Takeaway: This note argues why the current criticisms of JPMorgan's 2Q earnings quality seem misplaced. We also take a refreshed look at fair value.

This note was originally published July 12, 2013 at 12:11 in Financials

Insight: JPM 2Q EARNINGS - jpm 

(Editor's note: Hedgeye's Institutional Clients range from the country's largest mutual funds to the world's top hedge funds. For more information on Hedgeye's Institutional Research product offerings, please click here.)


Lateral Plays


JPM read throughs. We see Capital One (COF) as a clear winner when they report 2Q next week. The card results from JPM confirm our perception of accelerating underlying improvement in credit quality in the unsecured market. Also, the enormous Q/Q improvements in residential RE credit quality trends bode well for BofA (BAC) when they report next week.



Results Are Stronger Than They Appear

JPMorgan reported a strong second quarter (all things considered), a blueprint for how we expect the rest of earnings season to progress. That said, there are many size-able adjustments that bulls and bears alike can find plenty to like or take issue with in this report. Here's our take.


The printed number was $1.60 vs. the Street at $1.44. There’s lots of adjustments here, so let’s dig in.


  • First, the company posted a whopper of a reserve release at $1.356bn, or 23 cents per share. Consensus was looking for $1.26bn, or 21 cents per share . As such, that delta only accounts for 2 cents vs. Street numbers.
  • Second, the company posted a DVA benefit of 6 cents or $355mn from spreads widening. This is a tough one to make apples to apples adjustments to because, while we know there's a DVA benefit in the consensus estimate, we don't know how large it is. 
  • Third, they posted a 9 cent ($600mn pretax) charge for boosting litigation reserves.

Net, net we get to $1.60 less 2 cents (reserve release delta vs consensus) less 6 cents (DVA) = $1.52. Finally, if we give them the 9 cents in litigation reserve they pop back up to $1.61, and, if not, they stay at $1.52. Either way, they seem well ahead of the $1.44 estimate. Also, recall that the $1.44 already included some degree of DVA tailwind, so the true apples to apples number is likely stronger still.


Moving past the adjustments, here is a quick summary of some of the other notable items we spotted this quarter: 

  • NIM down 17 bps QoQ to 2.20% from 2.37%. Much of the decline was attributable to the company boosting cash levels by over $100 billion to meet LCR requirements. The interesting takeaway is that while NIM was down 7.2% Q/Q, Net Interest Income was down a much more benign 1.8% Q/Q. Also, taking a step back, if we look at the 7-quarter trend, we find that NII has been falling at trend-line rate of $202mn per quarter (Q/Q). This quarter's sequential decline of $208mn was essentially right in line with that trend. We're not cheering this as good news, but it is an important context factor relative to what appears to be horrible sequential performance in the NIM. Also, it's worth noting that the forward outlook is for stabilizing NIM in the back half and for NII to be sequentially higher in 3Q vs 2Q. For reference, in the last 7 quarters, NII has only advanced Q/Q once (4Q12).
  • Loan growth was negative 50 bps Q/Q. The outlook is for loan growth to begin to accelerate in the back half of the year as the company is reporting seeing early signs of a modest resurgence in loan demand.
  • Non-interest income was again strong this quarter, even after adjusting for DVA benefits. Clearly the Investment Banking business delivered stronger than expected results and Mortgage Banking held steadier than expected under the circumstances. Looking forward, the company clearly tempered expectations on the mortgage side, indicating that the current rate environment would lead to a 30-40% reduction in mortgage volume over the back half of the year. 
  • Efficiency was up Q/Q, rising to 61.1% from 59.7%, but is continuing its trend-line improvement since the start of last year. Looking back over the last 7 quarters, the company has driven efficiency lower by 1% per quarter (Q/Q). 
  • Credit quality was impressively strong this quarter. Supporting the massive reserve release, the company’s NPAs and NPLs were down, 4 and 9 bps, respectively. Meanwhile, coverage remained at 199% of NPLs in spite of the drawdown (flat with last 4 quarters).
  • Tangible book value per share advanced this quarter to $40.04 from $39.54 last quarter, and, importantly, has grown 12.1% in the last 12 months. This is in spite the London Whale fiasco. This quarter, the company posted a 13% return on equity and a 17% return on tangible equity.
  • Leverage Ratio - Yesterday's fanfare over the new supplementary leverage ratio requirements looks like it won't be a terribly big event for JPMorgan. To put things in context, the company is currently at a 4.7% leverage ratio under the new framework with a BHC requirement to get to 5% by 1Q18. They are generating a 16-17% return on tangible capital right now. If we gross up their capital base by 6% (5.0% / 4.7% = 106%), we find that that potential return on tangible equity compresses by roughly 100 bps, i.e. from 17% to 16%. On a fair value model for banks, a 100 bps compression in potential ROTE equates to roughly an 8% reduction in multiple to tangible book value. 8% of JPMorgan's $40 TBVPS = $3. However, based on the company's 16-17% ROTE, we estimate fair value is actually closer to 2x tangible book value (on a straight P/TBVPS : ROTE model (y = 9.4098x + 0.492) and on an EVA model (+3.2%) we estimate fair value is 1.73x TBVPS (y = 8.2686x + 1.4679), or $70-80 per share. So a $3 reduction in potential fair value seems de minimis relative to $15-25 upside.
  • Capital Return - The dividend was increased to 38 cents (2.7% yield) from 30 cents (2.2%) and the outlook for buyback remains unchanged.

