Given the plunge in LINN Energy's (NASDAQ:LINE) unit price, it's painfully obvious that investors now almost expect the company to cut its distribution. With its units now yielding 17%, investors simply don't think the company will be able to maintain its current distribution rate any longer. While I don't think the company needs to cut its payout just yet, it might actually be better off just cutting the payout now and using the cash it would save for something else. Like a massive buyback of its now significantly discounted units.
When life gives you lemons
As I've pointed out more times than I can count, LINN Energy's distribution should be incredibly safe. The company's oil and gas hedges have locked in an average of 90% of its cash flow for the next two years as we see on the following slide.
As that slide notes, LINN Energy hedges substantially more of its production than either its upstream MLP peers or its C-Corp peers. And yet, despite this protection its unit prices have been beaten into a pulp -- down an unbelievable 46% over the past year.
However, given that the company's cash flow is so well protected, instead of paying that cash flow out to unitholders, the company could decide to take the lemon of an obliterated unit price and make some lemonade by engineering a massive unit buyback. By doing so, the company could take out a huge chunk of units, which would reduce the amount of future distributions because they'd be paid over fewer units.
How the math works
In the second quarter, the company announced that its board had authorized the company to buy back units up to $250 million. Just a few weeks ago, that would have resulted in the company's ability to buy back 11 million units, which would have saved the company $30 million in annual distribution payments. However, that same buyback if done today would result in the company buying back 15.4 million units, which would result in the company saving $44.6 million in annual distribution payments. For some perspective, last quarter, the company's distribution was $241 million, so the current run rate is $964 million per year. So, just in executing its currently authorized buyback, the company could cut its distribution requirement by 4.6% over the next year. That alone would put its current distribution on much more solid ground.
That said, given the falloff in the company's unit price, I think LINN Energy could take things a step further and make the distribution cut everyone is expecting it to make. Let's say by 50% because that's about what the market is implying. Such a cut would save the company an estimated $482 million in distributions over the next year. Where things get really interesting is if that cash is plowed back into an even larger $750 million buyback. At recent prices, LINN could take out 46 million units, or 14% of its outstanding units. That's a substantial reduction in units, which would not only support the unit price but would increase the company's future coverage ratios as distributions would be spread across fewer units. Said another way, it would help make LINN Energy's future distributions much more sustainable.
If energy prices stay low, LINN Energy's cash flow, and therefore its distribution, should be safe at the current rate for the next two years. However, the company could just bite the bullet and cut its distribution now and use the cash flow it would save to buy back a meaningful amount of units. By doing so, it could put itself in a much better position to maneuver in the future should energy prices eat into its unhedged cash flow beginning in 2017.
Matt DiLallo 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.