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Looking at LINN Energy

Takeaway: Here's a deep dive into LINN Energy and the company's accounting practices.

Energy sector head Kevin Kaiser digs into the accounting practices of LINN Energy LLC (LINE, LNCO) and comes up with more questions than answers.

 

LINE is a Master Limited Partnership (MLP), a tax-advantaged corporate structure that traditionally attracts individual investors looking for a mix of above-average yield and safety.  Oil and gas exploration and production (E&P) MLPs typically acquire and operate older producing oil and gas fields with low decline rate fields (approximately 10% per year).  These fields tend to throw off decent revenues and, since the MLP does not pay corporate income taxes, the company distributes excess cash flow to its unit holders.

 

These so-called “upstream” MLPs typically grow through acquisition of producing fields, rather than through exploration, which is an expensive and capital intensive process. Simply, E&P MLPs are in the cash flow business, and the MLP structure mandates them to distribute the majority (+90%) of their excess cash flows to unit holders.

 

Today there are 11 publicly-traded upstream MLPs in the US.  LINE is the largest with a $19B enterprise value.  Pro forma LINE’s recent acquisition of Berry Petroleum, the stock trades at ten times 2013 EBITDA.  LINE shares closed Friday at $36.40.  Kaiser says his analysis indicates the stock is probably worth about $15 a share based on multiple of cash flow and net asset valuation approaches.

 

Are E&P MLPs Over-Valued?

Oil and gas wells are, by definition, declining assets, and cash distributions rely on the MLPs ability to manage its properties to sustain stable production – an difficult task, as any oil company executive will tell you.  Kaiser believes the upstream MLP sector is overvalued and riskier than most investors recognize, but no company more so than LINE. 

Kaiser points to two key generators of cash flow: hedging and maintenance capex. 

 

In both cases, he says, LINE’s accounting practices appear nontransparent.  Kaiser re-calculated certain of LINE’s key cash flow metrics using more conventional accounting approaches and arrives at the conclusion that LINE’s distribution is not sustainable.  In the period 2006-2012, LINE paid out approximately $2.2 billion to unitholders.  During that period – according to Kaiser’s calculations – actual free cash flow was a deficit of  approximately $1 billion.  In short, distributions are paid with capital raises as opposed to free cash flow.  This cannot continue indefinitely.

 

Among key issues Kaiser raises are LINE’s accounting for their hedging.  The purpose of hedging is to offset fluctuations in revenues from their oil and gas properties.  LINE appears to be accounting for its options hedge strategy in a way that makes all put option transactions look profitable, and appears to be accounting for its hedge transactions as part of the company’s recurring cash flow. 

 

Finally, Kaiser says there are limits to how far a company can take its growth-by-acquisition strategy. MLPs buy assets when markets are strong, and often overpay.  Then they suffer in weak markets, making the group highly pro-cyclical – meaning it tends to rise and fall together with broad market trends.  Kaiser says LINE will need meaningful capital expenditures to maintain their cash flow stream.

 

Conclusion

LINE may be the tip of a very large iceberg.  Investors who are enjoying above-average returns from high-yield MLPs should look under the hood.  While it is too early to say this whole business model is in jeopardy, LINE looks like a company trying to stay ahead of the curve by taking advantage of a series of accounting strategies.  We do not mean to imply that there is anything improper about what LINE is doing.  It should be enough warning for investors that their books are not transparent. Accounting rules have been so distorted by Congress and lack of clear regulation that no one needs to break the law in order to pull the wool over investors’ eyes.

 

 


DRI: A Rare Opportunity

Bountiful, Low-Hanging Fruit

 

Darden’s core concepts, Olive Garden, Red Lobster, LongHorn Steakhouse, account for approximately 90% of the company’s consolidated sales and have average unit volumes of roughly $4.1 million.  Chili’s accounts for 83% of Brinker’s sales and produce average unit volumes of $3 million. 

 

On a trailing-twelve-month basis, Darden’s consolidated restaurant-level operating margins are 560 bps higher than Brinker’s. While part of the gap in restaurant-level operating margins can be explained by Darden’s large real estate position, it is interesting to note that Brinker’s operating margins are, on a trailing-twelve-month basis, 100 bps higher than Darden’s.  The money Darden saves by not paying rent is being spent on a fat corporate structure.  We think that fat can be cut by an activist either by straightforward cost-cutting measures alone or by reorganization or both. 

 

 

What About Scale?

 

Darden management has been exalting the efficiency-related benefits of a multi-brand portfolio for years.  If that were true, the company’s operating margins would be better.  However convincing, or convinced, Darden’s executives may seem when discussing the “economies of scale” of the business model, we do not see it in the numbers. 

 

Cutting SG&A is the best way to achieving the 10-11% operating margins that we believe are within the company’s capabilities.  On a trailing-twelve month basis, the company’s operating margins have been running at 7.7%. 

 

We estimate that cutting SG&A by $239mm on an annualized basis, or 28% versus current levels, would bring margins to 10.5%.

 

In our recent Black Book, we discussed a sum-of-the-parts analysis that suggested a $17 premium to the current share price based on a valuation of the company's chains and real estate. Combining this with the SG&A savings of $239 mm pretax, or $1.40 per share, implies $37 per share of potential upside available if the company is reorganized and SG&A levels are rightsized. 

 

This implies a 75% premium to the current share price.

 

 

DRI: A Rare Opportunity - dri big 3 chilis auv

 

DRI: A Rare Opportunity - eat dri rest levl marg

 

DRI: A Rare Opportunity - eat darden opmargins

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst

 

 


Today: Expert Call with William W. Keep on Pyramid Schemes and the Multi-Level Marketing Industry

The Hedgeye Consumer Staples team, led by Rob Campagnino, will be hosting an expert call featuring William W. Keep TODAY at 1:00pm EST entitled "Pyramid Schemes and Multi-Level Marketing."