The charts below look at the trends in net interest income, tangible book value growth vs. price and returns, the current relationship of return on tangible capital to price/tangible book value (good), the current relationship between EVA and price to tangible book value (better), the current upside/downside to fair value by bank based on our EVA model, and, finally, the 2Q earnings snapshot.


Insight: JPM 2Q EARNINGS - jpm 2


Insight: JPM 2Q EARNINGS - josh1


Insight: JPM 2Q EARNINGS - simple scatter


Insight: JPM 2Q EARNINGS - eva scatter


Insight: JPM 2Q EARNINGS - cheap cheap


Insight: JPM 2Q EARNINGS - jpm earnings


Joshua Steiner, CFA



Jonathan Casteleyn, CFA, CMT




Following the release of 3Q13 results, we continue to believe that the long-term potential of JACK is underappreciated, particularly with respect to the future growth of Qdoba.  The company’s recent initiatives only enhance this view.


3Q13 Results

JACK reported 3Q13 adjusted EPS $0.03 above consensus along with a top line miss (-3.71%) that was in line with industry softness.  Company sales trends for the quarter were mixed as same-store sales for Jack in the Box fell short of expectations (+1.2% versus +1.8% consensus), while same-store sales for Qdoba came in above expectations (+0.5% versus -0.1% consensus).



Strategic Initiatives

In June 2013, upon completion of a strategic market review led by newcomer Tim Casey, the company announced plans to close 67 of its company-operated Qdoba restaurants.  We responded positively to this announcement in our note, “Jack: Right-Sizing The Qdoba Ship,” when we wrote:


                “The upside in JACK, as we have often written, is in the multiple assigned to the Qdoba business.  To the extent that it occurs, future upside to earnings is obviously also a positive.”

We continue to stand by this, and believe that CEO Linda Lang’s assertion that the closures are expected to result in higher future earnings, AUV’s, restaurant operating margin, cash flow and ROIC, will come to fruition.  To date, the company has closed 62 underperforming Qdoba locations, transferred 3 to a franchisee and will close the remaining 2 when their leases expire at the end of the year.


As for Jack in the Box’s refranchising strategy, they intend to sell 29 additional restaurants by the end of FY13 and an additional 60 by the end of FY14.  Upon completion, the company’s goal is to have between 80-85% of Jack in the Box locations franchised, which similar to the closure of Qdoba stores, should have a positive impact on financial performance.






Change at the Top

The company also announced this week that CEO Linda Lang plans to retire as of Jan. 1, 2014, and will be replaced by current President and COO, Leonard Comma.  We expect this transition to be seamless, as Leonard is well-respected within the industry and, in our view, fully capable of leading JACK in its future endeavors.



