roughly $2.04 billion in operating cash was generated while $2.63 billion was spent on developing oil and gas properties over the last three years. This isn't alarming in itself, but adding in $1.74 billion in cash outflow for unitholder distributions greatly increases the cash deficit worry.
While LINN's cash flow position admittedly improved in 2013 and it does have assets to monetize, one must be fairly pessimistic on the company's longer-term future until cash outlays more closely resemble cash generation.
LINN Energy is an appealing but chancy investment consideration. A beneficial acquisition and discounted market value make the short-term prospects attractive, while concerns about financial maneuvering and business model stability could make the long-term risky. After shunning LINN and its affiliate LinnCo for quite awhile, I now believe the positive near-term attributes make them a reasonable enough, though still perilous, investment holding. But it is still not clear whether I will receive a gain or just pain from my change of heart on LINN Energy.