Perspective on Linn Energy's Results

 | Mar 05, 2014 | 12:00 PM EST  | Comments
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Both partnership units and corporate shares of Linn Energy (LNCO), (LINE) dropped by more than 4%  last week on what the market saw to be disappointing guidance for 2014.

Linn has cleared some challenging hurdles as of late. For one, the Securities and Exchange Commission's informal inquiry seems to be over. Management also finally closed on the acquisition of Berry Petroleum. With these two big items out of the way, one would think that investors would relax a bit.

Investors have relaxed. Partnership units have recovered from around $25 per unit late last summer to almost $33 today. While there are no issues on the horizon which compare to the SEC inquiry, or Berry Petroleum, investors are rightly disappointed by lackluster guidance for the year 2014.

Linn is down for a few reasons. First, the distribution will be flat in 2014. This means that management's expectation of mid-to-high single-digit distribution growth will not pan out this year. For investors looking for dividend growth, this is a real drag.

 Second is the distribution itself. While the distribution still looks to be secure, management expects to generate only $12 million in cash excess of distributions in 2014. That gives us a "razor thin" coverage ratio of about 1.01 times. Other upstream MLPs have comparable yields, far cushier distribution coverage ratios and at least some distribution growth.

These are, without a doubt, some disappointing numbers. While Linn did easily hit its distribution coverage goal for 2013, that goal was achieved without the large obligation of new shares as a result of the Berry Petroleum acquisition. Now that management officially issued 1.69 shares of LNCO for each outstanding share of Berry, the distribution hurdle is that much higher.

Points of light

 Some now believe the Berry acquisition was a mistake precisely because this year the deal does not seem to be accretive to cash flow at that new 1.69 exchange rate. That is disappointing. But let's look at the other side of the coin.

First, management suggested that it could soon be selling a swath of Permian acreage acquired in the Berry transaction -- which has significant horizontal drilling potential. A sale of this acreage, according to management, would lower capital intensity and could therefore help increase distributable cash flow. Of particular benefit to Linn could be a swap of its high-growth but capital intensive horizontal drilling acreage, for mature but high-margin acreage in the same geography.

Here is another "point of light." Thanks largely to property acquired from Berry, Linn will grow production organically this year, by 3%-4%. That may not seem too impressive on the surface, but consider this: Linn is scaling back on capital spending for dry gas and pouring that money into development of oilier acreage. Higher-margin oil production will be a greater proportion of production overall.

While the distribution may be secure by only a razor-thin margin, this risk is greatly abated by Linn's ironclad hedging policy. One hundred percent of both natural gas and oil production in 2014 is hedged.

Conclusion

Here is how I would sum up the current situation. Did Linn pay a bit much for Berry? That is possible. In the long run, however, double-digit production growth from the North Midway Sunset and Uinta fields will put wind under this partnership's wings. Linn's high margin assets in the Permian also have lots of untapped CO2-injection potential. That is one element that most other partnerships simply don't have in their acreage.

Yes, this year's guidance is still a bit disappointing. There were some good points, however, such as solid 2013 operating results, some organic growth in 2014 and a secure distribution overall.

I would rate Linn's quarter a "C minus." While there may be better values than Linn in the upstream master limited partnership space right now, if you own shares or units of LNCO or LIN, you can certainly hold onto them without worrying.

Data source for quick reference: http://files.shareholder.com/downloads/LINE/2996050305x0x729318/378D95CC-1292-407F-BF2C-105C8F655C07/Q4_Earnings_Release_Supplemental_Info_FINAL.pdf

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