Potential Upside

In our view, the company’s aggressive move to restructure Qdoba is likely to improve the brand’s profitability and should provide investors with the confidence to assign the brand a growth multiple.  Due to this renewed growth profile, we see approximately 25% potential upside in the stock over the next 2-3 years.  Below we offer some more thoughts on 3Q13 results:



What We Liked

  • Strong strategic plays in refranchising and restructuring by Jack in the Box and Qdoba, respectively
  • Jack in the Box 3Q traffic improved sequentially from 2Q
  • Raised full-year restaurant operating margin guidance to 17-17.5%
  • Qdoba closures expected to add $0.15-$0.16 to FY13 EPS from continuing operations
  • Raised full-year operating EPS guidance to $1.72-$1.78
  • The company has $84.7m remaining in its stock buyback program that expires in Nov. 2014 and an additional $100m authorized for stock buybacks that expires in Nov. 2015


What We Didn’t Like

  • Jack in the Box company same-store sales were down in July
  • Scaled back full-year guidance for new Qdoba restaurants from 70-75 to 65-70
  • Qdoba margins decreased 270 bps to 20.6% in 3Q, driven by a combination of sales deleverage, commodity inflation, product mix changes and increased staffing levels
  • Competitive environment – seeing deep discounting from some casual diners as well as strong value plays by other QSRs










Howard Penney

Managing Director


From Asia to America...

Client Talking Points


A big macro day in China with Chinese CPI coming in at +2.7%, PPI declining for the 17th straight month down -2.3% year-over-year, and retail sales up a solid +13.2% year-over-year.  That last data point continues to be supportive of our view that Chinese GDP is in a phase transition from an export led economy with a focus on infrastructure build out, to a consumption driven economy, with a lower aggregate growth rate.


This Sunday we will get preliminary GDP numbers from Japan and this will be the focus of many global macro investors. The main event in global macro this year has been the rapid decline and volatility of the Yen.  In turn, this has supported strength in the U.S. dollar, which has implications across asset classes with varying degrees of correlations. We aren’t going to attempt to tell you where the number will come in.  That said, we continue to have conviction that regardless of any short term data, the Japanese will have to continue to stimulate, and aggressively so, in order to get anywhere in the zip code of their long run inflation target of 2% and nominal growth of 3%. To get to these targets, the Japanese policy makers will require a whole lot of “Control P” (printing), which makes the long run bear case on the yen very compelling.


The ferocious bear raid in U.S. equities took its toll with a cumulative decline of 71 basis points over the last four days (#SarcasmAlert). We’ve been harping on this all year, but as the U.S. economy continues to transition from stabilizing to accelerating with labor and confidence hitting levels not seen since 2007, U.S. equities will continue to find a bid on any sell off. The longer term supporting bid in U.S. equities is, of course, the theme that our financials team has been focused with their recent launch on asset managers, which is the current, and we expect continued, outflows from fixed income assets as interest rates grind higher.  This will only accelerate if U.S. economic data continues to come in strong.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

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.


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. 


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


George Clooney knows more about retail than Bill Ackman. $JCP



Shallow men believe in luck. Strong men believe in cause and effect.

- Ralph Waldo Emerson


Japan's finance ministry released data Friday showing that the country's debt burden has topped 1 quadrillion yen for the first time. If you want to get specific, Japan's central government debt at the end of June was 1,008,628,100,000,000 yen. (CNNMoney)

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 80.45%
  • SHORT SIGNALS 78.38%

Grind It Out

“Success is stumbling from failure with no loss of enthusiasm.”

-Winston Churchill


Four years ago, Keith, myself and Todd Jordan, our Managing Director of our Gaming, Lodging & Leisure team, embarked on a journey in which many people predicted we had little chance of succeeding at. With the support of our colleagues at Hedgeye, we entered the process to purchase the Phoenix Coyotes, a bankrupt NHL franchise.  Our proposal to purchase the team was seemingly received well (as you might imagine Keith played the lead role in that meeting!) and enabled us to become the key contender to own the team.


Our analysis of the situation in Phoenix was vintage Hedgeye. We started with a macro perspective that it was likely the ideal time to buy a distressed asset in the Phoenix region as housing was literally in free fall.  Our view was that housing would ultimately revert to the mean, and thus home prices would see a strong recovery, which would then drive discretionary spending on things like sporting tickets.  In the Chart of the Day, we show the improvement in home prices in Phoenix since that period.


We then took a hard look at the financials of the team (hat tip to our colleague Anna Massion for some good work here), we found a business that was bloated on the cost side with some easy pro-forma cost reductions.  On the revenue side, we developed a plan for steady revenue growth with the unique idea of playing five games in another market (think the Buffalo Bills playing in Toronto).  Even though we came to agreement with the NHL on the parameters of a purchase via a letter of intent, the deal ultimately fell through as we were unable to agree to terms on an arena lease.


