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.
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.