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LINN Energy & The SEC News

Takeaway: Reaction to the SEC’s Informal Investigation of LINN Energy.

This note was originally published July 02, 2013 at 09:15 in Energy

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 & The SEC News - SEC Bldg

 

“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.

 

Kevin Kaiser

Senior Analyst    

kkaiser@hedgeye.com


Reactions to the SEC’s Informal Investigation of LINN Energy

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.

 

Kevin Kaiser

Senior Analyst    

(o)


It's All About the Benjamins

Client Talking Points

YEN

We've said it before, and we'll say it again: Get the US Dollar right and you will get a lot of other things "Big Macro" right. Yen (vs USD) is down for a 4th day in a row and the Weimar Nikkei has ripped a +6.8% 4-day move on that. It is now back above our 13,389 TREND line of support. The Dollar matters, folks.

GOLD

We have no short position currently in Gold. But we are looking at this $1268-1332 range (immediate-term TRADE resistance) to start re-populating our entire metals/mining book on the short side. Gold is a lot like AAPL was. Wall Street Consensus is still trying to call bottoms, instead of pressing one of the better Macro short calls there is. There is no support to $1174.

GREECE

Just in case you didn’t know how this whole debt/debauchery thing ends, now you know. Greek stocks were front-running the re-entry of the "Troikan Eurocrats" this week. Greece is down an astounding -26.4% since May 17. That there is what we call crashing. With most Asian and European Equity tapes bearish TREND right now, people are running out of places to put their money. Yes, that is a bullish catalyst for US Equity flows.

Asset Allocation

CASH 55% US EQUITIES 15%
INTL EQUITIES 6% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 24%

Top Long Ideas

Company Ticker Sector Duration
WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

MPEL

Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 

HCA

Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road. 

Three for the Road

QUOTE OF THE DAY

It is better to be hated for what you are than to be loved for something you are not.

- Andre Gide 

STAT OF THE DAY

Danske Bank A/S, the most-accurate gold forecaster tracked by Bloomberg over the past two years, predicts $1,000 in three months.


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Standing Up

“If someone picks on your brother and you don’t stand up for him, don’t bother coming home.”

-Larry Bird, quoting his father (paraphrased)

 

From a stock research perspective, the last couple of months at Hedgeye have been interesting.  Specifically, our Senior Energy Analyst Kevin Kaiser has been knees deep in a classic battleground stock: LINN Energy.  Kaiser has done an immense amount of independent work on the stock and concluded that the Company is overvalued.  In fact, our fair value estimates are more than 40% lower than the current stock price.

 

This research has raised the ire of the Company’s management who has publicly refuted our thesis, has led to numerous ad hominem attacks from the likes of Jim “The Entertainer” Cramer, and also led to a letter to the editor of Barron’s from a large hedge funds that has accused the short sellers of LINN to be “unprincipled”.  (Ironic from a hedge fund that routinely shorts securities.)

 

Now, admittedly, when we think we are on to something we tend to go all in.  In this instance, that included presenting on the idea a couple of times, participating in the Barron’s article, and publicly defending our research and our analyst.  To Larry Bird’s quote above, if you are not going to defend your ideas and your teammates, don’t bother coming back to Hedgeye headquarters.

 

Late last night, we were rewarded for our hard work as LINN Energy 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.”

 

Now to be fair, this is America, and certainly the Company is innocent until “proven guilty” by the SEC, but nonetheless this was part of our point in warning investors that some of LINN’s practices were likely to attract the scrutiny of the SEC.

 

As always, though, Mr. Market will ultimately let us know if we are correct in our research on this name.  After all, in the short run the stock market is a voting machine and in the long run it’s a weighing machine.

 

Back to the global macro grind . . .

 

Not surprisingly, one of our third quarter themes will be related to Asia, which has been home to much of the global equity market pin action this year.  As Keith noted this morning, the Yen is down for the fourth straight day versus the U.S. dollar.  In that time period, the #WeimarNikkei is up +6.4% and is once again back above our TREND line of support of 13,389.