At that point, we chalked it up as a loss, but a win on the learning side, and watched over the last couple of years as various other groups attempted, yet failed, to purchase the franchise.  With the advent of the new collective bargaining agreement in 2013, which from our view created a very compelling economic situation for smaller market NHL teams, we decided to revisit the opportunity, almost three and half years after first looking at the team.


Over the course of the last few months, we and our partner Anthony LeBlanc were able to put together a very intriguing financing package with a major hedge fund as the lender. With Anthony’s guidance, an arena lease was negotiated that exemplifies a true public / private partnership.  And finally we found a lead equity investor in my friend George Gosbee from Calgary, who is now the Governor of the franchise, and closed the transaction earlier this week.


For Hedgeye and our partners, the deal was a true lesson in perseverance and teamwork.  Quitting at any point would have been easy, but ultimately we persevered and put the puck in the net.  While we are quite excited about the prospects for NHL hockey in Phoenix, I will ease the minds of any NHL hockey fans out there . . .  despite owning a small piece of the team, you can be rest assured Keith and I won’t be getting on the ice any time soon!


Switching back to the global macro grind, we have a slew of data out this morning.  It was a big macro day in China, in particular with Chinese CPI coming in at +2.7%, PPI declining for the 17th straight month down -2.3% y-o-y, and retail sales up a solid +13.2% y-o-y.  That last data point continues to be supportive of our view that Chinese GDP is in a phase transition from an export led economy with a focus on infrastructure build out, to a consumption driven economy, with a lower aggregate growth rate.


This Sunday we will be getting preliminary GDP numbers from Japan and this will undoubtedly be the focus of many global macro investors. The main event in global macro this year has clearly been the rapid decline and volatility of the Yen.  In turn, this has supported strength in the U.S. dollar, which has implications across asset classes with varying degrees of correlations. 


We have a lot of things at Hedgeye, but a crystal ball is not one of them, so we aren’t going to attempt to tell you where the number will come in.  That said, we continue to have conviction that regardless of any short term data, the Japanese will have to continue to stimulate, and aggressively so, in order to get anywhere in the zip code of their long run inflation target of 2% and nominal growth of 3%. To get to these targets, the Japanese policy makers will require a whole lot of “Control P” (printing), which makes the long run bear case on the yen very compelling.


Back in the U.S., the ferocious bear raid in U.S. equities (to quote my colleague Christian Drake) took its toll with a cumulative decline of 71 basis points over the last four days (#SarcasmAlert). We’ve been harping on this all year, but as the U.S. economy continues to transition from stabilizing to accelerating with labor and confidence hitting levels not seen since 2007, U.S. equities will continue to find a bid on any sell off.


The longer term supporting bid in U.S. equities is, of course, the theme that our financials team has been focused with their recent launch on asset managers, which is the current, and we expect continued, outflows from fixed income assets as interest rates grind higher.  This will only accelerate if U.S. economic data continues to come in strong.


Our immediate-term Risk Ranges are now as follows:


UST 10yr Yield 2.57-2.73%



VIX 11.62-13.94

Yen 96.16-98.71

Copper 3.05-3.25


Have a great weekend with your friends and families!


Keep your head up and stick on the ice,


Daryl G. Jones


Grind It Out - Chart of the Day


Grind It Out - Virtual Portfolio

LINN Energy 2Q13 Review: Just Not Good

Summary bullets:

  • LINE, LNCO remains a “Best Idea” short for us.  Poor 2Q13 results strengthen our conviction in that call.
  • No material update on the ongoing SEC inquiry or the pending BRY merger;
  • Production, adjusted EBITDA, DCF all miss guidance, and it would have been worse if not for some low quality earnings;
  • Total capital capex surprised to the upside, and the gap between total capex and maintenance capex grows wider, despite no production growth;
  • 2H13 guidance for production, adjusted EBITDA, DCF all cut;
  • 2H13 guidance assumes strong NGL prices and realizations – that optimism seems misplaced.

