What We Learned from LINN Energy's Latest S-4/A

LINN Energy (LINE, LNCO) filed its 4^th amended S-4 (LINN/BRY merger proxy) with the SEC on 9/18/2013.

 

The new S-4 has plenty of new terminology, methodology, and disclosure, though the distribution remains intact.  But LINN’s credibility, particularly with respect to maintenance CapEx, likely does not.  The outcome of ongoing SEC inquiry remains uncertain, as does the LINN/BRY merger.  Below we highlight the key takeaways from the new filing.

On the Ongoing SEC Inquiry...

• “The SEC staff is investigating whether any violations of federal securities laws have occurred” (pg. 208).  That is new language.
• New disclosure regarding the ongoing SEC inquiry states that a restatement of financials is possible (our emphasis): “LINN and LinnCo are unable to predict the timing or outcome of the SEC inquiry or estimate the nature or amount of any possible sanction or enforcement action the SEC could seek to impose, which could include fines, penalties, damages, sanctions, administrative remedies and modifications to LinnCo and LINN’s disclosure, accounting and business practices, including a prohibition on specific conduct or a potential restatement of LINN’s or LinnCo’s financial statements, any of which could be material” (pg. 46).  That is also new language.
• LINN’s high legal expenses are not going away soon: “LinnCo and LINN’s legal expenses incurred in defending the lawsuits and responding to the SEC inquiry have been significant and LinnCo and LINN expect them to continue to be significant in the future” (pg. 47).

Changing Everything and Nothing...

• In a move that could eventually reverberate across the MLP space, LINN will no longer use the non-GAAP terminology “maintenance capital expenditures” and “distributable cash flow.”  Perhaps a small step in the right direction for this sector.
• LINN has changed how it calculates adjusted EBITDA, and has restated the prior period numbers.  LINN no longer includes adjustments for cash flows from A&D between the effective and closing dates, and will also deduct the premiums paid for put options that settled during the period.  As a result, 2Q13 adjusted EBITDA falls 10% from $362MM to $326MM, and 2012 adjusted EBITDA falls 16% from $1,402MM to $1,172MM.  This will allow investors to more appropriately value LINN Energy on an EBITDA basis, and compare that valuation to other E&Ps that do not account for derivatives in this way.
• Given that the reductions in adjusted EBITDA would flow directly to the distribution, LINN has changed its methodology for determining distributions.  It will now start with GAAP cash flow from operations, make discretionary adjustments to that figure including premiums paid, changes in working capital, and, “Discretionary reductions for a portion of oil and natural gas development costs,” which takes the place of “maintenance CapEx.”  
• LINN has changed non-GAAP terminology, methodology, and disclosure – but the end result is the same.  LINN still arrives at the exact same number that it previously called “distributable cash flow;” will continue to benefit from past premiums paid; has the methodology in place benefit from future premiums paid; and has only changed what it calls “maintenance CapEx,” not how it’s calculated.  The changes and new disclosures are a blow to the Company’s credibility, and investors are, on the margin, better equipped to decide for themselves whether or not LINN’s distribution is an accurate representation of its economic reality, however, if this is enough to satisfy the SEC, it is doing investors a disservice, in our view.

Good Riddance Maintenance CapEx, Hello “Discretionary Reductions…”

• We presume that the SEC was not on board with LINN using the term “maintenance capital expenditures” without it actually maintaining anything.  LINN also noted that, “Unlike many publicly traded partnerships, LINN’s limited liability company agreement does not include the concept of “maintenance capital expenditures,” but LINN has historically used this term because of its broad market acceptance among publicly traded partnerships, analysts and investors as a way of distinguishing between different types of capital expenditures for purposes of distribution payment” (pg. 235).
• Because we know that our readers enjoy a good laugh, we quote LINN’s new disclosure around, “Discretionary reductions for a portion of oil and natural gas development costs” with our emphasis:

“In determining the amount of cash that it distributes to its unitholders, LINN makes an estimate at the end of each year of the amounts (which LINN refers to as discretionary reductions for a portion of oil and natural gas development costs) that LINN believes will be necessary during the following year to offset natural declines in its existing cash producing assets through drilling and development activities. In determining this portion of oil and natural gas development costs, management evaluates historical results of LINN’s drilling and development activities based on periodically revised and updated information from past years to assess the costs, adequacy and effectiveness of such activities and future assumptions regarding cost trends, production and decline rates and reserve recoveries. However, LINN’s management does not conduct an analysis to evaluate historical amounts of capital actually spent on such drilling and development activities. LINN’s ability to pursue projects with a view toward offsetting natural declines in its existing cash producing assets through drilling and development activities is limited to its inventory of development opportunities on its existing acreage position. Management’s estimate of this discretionary portion of its oil and natural gas development costs does not include the historical acquisition cost of projects pursued during the year or the acquisition of new oil and natural gas reserves. Moreover, LINN’s assumptions regarding costs, production and decline rates and reserve recoveries may prove incorrect. If LINN is unable to offset natural declines in its existing cash producing assets from this discretionary portion of its oil and natural gas development costs, LINN’s net cash provided by operating activities could be reduced, which could adversely affect its ability to pay a distribution at the current level or at all. Furthermore, LINN’s existing reserves, inventory of drilling locations and production levels will decline over time as a result of development and production activities. Consequently, if LINN were to limit its total capital expenditures to this discretionary portion of its oil and natural gas development costs and not complete acquisitions of new reserves, total reserves would ultimately decrease over time, resulting in an inability to sustain production at current levels, which could adversely affect LINN’s ability to pay a distribution at the current level or at all” (pg. 51).

“[They] represent discretionary reductions for a portion of oil and natural gas development costs, an estimated component of total development costs, which are amounts established by the board of directors at the end of each year for the following year, allocated across four quarters, that are intended to offset natural declines in LINN’s existing cash producing assets during the year as compared to the prior year. The portion of oil and natural gas development costs includes estimated drilling and development costs associated with projects to convert a portion of non-producing reserves to producing status. However, the amounts do not include the historical cost of acquired properties as those amounts have already been spent in prior periods, were financed primarily with external sources of funding and do not affect LINN’s ability to pay distributions in the current period” (pg. 237).

• Most investors and analysts believe that maintenance CapEx represents the capital required to maintain production and reserve volumes over time, but LINN is telling us, flat out, that this measure does NOT represent that, as we demonstrated in our prior research.  As a reminder, we believe that that number would be over $1B per year; and if LINN deducted that amount from operating cash flow, the entire distribution would be wiped out. Further, LINN is telling us that the number is, essentially, made up.  It is an estimate that LINN does not reconcile to actual results.  Given its importance in calculating distributions, and valuing the equity (for many), this is concerning.
• What investors should take away from this new disclosure is that LINN needs to raise additional capital (or cut the distribution) just to keep production and reserves from declining.  We always believed this to be the case, but now LINN has disclosed it. 
• We also now know for sure that LINN’s maintenance CapEx:
  • Does not include the cost of acquiring undeveloped reserves and acreage;
  • Only takes into account offsetting some production decline, not maintaining other PP&E (as of the 6/30/2013 balance sheet, LINN had $534MM gross and $443MM net other PP&E).
• What remains unclear is what production decline LINN is attempting to offset when estimating maintenance CapEx at the end of each year for the following year.  It appears that it is not pro forma production at YE, but actual production in the prior year (pg. 237).  Given that 2013 actual production will be ~804 MMcfe/d (ex. Berry), up 20% over the 2012 production rate of 671 MMcfe/d, should we expect LINN’s maintenance CapEx to step change higher in 1Q14?  This has not been the case in prior years, but the additional disclosure around the methodology suggests that this could be the case.  Further, it remains unclear how LINN’s disappointing Hogshooter wells in early 2013 will impact 2014 maintenance CapEx relative to 2013.  This could be another problem, as LINN has diverted capital away from those high IP rate locations.  Perhaps these are moot points because LINN will just say the number is whatever it wants?

It’s Strange to Us That…

• The SEC is not OK with LINN deducting premiums paid and adding back cash flows from A&D activity in adjusted EBITDA, but is OK with LINN doing this when determining distributions (pgs. 329, 237/8).
• LINN no longer uses “distributable cash flow” or “maintenance capital expenditures,” but management’s 2012 quantitative performance measures stated in the S-4 still rely upon of these metrics (pg. 298).
• LINN has changed how it calculates adjusted EBITDA and the prior period numbers, but the fairness opinions of the bankers, which relied upon, in part, the old adjusted EBITDA numbers, have not changed.
• LINN’s board of directors “has considered current shortfalls” in available cash versus distributions, but “has decided to maintain the distribution at its current level” (pg. 236).

Kevin Kaiser

Senior Analyst