 

The other noteworthy equity move in the region was from Australia.  In the land down under, Aussie stocks had their largest 1-day move in the last two years, up more than 2.5%.

 

The Reserve Bank of Australia left rates unchanged and also indicated that they are maintaining an easing bias with a scope to cut again. So, yes in U.S. dollar terms kangaroo pelts are cheap and getting cheaper!

 

The data flow out of Europe this morning is also universally supportive of more easing from the ECB.  First, French car sales came in at literally 20-year lows.  Second, Portugal’s Finance Minister resigns due to public discord over austerity.  Finally, it seems Greece may not be able to satisfy the Trioka in the next 3 days and concession will have to be reached on its next aid tranche.   This later point was obviously foreshadowed by Greek equities which are down -26% since May.

 

On a relative basis, the actions in both Japan and Australia, and data from Europe, are supportive of our bullish view of the U.S. dollar.   Currency trades on marginal moves in policy and, on the margin, the U.S. appears to be getting more hawkish as the rest of the world stays or gets more dovish.   Of course, as the facts change so will we and this is a big week for incremental data with U.S. payrolls being reported on Friday and the ECB meeting on Thursday.

 

Coming into the year, one of the asset classes we were most negative on was gold.  Primarily, this was due to expected U.S. dollar strength.  This thesis has played out in spades with gold down more than -25% in the year-to-date.   Currently, we have no position in gold, but continue to look for a re-entry point on the short side.  Consensus is still trying to call the bottom, but the reality remains that prolonged strength in the U.S. dollar will be a major headwind for gold.

 

Switching gears to the U.S., we will be hosting a call next week on July 9th to introduce a new investment theme on defense spending entitled, “Torpedoes in the Water?”  In summary, we are introducing a bearish view on many defense contractors, which have been outperforming industrials broadly, as we believe the earnings estimates are likely to go lower as a long term reduction in procurement spending sets in.  Email if you’d like to attend.

 

Our immediate-term Risk Ranges are now:

 

SPX 1

Nikkei 13

USD 82.46-84.16

Yen 98.02-99.91 

Oil 102.26-104.86 

Gold 1174-1268 

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

Standing Up - LINE 2

 

Standing Up - vp7 2


The Great Bear Raid of 2013

This note was originally published at 8am on June 18, 2013 for Hedgeye subscribers.

“If you are a short seller, that’s cacophony of negative reinforcement.  You’re basically told that you’re wrong in every way imaginable every day. It takes a certain type of individual to drown that noise and negative reinforcement out and to remind oneself that their work is accurate and what they’re hearing is not.”

-Jim Chanos

 

As many of you know, short selling is not for the faint of heart. We've learned that in spades recently on a position we added to our Best Ideas list in late March called Linn Energy (LINE).

 

Barron's got to the name before us, but their write-up piqued our interest, so our energy team, led by Senior Analyst Kevin Kaiser, rolled up their sleeves and dug in. Needless to say, after looking under the proverbial cover we didn't like what we saw. 

 

The position itself has worked out well for us and on a price basis is down more than 15% as the company reported soft earnings and has had delays closing its merger with Berry Petroleum (BRY). Unfortunately our analysis has raised the ire of the indefatigable Jim Cramer, who has had the misfortune of being on the wrong side of the trade in Linn Energy in his charitable trust. 

 

In recent days, it has become Cramer's bully pulpit on CNBC versus Hedgeye's analysis. If the stock price action is an indicator, we like our odds in the battle.

 

Unfortunately, as is sometimes natural when backed into a corner, Cramer has resorted to ad hominem attacks in trying to discredit our research. Things like calling us too young to do professional analysis, implying we are violating the Securities Act of 1934 (my Compliance Officer Rabbi Moshe Silver vehemently disagrees there), and this is by far the best, he's been tweeting that we are leading an orchestrated "Bear Raid". 

