Once an income investor's best friend, LINN Energy (OTC:LINEQ) has recently provided some nightmares for that conservative crowd. Distributions rose 97% from its 2006 inception to early 2008. Subsequent hikes have been few and far between. Investors' take home grew a measly 15% in the following six years. While the recession and poor pricing deserve some of the blame, size itself has also become a challenge limiting LINN's long-term prospects.
Both LINE units and LinnCo (UNKNOWN:LNCO.DL) shares are caught in a downdraft. Not even consummation of the prolonged Berry courtship eased shares out their slump and tepid guidance for 2014 only enhances concern.
Slim coverage for 2014
Most worrisome for many is the tight coverage ratio built into that guidance. The company forecasts a mere $12 million excess over full year DCF. On LINN's $961 million distribution, that's a bare-bones coverage ratio of 1.01. The tightness was cited by Barron's as a primary reason for JPMorgan's recent downgrade.
The immediately obvious culprit would be the dilutive effect of the Berry acquisition. LINN's size now creates a need for acquisition in huge chunks and the Berry acquisition was important as proof-of-concept with respect to future C-corp acquisitions.
The size of the deal, coupled with LINE's weakness in the face of a short attack, made that deal far more dilutive than management intended. Despite this, I think Berry's production mix will compensate. The economic value of its high oil content mitigates the consequences of that dilution substantially.
Ultimately though, it's a factor completely within LINN's control that contributes most directly to the tight coverage. That's a dramatic hike in capex in 2014—specifically maintenance capex.
What is maintenance capex?
To clarify LINN's accounting, the SEC forced a few changes in LINN's non-GAAP reporting. Hedging costs are now deducted from cash flow when calculating DCF. The term 'maintenance capex' was also deemed too abstract. It's been replaced by the line item "discretionary reductions for a portion of oil and natural gas development costs." It's really the same figure with a new name. It's also a line item to keep an eye on.
When LINN plans capex for the coming year, it grades projects by probability of success and anticipated production. It then sets aside a sufficient subset of its high probability drilling projects to offset its production decline. In short, maintenance capex is the capital budget needed to hold production flat.
That maintenance capex is directly subtracted from operating cash flow to generate distributable cash flow, more commonly referenced by the acronym DCF. DCF is all the cash that LINN believes it could throw your way. So, all the drilling deemed necessary to hold production flat is organically funded through cash flow. The remainder of LINN's capex budget—its growth capex — is funded through debt.
As LINN has grown, the split between maintenance capex and growth capex shifted considerably. The chart below shows its capital budget over the last four years. Only 29% of LINN's $575 million 2011 budget was designated for maintenance. That percentage mushroomed after 2012, reaching 50% of 2014's $1.6 billion capital budget.
Every penny of cash flow diverted to maintenance capital lowers DCF, which in turn compresses coverage. That's ultimately a large piece of the reason for LINN's tight coverage guidance. Rising maintenance capex is trimming DCF.
The magnitude of that acceleration is apparent if you compare LINN's budgeted Q1 spend to its full year maintenance capex. Maintenance capex for Q1 is $193 million, or $772 million at an annualized rate. Yet, LINN's full-year guidance is $802 million, a $30 million excess over Q1's spending pace.
That increase in maintenance capex – a discretionary non-GAAP charge – is the reason for the tight projected full year coverage. Back out that increase and the DCF excess becomes $42 million. That's a large enough surplus that unitholders might begin to clamber for a distribution hike. Management doesn't need added pressure for a hike that future production might be unable to cover.
Managing near-term expectations is one possible cause for this sharp maintenance capex hike. Conservative guidance serves the dual purpose of communicating uncertainty and validating management's decision to hold the distribution, providing time for LINN to explore monetization of its unconventional Permian assets.
Alternatively, this could be part of a longer-term structural trend. LINN's large production base may just now need substantial capital to offset decline. In fact, Barron's cites capex increases as the specific cause for JPMorgan's downgrade. It's a factor that investors should watch in the future.