My last article on Linn Energy, Linn Energy Remains An Excellent Buy For Courageous Investors, was published on June 27. The next week LINE was one of the most discussed stocks (actually units) on the New York Stock Exchange, and it sank from the high 30s to the low 20s on unusually high volume. LINE has become a fight between supporting management versus attacking management, and each side has an army of supporters. Management includes loyal fans and Omega Partners (the largest outside owner). Hedgeye Risk Management and Barron's are leading the side of the shorts. Then on July 8, after the plunge in the prior week, Bank of America Merrill Lynch raised its rating on LINE.
LINE is a leading upstream MLP, different from most other MLPs. On tracts of land, it extracts gas and oil using fracking technology and it uses hedges to lock in prices over the next 5 years. This allows management to better plan future operations, a common practice in the business world (also among farmers). But the shorts say the accounting methods do not give an accurate picture of distributable cash flow [DCF] used to pay distributions. They claim LINE will not be able to sustain distribution levels going forward. The dispute caught the interest of the SEC which requested LINE documents relating to the merger with Berry Petroleum (BRY) along with the use of non-GAAP financial measures and hedging strategy used by LINE.
Leon Cooperman, CEO of Omega Advisors, became a strong advocate for LINE management. Omega Advisors is optimistic about the growth and the company's financial performance. Cooperman's June 17 letter explains why he is comfortable with the investment in Linn Energy. Omega Advisors owns 3% of LINE units and has a 2% stake in LinnCo (LNCO), the companion stock for LINE.
Hedgeye Risk Management (along with Barron's) is leading the side of the shorts. Hedgeye said LINE will not be able to continue paying distributions because accounting standards LINE uses will not be able to support distributions and will run out of targets to acquire. Its rebuttal to Leon Cooperman on June 24 did not waver from previous advice that distributions and security prices are going lower.
Adding confusion, on July 8 (following a dreadful week for LINE owners), analysts at Bank of America Merrill Lynch [BAML] said they don't believe LINE's accounting distorts cash flow and affirmed the accounting figures used by LINE. According to analysts:
We do not believe LINN's stated distribution coverage would be materially impaired had the put strategy not been employed, while we believe LINN's stated level of maintenance capital is entirely consistent with reserve replacement cost and peer company results for those operating in similar regions.
After the sharp sell-off, they upgraded LINE units to 'Buy' from 'Neutral.' However, the target price for LINE was reduced from $41 to $30, because of an elevated risk of investor scrutiny and the uncertain outcome of the SEC review.
The first week of July was highly volatile time with extraordinary volume for LINE and LNCO. LINE's chart is shown below:
Linn Energy (LINE) July 1-12, 2013 (click to enlarge)
This is an unusually difficult for investors to understand. LINE is putting out numbers about DCF, but there are no accounting standards on how to make calculations. REITs (Real Estate Investment Trusts) use funds from operations [FFO], a figure that includes net income and non-cash items, to show how much is available for dividends. MLPs need a comparable standard to calculate DCF so that everybody can understand the basis for declaring distributions.
Meanwhile, LINE will carry on with its business. The company pulls energy from the ground, which generates funds for distributions/dividends. Starting this month, distributions, based on a $2.90 annual rate, are being paid in the middle of each month. Acquisitions have also been important for growth at LINE, but they may be put on hold for several months.
The outcome of the Berry Petroleum merger is unclear. The offer from LINE is to exchange 1.25 LNCO shares for each share of BRY. With BRY selling at $41 and LNCO near $29, that ratio does not make sense. Investors will have to bid up the price of LNCO or the terms will have to be increased with more LNCO stock.
I still like Linn securities. However given the elevated level of uncertainty about distributions and the BRY merger, these units/shares are not for timid investors. There was extraordinary volume in the first week of July (shown in the above chart). Some of the shorts had talked about taking the stock down to $24 or less, and they may have bought stock to lock up sizeable profits. Others continued selling, emboldened by their gains. Volume was lower in week 2 of July, but daily volume of 5-8 million shares is still quite high (after running at 1-2 million previously). However LINE's unit prices stabilized, to some degree, in the mid-20s.
Until the SEC reports its findings, LINE will be under a cloud. Going forward, management will not make presentations or put out any word beyond required notices. But management has been speaking in other ways by buying units/shares. Recent LINE and LNCO insider purchases are shown below. Linda Stevens and Terrance Jacobs are directors of LNCO and the other 2 are the principal officers for Linn Energy.
Position | Number | Price | Security | Date | ||
Terrence | Jacobs | Dir-LNCO | 5,000 | $34.58 | LINE | 10-May |
Terrence | Jacobs | Dir-LNCO | 5,000 | $34.03 | LINE | 30-May |
Terrence | Jacobs | Dir-LNCO | 5,000 | $34.28 | LINE | 30-May |
Mark | Elllis | CEO | 10,000 | $30.70 | LINE | 14-Jun |
Arden | Walker | EVP & COO | 5,000 | $30.42 | LINE | 14-Jun |
Terrence | Jacobs | Dir-LNCO | 10,000 | $29.92 | LINE | 17-Jun |
Linda M | Stephens | Dir-LNCO | 5,000 | $35.03 | LNCO | 17-Jun |
Active shorts are looking for even lower prices (in the high single digits). At a minimum, high volatile periods lie ahead until the SEC makes a decision about accounting. More bear attacks can be expected, and the shareholder meetings about the BRY merger will be contested. Also, the battle between the longs and shorts is being fought in the press.
I remain long LNCO and dividends are being reinvested. With a 10% yield and 100% of the 2012 dividend considered non-taxable, it is a tempting buy. Because of the uncertainty over SEC findings, I am holding off on additional investments.
Easily forgotten when looking at the micro picture, business fundamentals remain strong. Last week, US oil production jumped to the highest level since January 1992. The Energy Information Administration said domestic crude output will average 7.3 million barrels a day [MMPD] in 2013 and 8 MMPD in 2014. The gas business is growing, although low prices have been tough on energy companies. These are good businesses over the long term, and LINE is a major player. The IPO for LINE raised $261 million in January 2006, and, even after recent selling, LINE and LINCO have a market value of $7 billion. This company should survive, but holding the securities is primarily for hearty investors who can ride out major shock waves.
Disclosure: I am long LNCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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