Mum is the word on SEC inquiry and BRY merger…..No real direction on the SEC inquiry or the BRY merger in the conference call or in the new 10-Q or S-4/A.  There is no longer a guided closing period for the merger in the S-4/A, and there are several new risk factors to the merger.  We find it strange that LINN said yesterday morning (8/8) that its S-4/A would be filed with the SEC yesterday “afternoon” (8/8), though it wasn’t filed until early this morning (8/9).  Why the delay?  We don't know, but we find it odd...  We highlight some key changes and additions to the risk factors and disclosures in the 10-Q and new S-4 in the appendix of this note.


On the 2Q13 results……Hard to find positives here.  Production of 780 MMcfe/d was at the low end of guidance, 780 - 820 MMcfe/d, and down 2% QoQ.  Adjusted EBITDA of $378MM missed guidance by 4% and DCF missed guidance by 10%.  Distribution coverage was 0.89x vs. guidance of 1.00x.  And the results were low quality, as other revenues, natural gas marketing margin, and an anomalous drop in taxes other than income increased DCF by $15 – 20MM.  Further, premiums paid on settled derivatives in the period were $43MM.  Excluding those costs boosted DCF by 28%.  Backing out premiums paid and other special items, we arrive at our own non-GAAP numbers: EPU of $0.05, FCF/unit of -$0.44, CF/unit of $1.01, and Open EBITDA of $310MM.  


LINN Energy 2Q13 Review: Just Not Good - linn1


LINN Energy 2Q13 Review: Just Not Good - linn2


On downward revisions to 2H12 guidance……LINN cut 2H12 production guidance (from the April 25th guidance)  by 2%, oil production guidance by 4%, adjusted EBITDA by 6%, and DCF by 15%.  Distribution coverage drops to 0.90x from the prior guidance of 1.06x.  We note the $22.5MM increase to 2H13 non-GAAP (cash) G&A guidance.  On page 50 of the 10-Q we read, “Our legal expenses incurred in defending the lawsuits and responding to the SEC inquiry have been significant and we expect them to continue to be significant in the future.”  I guess LINN’s lawyers don’t take unit-based comp?


LINN Energy 2Q13 Review: Just Not Good - linn3


Total capital expenditures surprise to upside……Total capital expenditures in 2Q13 were $338MM (development capital + purchases of other PP&E + joint venture funding, per the cash flow statement), up from $277MM in 1Q13.  We consider this QoQ increase of $66MM a large surprise to the upside, especially considering the 1% drop in production QoQ.  Further, CEO Mark Ellis answered this question incorrectly on the conference call:


Analyst: “And just last one for me, and I’m sorry if I may have missed this, but how much total CapEx was spent this quarter?”


CEO Mark Ellis: “I don’t have that number off the top of my head, hang on one sec.”  [15 second delay] “$260 million.”   


The 10-Q (which we did not have when Mr. Ellis made this statement) plainly states on page 22 that for 2Q13, “capital expenditures, excluding acquisitions, of approximately $334 million” ($4MM delta between that and the CF statement is an accrual issue).  Mr. Ellis’ answer on the call was materially incorrect. 


Total capex vs. maintenance capex vs. production growth……In 2Q13, total capex including JV funding exceeded maintenance capex by $226MM, with pro forma production down 1% QoQ.  Over the TTM, total capex including JV funding has exceeded maintenance capex by $875MM ($219MM/quarter!) with no organic production growth to speak of.  In fact, by our estimates, pro forma organic production in 2Q13 was down 5% from the 3Q12 average.  We believe that LINN’s maintenance capex is massively understated; if it was at an appropriate level, all of DCF would be wiped out.


LINN Energy 2Q13 Review: Just Not Good - linn4


Understated maintenance capex is not a TX Hogshooter problem……LINN’s comments on the 2Q13 call suggest that the explanation for the delta between total capex and maintenance capex, +$200MM/quarter, coupled with production flat-to-down, is largely because of its disappointing TX Hogshooter program in 2012 and 1Q13.  LINN drilled 28 gross Hogshooter wells on the TX side of the border; management noted that 14 of those wells underperformed expectations.  LINN stated on the 1Q13 conference call that its working interest in those wells was 60% on average, so 8.4 net wells underperformed.  At $8.5MM/well, that is $71MM of capital that underperformed.  Spreading that out of 5 quarters, gets us to $14MM/quarter, or ~6% of the difference between total capex and maintenance capex.  This is not a TX Hogshooter issue, and the issue is not going away.