 

Don't worry you’re not the only one that doesn't know what the term "Bear Raid" means.  But, then again, we don't know what Booyah means as it relates to investing either.  Although, we could offer some guesses . . .

 

That all said, being the friendly young (Cramer's emphasis not mine) analysts we are, we would like to cordially invite him to our 11am call today on Linn Energy. (Jim, Feel free to email me for details - djones@hedgeye.com).  Incidentally, we have also invited the management teams of Linn Energy, Berry Petroleum, and many of the largest shareholders. At the very least, Cramer will have a hard time saying that we aren’t transparent.

 

Back to the Global Macro grind . . .

 

At 11am eastern, Kaiser will go through his “Linn Energy Not Top 10” and we will give you a little preview, with a top three selection:

 

1.   Using LINE’s 2012 organic F&D cost of $3.66/Mcfe, LINE has to spend $1,093 in 2013 to replace produced reserves.  This exceeds LINE’s 2013 maintenance cap-ex estimate by ~$636 million.

 

2.   On a $/acre basis. LINE’s NAV suggests $35,000 - $55,000 per acre for its Granite Wash play.  The most Granite Wash deal – Laredow/Enervest in May 2013 – was done at $4,000/acre.

 

3.   Cramer is recommending you own LINE.  (Joke!)


As it relates to global macro news flow, the last 24 hours have been relatively quiet.  Draghi spoke in Jerusalem earlier today and reiterated his “whatever it takes” pledge saying that the ECB has an “open mind” on non-standard monetary policy if circumstances warrant.  Last week, we gave an update on European economy and we wouldn’t take “whatever it takes off the table”.

 

We see more evidence European sluggishness this morning with EU27 New Car Registrations that were down -5.9% year-over-year in May.  For those that are keeping track, that is the lowest level since 1993, or about two decades.  To the extent that new car sales are a gauge for consumer sentiment and willingness to spend, this was not a great data point.

 

Not that we want to be known as the curmudgeon short sellers that pile on the bad news, but the other key data point from Europe relates to Spain.  First, Spain sold about €5.04B of 6- and 12-month bills on Tuesday.  This was at the high end of the range, but saw yields increase dramatically from last month (0.492% -> 0.821% on the 6-months and 0.994% -> 1.395% on the 12-months). As well, Spanish banks reported that banks bad loans as percentage of total credit rose to 10.9% in April from 10.5% in May. With unemployment north of 20%, this is not really a big surprise.

 

In other news, our #EmergingOutflows theme continues to play out.  Brazil’s Bovespa dropped below 50,000 yesterday and is now in full blown crash mode (down more than -22% since January 3rd).  This is on the back of some of the largest Brazilian protests in some twenty years.  In China, foreign direct investment slowed to trickle in May, which is likely a sign that foreigners are recognizing the precarious debt situation in China.

 

But, alas, all is not terrible in the world.  In fact, we believe we have discovered what we think may be the next great consumer growth market in the United States . . . electronic cigarettes.  Your eyes are not deceiving, e-Cigs have the potential to be an almost 10-bagger in terms of market share growth over the next decade.  On Wednesday, we are hosting a call with the CEO of one of the few e-cig pure plays who will give us an update on the market.  Email sales@hedgeye.com for details.

 

We’d be remiss if we didn’t end this note with a line from one of our favorite songs from Johnny Cash:

 

“I keep a close watch on this heart of mine,

I keep my eyes open all the time.

I keep the end out for the tie that binds.

Because you’re mine, I walk the $LINE.”

 

Our immediate-term Risk Ranges for Gold, Oil, US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1361-1404, $103.74-106.22, $80.09-81.21, 93.24-96.42, 2.07-2.29%, 14.57-18.69, and 1605-1652, respectively.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

The Great Bear Raid of 2013 - Chart of the Day

 

The Great Bear Raid of 2013 - Virtual Portfolio


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.64%
  • SHORT SIGNALS 78.57%
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