In a press release put out after market hours last night (7/1/13), LINN Energy (LINE, LNCO) disclosed that the SEC has commenced a private, non-public inquiry regarding LINN and LinnCo. We quote the body of the press release in its entirety, with our emphasis:
“LINN Energy, LLC (Nasdaq:LINE) ("LINN") and LinnCo, LLC (Nasdaq:LNCO) ("LinnCo") announced that they have been notified by the staff of the Securities and Exchange Commission ("SEC") that its Fort Worth Regional Office has commenced a private, non-public inquiry regarding LINN and LinnCo. The SEC has requested the preservation of documents and communications that are potentially relevant to, among other things, LinnCo's proposed merger with Berry Petroleum Company, and LINN and LinnCo's use of non-GAAP financial measures and hedging strategy. The SEC has stated that the fact of the inquiry should not be construed as an indication that the SEC or its staff has a negative view of any entity, individual or security. LINN and LinnCo are cooperating fully with the SEC in this matter.
Although the impact of the inquiry on the timing of LinnCo's proposed merger with Berry Petroleum Company is difficult to predict, LinnCo and LINN remain committed to the completion of the transaction.”
This is a good start and the SEC appears to be looking in the right places – non-GAAP financials, commodity derivatives, and terms of the LINN/BRY merger. Our negative view on LINN Energy was largely predicated on all three of these issues. We speculate that possible outcomes of this investigation are that the SEC ultimately requires LINN to:
- Restate prior period non-GAAP financials, including adjusted EBITDA and distributable cash flow (DCF);
- Restate prior period “realized gains/losses” and “unrealized gains/losses” on commodity derivatives;
- Redefine “realized gains/losses” and “unrealized gains/losses” such that realized gain = settlement minus cost basis;
- Disclose the premiums paid for commodity derivatives that settle in all future periods;
- Increase disclosure on how, exactly, LINN defines and calculates estimated maintenance capex;
- Provide a reconciliation of prior period estimated maintenance capex to actual maintenance capex;
- Make maintenance capex a more transparent and less subjective measure, such as an F&D cost or DD&A rate;
- Include maintenance capital needed to maintain other PP&E (plants, pipes, etc.) in maintenance capex;
- Increase disclosure on the tax consequences of the LINN/BRY merger on LINE, LNCO, and BRY, specifically with respect to the election of the “remedial method”;
- Revise forward-looking guidance for maintenance capex, adjusted EBITDA, and DCF.
We believe that the SEC inquiry puts the proposed LINN/BRY merger at serious risk. Note that the press release does not say that “LinnCo, LINN, AND BERRY remain committed to the completion of the transaction.” The press release was also not jointly issued by LINN and BRY, as was the 5/31/13 joint press release title, "LINN Energy, LinnCo and Berry Petroleum Company Provide Update on Merger."
For anyone bullish long-term on stand-alone BRY, we believe that this is good news. It’s likely that LINN/BRY will not close the merger while the investigation is ongoing, and Berry will be free to terminate the merger without paying the $83.7MM ($1.50/share) termination fee if the merger does not close by the “End Date,” October 31, 2013. It’s impossible to predict how long the SEC’s investigation will take, but they can be on the order of several months to quarters. This site provides a simple overview of the SEC's investigation process. Further, our interpretation of the proxy is that the SEC's investigation of LINN qualifies as an "LINN Party Material Adverse Effect," which allows Berry to terminate the merger at any time without penalty.
For LINE/LNCO, this is devastating. The SEC shining a light on LINN’s non-GAAP measures will likely show investors how far they are from economic reality (net income per unit, for instance). And with the BRY merger now in serious doubt, the “LINN will buy every C-Corp E&P out there” bull case doesn’t seem like such a great idea. We will also see more consecutive quarters of organic results from LINN, which we expect will show flat-to-declining production, rendering LINN’s estimated maintenance capex number more and more difficult to defend. We also believe that there’s a good chance that the distribution will ultimately be cut as the SEC’s actions could materially reduce “DCF/unit” going forward. That’s going to make it difficult to value LINN with a yield target. And there will be a wave of negative feedback. JP Morgan and Raymond James downgraded LINE/LNCO to neutral this morning; we expect other analysts to follow suit, or just suspend coverage. Recall that LINN is largely retail-owned, and for years, LINN thrived partly thanks to the constantly bullish recommendations from these analysts.
We maintain that fair value for LINE (LNCO) is around ~8.00/unit (share).
As far as broader implications of this investigation go – we imagine that there are quite a few MLP executives that are feeling a little uneasy about the SEC looking into LINN’s non-GAAP measures, which likely includes maintenance capex and DCF. Our research suggests that understated maintenance capex (and overstated DCF) is endemic in the MLP sector – particularly among the upstream MLPs. If the SEC requires LINN to enhance disclosure on maintenance capex and/or make the calculation of maintenance capex a less subjective exercise, it would be negative for the entire sector. We would highlight Breitburn Energy Partners LP (BBEP), EV Energy Partners LP (EVEP), and QR Energy LP (QRE) as companies that may significantly understate maintenance capex, and as a result, overstate DCF.