NGL price optimism is misplaced……LINN’s realized NGL price in 2Q13 was $26.69/bbl, which was 70% of the Mont Belvieu benchmark NGL price in the quarter, $38.00/bbl.   LINN’s guidance for 2H13 NGL price is $33.00/bbl, suggesting a material improvement in realized NGL prices.  As we show in the two charts below, that optimism seems misplaced.  Ethane – particularly Jonah Field ethane that is priced at Conway – is at rejection levels, as it has been for more than a year.  And the NGL barrel price at Mont Belvieu today is at $39.00/bbl, only $1/bbl higher than the 2Q13 average.  In our view, current NGL prices suggest a realized NGL price for LINN in 2H13 around $27 - $28/bbl.  As LINN will produce ~5.0 MMbbls of NGLs in 2H13, LINN could be guiding  DCF $25MM - $30MM ($0.11 - $0.13/unit) too high.  Recall that LINN does not have NGL hedges.


LINN Energy 2Q13 Review: Just Not Good - linn5


LINN Energy 2Q13 Review: Just Not Good - linn6


Peculiar drop in taxes other than income……Taxes other than income taxes (production taxes) in 2Q13 were $32.3MM, 6.6% of revenues, and $0.46/Mcfe; that was 26% below guidance of $44MM.  It is an also an outlier relative to prior periods (in 2012 production taxes were 8.2% of revenues and $0.54/Mcfe, and in 1Q13 production taxes were 8.6% of revenues and $0.55/Mcfe) and forward guidance (3Q13 guidance is for production taxes to jump back up to $48MM, or $0.64/boe).  This could be the one-time item: “Ad valorem taxes, which are based on the value of reserves and production equipment and vary by location, decreased by approximately $2 million compared to the three months ended June 30, 2012, primarily due to an adjustment related to the properties acquired in the Green River Basin region partially offset by taxes associated with property acquisitions in 2012 and higher rates on the Company’s base properties” (2Q13 10-Q, page 28).


Peculiar increase in other revenues and natural gas marketing margin……Other revenues and natural gas marketing margin came in at $14.5MM in 2Q13, up $7MM QoQ and $7MM (94%) ahead of guidance.  Another low quality source of DCF in the quarter.


LINN ramps up in the Jonah, likes the OK Hogshooter, has high hopes for HZ Wolfcamp……LINN plans to ramp up drilling activity in the Jonah Field in 2H13, and that will drive the back half production growth.  The fact that they are ramping back up in this gas/NGL play now says a lot about the asset base on the whole.  Seems like a desperate attempt at production growth – and not returns – to us…….LINN was quite bullish on the OK Hogshooter on the call, but we wonder if that’s optimism is justified.  The Company has drilled only 9 gross (~4 net) wells, will not give us a 30d rate, but did say that the wells have an 80 – 85% initial decline (which is quite high, in our view).  We thinks its a bit early to sing the praises of this play……LINN also noted that it has Permian acreage prospective for the HZ Wolfcamp; it will participate in four non-op wells “with a pretty small working interest” and drill one operated well in 2H13.  No well results expected before 1Q14.  We don't consider it material to the stock at this time.



Kevin Kaiser

Senior Analyst



APPENDIX: New disclosures worth reading…..


On BRY merger risk, 10-Q page 50: “Due to the pending SEC inquiry, the timing of LinnCo’s pending merger with Berry is uncertain. If the merger is not completed, or there are delays in completing the merger, our unit price and our business could be adversely affected and we would be subject to a number of risks…”


On premiums paid, 10-Q page 42: “The premiums paid for put options that settled during the three months ended June 30, 2013, and June 30, 2012, and during the six months ended June 30, 2013, and June 30, 2012, were approximately $43 million, $36 million, $86 million and $62 million, respectively. Deducting the premiums paid for put options would reduce the Company’s adjusted EBITDA and DCF; however, the Company pays cash for put options at the time of execution and no additional amounts are payable in the future under the contracts. Therefore, the Company’s calculation of adjusted EBITDA and DCF is more representative of the cash available for distribution during the period. The Company considers the cost of premiums paid for put options as an investment related to its underlying oil and natural gas properties only for the purpose of calculating the non-GAAP financial measures of adjusted EBITDA and DCF.”


