Our negative call on LINN Energy (LINE, LNCO) was featured prominently in Barron's this weekend. LINN's CEO Mark Ellis appeared on Mad Money last night to (attempt to) refute some of our critiques. You can find that video here: http://video.cnbc.com/gallery/?play=1&video=3000166362.
Our Take on the Interview
Overall, we thought Ellis' defenses were weak, which is not a surprise to us (there aren't any good ones). No change in our view here - LNCO/LINE is still one of the best sells/shorts in the energy sector today.
Jim Cramer: “Are [the bankers advising LINN Energy and Berry Petroleum on the pending merger] saying that [LINE] is worth $18 like Barron’s says?”
Mark Ellis, CEO of LINN Energy: “Absolutely not, Jim. They’ve done a complete independent analysis; we’ve had three different independent analyses done. They are all coming in with valuations in the high 30’s to mid 40’s for the Company. We’ve done our own valuation, it’s in the mid 40’s to as high as $60 per unit depending on how far you go into the 3P reserves.”
Hedgeye: You are citing the fairness opinions of the bankers that are getting paid to work on the merger? Really? We are independent, don’t get paid banking fees from LINN or Berry, and believe that LINE is worth $5 – $18/unit.
Ellis: “Our accounting is in strict adherence to GAAP measures.”
Hedgeye: We agree.
Ellis: “We’ve been very clear and transparent as it relates to our non-GAAP measures that we use to measure the performance of our business. And in our most recent 8-K’s we’ve given total transparency in terms of how those measures are calculated.”
Hedgeye: We disagree. How LINN excludes the cash cost of put options from “distributable cash flow” by amortizing them through the unrealized loss on commodity derivatives line has neither been adequately explained nor justified (it's complex and most LINE investors don't understand it). Further, “maintenance capex” is still very much a mystery; we are not able to calculate or estimate this number on our own. In fact, LINN’s IR team has told us that it’s not possible with publicly available information. This is hardly transparent.
Cramer: “[Kevin Kaiser] says that ‘LINN can’t keep production flat despite $260MM of capital expenditures, yet the amount of capital spending that is deducted from their definition of distributable cash flow was only $110MM.’ He’s saying that your free cash flow was actually negative $40MM…”
Ellis: “Jim, what you have to understand in our business is that one quarter does not make a company. One quarter is not the appropriate measure for determining whether or not your maintaining your asset or not [sic]. You have to look at the body of the work over the course of a full year; so I think he’s taking a pretty short view of our business.”
Hedgeye: This is a weak argument that is not supported by the data. First off, LINN is a pretty standard E&P company – spud-to-sales times are ~30 - 60 days. There are no significant upfront costs to be followed by a large increase in production months or years later. Second, let’s do what Mr. Ellis suggests and look at the Company's performance over a longer duration. LINN says that maintenance capex should be considered on an annual basis, but let’s look at the last two quarters plus the guidance for 2Q13; this is an instructive exercise because the Company did not close any material acquisitions over these three quarters, so we have three straight quarters of organic numbers. Production averaged 800 MMcfe/d in 4Q12, 796 MMcfe/d in 1Q13, and management has guided 2Q13 production to 780 – 820 MMcfe/d. After adjusting the 2Q13 guidance for the Panther divestiture (expected to close on 5/31/13), the midpoint of the 2Q13 guidance is 806 MMcfe/d (by our estimates). So for three consecutive quarters LINN will have essentially no production growth, and total capex will exceed maintenance capex by $491MM. "Distributable cash flow” over these three quarters equals $497MM. In our view, if maintenance capex was anywhere near what it is really costing LINN to maintain production, there would be no distributable cash flow (see table below).
Ellis: "I think many of the facts were misleading."
Hedgeye: Freudian slip?
Quick Look at the BRY 1Q13 Results
Berry Petroleum (BRY), the E&P that LINN is attempting to acquire in a $4.3B all-stock transaction (expected to close around the end of 2Q13), reported 1Q13 results last night. Production increased 0.44% q/q, CFFO was $134MM, and CapEx was $179MM, for a free cash flow deficit of $45MM. CapEx surprised to the upside versus consensus expectations ($152MM), management's guidance ($500 - $600MM for the FY13), and last quarter ($158MM).
Production in 1Q13 was 39,676 boe/d and guidance for the FY13 (unchanged from February 2013) is 38,000 - 40,000 boe/d on $500 - $600MM of CapEx. It is reasonable to assume that production either holds flat or declines sequentially over the course of the 2013 (or increases with CapEx +$600MM).
Strangely, LINN is guiding 2H12 BRY "maintenance CapEx" to $121MM, or $242MM annualized. So BRY on its own in 2013 will see production flat-to-down on $500-600MM in spending, but once LINN acquires it, maintenance CapEx is only ~$242MM on an annualized basis. Interesting math...
This is how LINN can acquire (all-stock deal) a company that does not generate any free cash flow, admit no material synergies (note: BRY paid only $1MM of cash taxes in 1Q13), and claim that it will be accretive to "distributable cash flow" per unit.