It’s easy to see why investors are attracted to oil & gas production MLP Linn Energy (NASDAQ:LINE) and its subsidiary LinnCo (NASDAQ:LNCO). The firm — through its dual structure — has managed to continuously grow its already high distribution yield for the past few years via strong production and smart acquisitions.
Nonetheless, that high yield and those cash flows haven’t come without criticism.
There has been a resounding cry of “foul play” — especially from the hedge fund community — with regards to the Linn’s use of hedging derivatives, CAPEX spending and lowered Q1 energy production. The firm’s dual share classes remain among the most heavily shorted stocks on the Nasdaq.
The first cannon fire seemed to bounce off of Linn’s hull as company announced an immediately accretive purchase of Berry Petroleum (NYSE:BRY). However, after another analyst questioned the company’s hedging practices in a negative Barron’s article this weekend, shares slipped hard.
What we need to decide is whether this is a buying opportunity or a harbinger of bad news.
The Bear Case
The issue for Linn is twofold.
First, analysts have begun to question how Linn Energy uses derivatives to hedge its production and how it accounts for those calls and puts on its balance sheet. As a result of using derivatives for its production, Linn has been able to realize significant gains on what it pumps out of the ground. For example, Linn was selling its natural gas for more than $5 per MCF during the first quarter, when the market price was about $3.50.
That’s all well and good, until people begin to question — as some analysts have — how it records those hedging measures on its balance sheet.
According to Barron’s, Linn spent roughly $583 million on in-the-money put options on natural gas last year. While the put expense is properly reflected in Linn’s GAAP financials, the E&P MLP excludes it from distributable cash flow. This metric is commonly used by MLPs as a more accurate measure of what shareholders can expect in terms of cash flow. This is similar to real estate investment trusts and FCF measures and has do with the fact that both company structures do not pay corporate taxes.
Linn views its put-buying as a “capital” cost and considers the premiums it pays for derivatives as part of the investment in its business. That seems to be the issue for hedge funds shorting the stock. As New York-based Green Owl Capital put it in the Barron’s article:
“Linn recognizes the full proceeds of hedging transactions upon maturity while recognizing none of the initial costs.”
Secondly, there are issues with Linn’s production — which seems to be declining despite heavy capital expenditures. The company’s first-quarter earnings report showed total energy production averaging 796 million cubic feet per day. That was down from 800 million cubic feet a day in 2012’s fourth quarter and little changed from the 782 million cubic feet in Q3.
Overall, this declining production could come back to bite Linn’s distributable cash flows — which some consider to be overstated due to the previously mentioned hedging.
Ultimately, Barron’s believes Linn Energy’s dividend could be cut if conditions are less than perfect.
The Bull Case
Linn bulls say poppycock to all of this.
According to Wells Fargo analyst Praneeth Satish, the Barron’s piece doesn’t bring anything new to table that hasn’t already been discussed or brought to the public’s attention. Linn has released several supplemental 8-K’s detailing exactly how it performs its hedges and how it calculated its distributable cash flows. DCF is still a much better metric for determining MLP health, and that coverage still seems healthy.
Distribution coverage by Linn is forecast to be 1.02X in 2013. That’s based on a $2.90 distribution rate. Over the next few years, that grows to 1.13X and 1.18X for 2014 and 2015, respectively. This coverage doesn’t take into effect the Berry acquisition or any other purchases by Linn.
Upstream MLPs need to continuously add to their reserves to grow their dividends. Linn has been quite successful at doing just that, and according to Satish, “the LNCO financing vehicle provides the company with a competitive advantage and could help both support distribution growth and improve Linn’s leverage ratios over the coming years.”
While they might seem aggressive, Linn’s accounting practices are legal and SEC-compliant. So the idea of an Enron-style blowup is farfetched. Linn isn’t a fraud waiting to happen.
Perhaps the biggest bullish case can be summed up by Linn CEO Mark Ellis in an interview on CNBC’s Mad Money. Ellis thought the article was completely misleading, and he disputed the idea that LINE shares might be worth far less than the current quote or that the company will be required to cut distributions because of poor hedging or lowered DCF measures.
Perhaps more importantly — thanks to the work of independent analysts for the BRY acquisition — Ellis said, “None of the valuations we’ve seen by any one of the independent parties is anywhere close to what was represented over the weekend in the Barron’s article.”
The Bottom Line
LINE and LNCO are turning into quite the battleground stocks.
Linn isn’t for everybody. It’s a complex company that uses some complex accounting and derivatives measures to pay its hefty distribution. Buying it solely for the yield without understanding where that dividend is coming from is not advised.
However, anyone looking to add the company to a portfolio could use this dip as an opportunity to load up on shares. The Barron’s article seems to rehash old ideals that didn’t stick the first time they were published.
As of this writing, Aaron Levitt was long LNCO.