Last week LINN Energy (LINE) published “LINN Energy Response To Another Round Of Short Seller Comments” on its website. Two points are in order before we proceed. First, Hedgeye is is not a short seller. We are purely a research firm, an on-line financial media firm providing investment research free from the conflicts of proprietary trading or of managing money for third parties. Second, we leave it to you to consider the implications of LINN posting this “rebuttal” on April Fool’s Day. As we said in our initial presentation, we believe LINN’s financial reporting is… how shall we say…? lacking in transparency. That has not changed. Read on.
Your Bottom Line Hasn’t Changed
If you are like most investors, your own LINN units for the income they provide. As was asked again at the close of today’s call – where else can you get an instrument yielding over 8%? Would it upset you if we suggested that Argentina 2-year bonds are yielding over 8%? The bottom line for LINN is: how safe is the distribution yield? In our opinion – not very. Maybe not at all.
For our money – more importantly, for yours – we say LINN has not addressed the issue of Free Cash Flow. There just doesn’t appear to be enough for them to reliably keep hitting the targets they keep setting when they announce guidance of what next quarter’s distribution to unitholders will be.
To review, we raised four fundamental issues in our March 21st call – and we added a new one today:
1- Not enough Free Cash Flow (FCF)
2- LINN’s unusual accounting for its options hedging gives them dollar-for-dollar credit for what they spend as cash available to the company
3- The “Maintenance CapEx” metric is not even appropriate to this kind of company, and it understates the actual costs of m the business
4- Thanks for the second look: on re-examination, we have lowered our valuation for LINN shares. On March 21st we were willing to give the shares a fair value of around $15. We now think it may be as low as $5.
5- New item: LINN may be providing misleading calculations of how it values its acquisitions. We believe this continues to inflate the reported value of the company, and is part of the reason we have lowered our valuation
Here are some key points we re-emphasize from our first presentation – points that we believe LINN’s April 1st response did nothing to clarify.
Adjusted cash flows from operations: our analysis of LINN’s DCF (Discounted Cash Flows) calculation indicates there was a $1.047 billion cash shortfall over the 2009-2012 period, being the difference between what we calculate to be $686 million in actual free cash flow, and $1.732 billion paid out in distributions.
When we net out the treatment of option premiums, the numbers get worse. The cash shortfall over the period doubles, to $2.165 billion.
Material? We think so.
How safe is your 8% yield looking now?
LINN management says they are no longer buying put options to hedge production. But that still leaves over 30% of their annual production hedged with existing puts out to 2017. The way we figure it, this could overstate future cumulative DCF by more than $600 million.
To hit their distribution guidance targets – in other words, to keep you happy getting your 8% yield – LINN needs to raise between $500 million - $850 million every year, either from the capital markets, or by selling off assets.
Maintenance Capex: Kaiser says he has questioned LINN’s investor relations department on numerous occasions for clarification of their Maintenance CapEx calculation. IR says it is impossible for anyone but LINN to calculate this, because it is derived from non-public company internal data. To put it bluntly: Maintenance CapEx is unverifiable, which means it is what management says it is. The real nugget here is that LINN’s asset base is much more capital intensive than investors seem to recognize. Kaiser’s work indicates LINN’s actual maintenance capex expense may be nearly twice what company figures indicate.
More to the point (see our write-up of Kevin’s March 21st presentation) Maintenance CapEx is a metric that applies to pipeline companies, not to Exploration & Production companies.
Value: So what’s LINN worth, anyway? The company claims its shares are undervalues. Says Kaiser, “Markets don’t care what managements say.” With so many estimates and non-public factors going into the calculation of LINN’s asset base, the net asset value calculation starts to look like a free-for-all.
Kaiser says that, compared to companies in its peer group, LINN is trading at a significant premium on a number of key ratios. As just one example, the Price to Undeveloped Acreage metric. Most companies in the group have an average 75% still undeveloped acreage value to stock price ratio. LINN’s ratio is 3%. LINN says they have unproven drilling inventory worth between $27-$48 per unit. In fact, based on comparisons to other companies, and using LINN’s publicly reported figures, Kaiser says LINN’s unproven drilling inventory may very well be zero.
As an example of how confusing LINN’s reporting is, Kaiser points to the company’s independent auditor who assigned a reserve of 0.67 BCFE to 2500 of LINN’s locations. (Billions of Cubic Feet Equivalent – an industry term meaning how much untapped gas can actually be pumped and delivered over the life of the well.) In contrast, LINN – using its own data – assigns an average of 1.67 BCFE across more than 8500 locations. This is a completely unequal comparison and all but impossible to analyze. Kaiser says an investor would want to see the calrification for management assigning a BCFE figure two and one-half times the quantity assigned by their independent auditor.
Finally, Kaiser says LINN assigns high values to properties it acquires, implying that some of the biggest and most sophisticated energy companies are giving away valuable acreage. He points to instances where LINN has cranked up the valuation of a property to three times the value implied in the purchase price. Once it gets on LINN’s books, it appears these acquisitions all of a sudden become far more valuable than the amount LINN paid to acquire them.
Comparing LINN’s producing properties to other companies in the same geographic regions, Kaiser calculates that last week’s asset sales imply the units are potentially worth only… are you ready? As little as $1-$6.50 a unit.
Acquisitions: Kaiser’s work indicates LINN may have substantially overstated the value of its acquisitions. By using its method of accounting for its options, LINN does not include the options expense in the stated price of an acquisition. This makes deals look more accretive than they are, and Kaiser points to a key 2012 acquisition that LINN said was completed for 6.1 X first year EBITDA (Earnings Before Interest, Taxes and Depreciation, a key investment banking metric). On examination, Kaiser says LINN appears to have paid over 10 X EBITDA.
Nothing has changed.
LINN Energy continues to be one of Kaiser’s “Worst Ideas” – a cautionary tale for investors desperate for safe returns in this low-interest rate environment. Holders of LINN units should reflect that the energy business by its nature throws off unpredictable revenues. That means they have to find the cash somewhere else, in order to keep the distributions at the same level. Unitholders will have to decide for themselves whether a steady, predictable return of 8% on your money looks too good to be true.