On maintenance capex, 10-Q page 43 (our emphasis): “Maintenance capital expenditures, a component of total capital expenditures, is a non-GAAP calculation established at the beginning of each calendar year that represents the estimated capital investment required to approximately maintain production levels from the prior year and replace proved developed producing reserves that are forecasted to be produced as a result of maintaining production levels from the prior year. Management makes estimates of maintenance capital expenditures as part of the annual budget process, ranks the most efficient projects by production replacement and proved developed producing reserves replacement and allocates the total planned expenditures across the four quarters of each calendar year. While the Company believes its estimates and assumptions to be reasonable under the circumstances, they are subject to, among other things, risks and uncertainties including production rates, reserve quantities and capital costs estimates. At the end of each calendar year, the Company evaluates the performance of its annual capital program, re-ranks its most efficient projects and incorporates the results of this analysis in its subsequent calendar year estimated maintenance capital expenditures. The calculation includes the cost to convert nonproducing reserves to producing status and does not include the initial cost to acquire the underlying asset as that amount has already been spent in a prior period and therefore does not impact the ability to make distributions in future periods.”


On maintenance capex, 10-Q page 50: “ If we underestimate the appropriate level of estimated maintenance capital expenditures or the estimated maintenance capital expenditures do not produce the expected results, we may have less cash available for distribution in future periods when adjustments from the previous year are included in future estimates.  Over time, if we do not set aside sufficient cash reserves or have available sufficient sources of financing and make sufficient expenditures to maintain our asset base, we may be unable to pay distributions at the anticipated level and could be required to reduce our distributions.”


On NGLs, 10-Q page 49: “We have been and continue to be limited in our ability to effectively hedge our NGL production. As a result, we are subject to the current depressed price environment for NGLs, and in particular, ethane prices. If current price levels for NGLs continue into the future, our revenues and results of operations will be affected, which could result in distributable cash flow that is insufficient to maintain our current distribution to unitholders.”


On put options, 10-Q page 46: “In certain historical periods, the Company paid an incremental premium to increase the fixed price floors on existing put options because the Company typically hedges multiple years in advance and in some cases commodity prices had increased significantly beyond the initial hedge prices. As a result, the Company determined that the existing put option strike prices did not provide reasonable downside protection in the context of the current market.”


On merger tax implications, S-4/A page 179 (our emphasis): “As a result of the anticipated increase in tax liability due to the remedial allocation, LINN has agreed to pay LinnCo $6 million per year for three years (2013, 2014 and 2015). The $18 million to be paid during this period is expected to compensate LinnCo for a portion of the increase in its total tax liability with respect to the assets acquired in the Contribution, and is not intended to fully compensate LinnCo for the increased total tax liability. The total tax liability generated from the remedial allocation will be recognized over the remaining life of the underlying assets, which could extend beyond 50 years. The total deferred income tax liability impact from the transactions is estimated to be approximately $452 million (included in the total approximate $477 million deferred income tax liability shown on the pro forma condensed combined balance sheet). This tax liability will be partially deferred when considering the tax shield that LinnCo receives with respect to the LINN units it currently owns. If LinnCo were to sell or otherwise liquidate the LINN units acquired, the deferred tax liability of $477 million would be payable. The tax shield and other factors were considered by the conflicts committees of both LINN and LinnCo in negotiating the compensation to be paid by LINN to LinnCo for LinnCo’s tax liability.


“Under the Contribution Agreement, LINN and LinnCo have agreed (i) to work in good faith at the end of each of calendar year 2014 and 2015 to evaluate whether the amount distributed to LinnCo as discussed above has reasonably compensated LinnCo for the actual increase in tax liability to LinnCo, if any, resulting from the allocation of amortization, depletion, depreciation and other cost recovery deductions using the “remedial allocation method” pursuant to Treasury Regulations Section 1.704-3(d), with respect to the assets acquired in the Contribution and (ii) to make any adjustment to such distribution as mutually agreed. The total tax benefit that LINN expects to realize from this transaction, undiscounted, is approximately $1.4 billion (purchase price times 38%) of additional depreciation, depletion and amortization that will be recognized on a unit-of-production basis over the remaining life of the property. Based on its pro forma ownership percentage, approximately one third of the approximate $1.4 billion total undiscounted tax benefit will be allocated to LinnCo.”

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