 

CALL DETAILS

  • Date: Monday, March 25th at 1:00pm EST
  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 587456#
  • Additional reading materials: CLICK HERE

 

 TOPICS WILL INCLUDE 

  • What is Multi-Level Marketing (MLM) and where does it come from?
  • What are the key factors that determine a pyramid scheme versus a legitimate MLM company?
  • Framing the industry's learnings from such pyramid schemes as Equinox, Burn Lounge and Fortune Hi-Tech Marketing
  • Discussion of the FTC's role in the industry
  • Contextualizing Herbalife moving forward

 

ABOUT WILLIAM W. KEEP   

 

Keep is a professor of marketing at The College of New Jersey and currently serves as Dean of the school. His research and writings -- published in the Journal of Marketing, the Journal of Public Policy and Marketing, the Journal of Business Ethics, and The Chronicle of Higher Education, among others -- focus on long-term business relationships, business ethics, public policy and higher education. As a consultant he worked with a variety of firms and served as an expert witness in the prosecution of pyramid schemes, including Security Exchange Commission (SEC) v. International Heritage Inc., at the time the largest pyramid scheme ever prosecuted by the SEC. Keep has appeared on CNBC to discuss the topic of pyramid schemes, the MLM industry, and Herbalife and published articles on the subjects for CNBC and Seeking Alpha.

 

Professor Keep holds a PhD in Marketing from the Eli Broad College of Business at Michigan State University (MSU) and a B.A. from James Madison College at MSU in social science and economics.

 

 

CONTACT

Please email  to obtain the dial-in information for this call and a copy of the presentation, or to learn more about our research.

 

 

ABOUT ROB CAMPAGNINO

Rob has nearly 20 years experience in the industry and within the last 5 years on the buy side at some of the top hedge funds in the business, including Pioneerpath, Diamondback Capital, and Searock Capital. Prior, he was a senior equity analyst at Prudential Securities where he was consistently Institutional Investor ranked. Before Prudential he was at Sanford Bernstein as an equity research associate covering food, beverage, and retail. He began his career as a strategic consultant with PricewaterhouseCoopers. Rob has a MBA from Columbia and BA in Economics from Duke.

 

ABOUT HEDGEYE

Hedgeye Risk Management is a leading independent provider of real-time investment research. Focused exclusively on generating and delivering actionable investment ideas, the firm combines quantitative, bottom-up and macro analysis with an emphasis on timing. The Hedgeye team features some of the world's most regarded research analysts - united around a vision of independent, uncompromised real-time investment research as a service.

 


Early Look

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European Banking Monitor: Cyprus Doesn’t Shake Systemic Confidence

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

 

* Systemic Risk vs. Local Risk. The most interesting callout in this week's risk monitor is the divergence between Euribor-OIS and EU bank swaps. Euribor-OIS was tighter week-over-week, moving from 12.70 bps to 12.20 bps. Meanwhile, bank swaps across Europe were meaningfully wider. This speaks to Cyprus not being a systemic risk to the banking system in spite of the media's best efforts at making it one, or at least the markets didn't see it that way. 

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If you’d like to discuss recent developments in Europe, from the political to financial to social, please let me know and we can set up a call.

 

Matthew Hedrick

Senior Analyst

 

European Financials CDS Monitor – Not surprisingly, EU bank swaps widened sharply last week. French banks were among the hardest hit with BNP wider by 26 bps, Credit Agricole wider by 35 bps and Soc Gen wider by 39 bps. German, Italian and Spanish banks followed suit.

 

European Banking Monitor: Cyprus Doesn’t Shake Systemic Confidence - xx. banks

 

Sovereign CDS – Despite the turmoil, global sovereign swaps were only modestly wider last week. Portugal was the worst performer, widening by 18 bps WoW.

 

European Banking Monitor: Cyprus Doesn’t Shake Systemic Confidence - xx. sover 

 

Euribor-OIS spread – The Euribor-OIS spread tightened by 1 bps to 12 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

European Banking Monitor: Cyprus Doesn’t Shake Systemic Confidence - xx. euribor

 

ECB Liquidity Recourse to the Deposit Facility – In spite of the turmoil in Cyprus, ECB overnight deposits were unchanged last week. The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  

 

European Banking Monitor: Cyprus Doesn’t Shake Systemic Confidence - xx. facility


Copper and the Dollar

Takeaway: Get the US dollar right, you'll get a lot of other things right - like copper, for example.

What's good for the US dollar is bad for commodities these days. We see that correlation across many different commodities, but copper prices are showing a particularly strong correlation as you can see in the chart below. The chart shows high grade copper prices versus the the US dollar index for the past 30 days.

 

Copper and the Dollar - Copper vs USD

 


MACAU GROWTH SLOWS - BUT NOT MUCH

Macau put up another strong week and while ADTR failed to keep up with the torrid pace of the first two and half weeks, revenues were still very good.  ADTR grew 33% YoY this past week to HK$886 million.  Our full month projection is higher once again, to HK$29.5-30.5 million which would represent YoY growth of 22-26%.  We are hearing that high VIP hold is only partly responsible for the March strength as volumes in both Mass and VIP have been very healthy.

 

Market shares thus far in March are consistent with recent trends for the most part.  The slight exceptions are SJM higher and MGM lower.  We continue to like MPEL and LVS as the best Macau long ideas.

 

MACAU GROWTH SLOWS - BUT NOT MUCH - mmm

 

MACAU GROWTH SLOWS - BUT NOT MUCH - fff


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