|Shares Out. (in M):||234||P/E||0.0x||0.0x|
|Market Cap (in $M):||8,700||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||5,675||EBIT||0||0|
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Linn Energy, LLC (NASDAQ: LINE)
February 14, 2012
Market Cap: $9 billion
Full writeup in PDF format (w/images): http://dl.dropbox.com/u/146867217/Linn%20Energy_2-14-13.pdf
Linn Energy, LLC is an oil and gas E&P MLP with a market cap of $9 billion. Linn sells itself as a stable, growing fixed income alternative. The corporate tagline is “The power of stability AND growth.” However, Linn’s business model – exchanging overvalued paper for assets to complete “accretive” acquisitions – requires constant capital markets access and a deep pool of unwary investors. Upon closer examination, investors will realize that Linn:
Investors will then ask themselves “What is the Company worth?” instead of “How much will someone else pay for this yield?” I believe the answer is $10 – 20 per share, or over 50% below current prices.
Introduction: A Very Different Kind of Oil and Gas Company
Question: What does Wall Street do?
Answer: Gives investors what they want.
Question: Well, what do investors think they want?
Answer: Cash – even if it’s the same cash they just forked over.
Welcome to the story of Linn Energy, a very different kind of oil and gas company.
From humble beginnings in 2006 with a ~$250 million IPO, Linn Energy has grown into a $14 billion enterprise value business primarily by raising equity from public investors and using the proceeds to acquire oil and gas assets. In effect, Linn is a machine that exchanges paper for assets.
Linn’s “business model” – serially acquiring oil and gas assets – is based on the idea that:
1) They are smarter than the people they purchase from
2) Their cost of capital is lower than competitors because of their tax-advantaged MLP structure
3) Astute hedging allows them to generate safe, stable levels of cash flow from acquired properties
Let’s examine these propositions:
1) Smarts – Linn purchases widely marketed oil and gas assets with known cash flows and little exploration risk from sophisticated sellers such as Anadarko, Dominion Resources and Plains Exploration and Production
2) Tax Advantage – Linn generates no taxable income. The Company publicly stated that they do not anticipate generating any taxable income for the next five years. Without taxable income to shield, Linn receives no advantage from the MLP structure. This is not surprising – even C-Corp oil and gas companies generate little taxable income owing to high depletion expenses and up-front expensing of intangible drilling costs.
The real “benefit” of Linn is not lower taxes, but the widely proclaimed level of cash distributions. Linn currently pays investors a cash distribution equal to 7.8%. But where does all the cash come from?
Well, oil and gas production produces some cash. After interest expense and maintenance CapEx, this business has generated ~$382 million of cash since 2009.
Fortunately, Linn also operates a very profitable “financing” business. Which leads us to:
3) Hedging – Linn has generated gains from hedging of $414 million since 2009.
Now, this would be a nice performance under most circumstances, but not extraordinary for a $14 billion business.
But Linn does even better than that.
Linn subdivides the gains from hedging into two buckets: realized gains and unrealized gains. The company says investors should only focus on realized gains, since unrealized gains haven’t happened yet. Only realized gains are included in Adj. EBITDA and Distributable Cash Flow. Simple enough, right?
Linn has a nearly flawless record of profitability when judged by realized gains. Consider that:
- Linn has reported a realized gain on hedges every quarter since Q4 2008
- Since the start of the business in 2004, Linn has cumulative gross realized gains on hedges of ~$1,400 million compared to gross realized losses of only $78 million. This works out to a 17:1 ratio of gains to losses.
One might wonder why Linn bothers with buying oil and gas properties at all. Clearly, trading commodities is where their talents lie.
What is the secret to Linn’s success?
Linn has a curious definition of “realized gain.” Linn considers all proceeds that it receives upon settlement of a derivatives transaction as a “realized gain.” For example, if Linn purchases a derivative for $2 million and later sells it for $1, Linn reports a “realized gain” of $1 – the amount of cash they got back. No wonder they (almost) never lose! 
In conventional accounting you only generate a gain if you sell something for more than you paid for it. If you sold something for less than you paid for it? That’s a loss.
Conventional accounting doesn’t apply to Linn.
But, a guaranteed “gain” is not enough for Linn. Those pesky accounting rules like to govern when you recognize profits, not just how much. As you’ll see, Linn has solved that problem, too.
Linn is an E&P MLP focused on acquiring mature oil and gas properties in the United States. In addition to the MLP structure, the Company distinguishes itself from oil and gas peers by hedging out 100% of anticipated production for five to seven years. Management often boasts of an “industry leading hedge strategy.” Since inception in 2003, Linn has completed ~$10 billion in acquisitions to grow into the 8th largest MLP and the 11th largest independent E&P company in the US. This growth has been funded by raising over $6.5 billion in equity, primarily from retail MLP investors, who believe they are receiving an attractive 7.9% yield, stable cash flows and growth in distributions.
“Adjusted” EBITDA and Distributable Cash Flow
MLP investors engage in relative valuation by comparing companies based on their distribution yield and their distributable cash flow. Distributable cash flow is a MLP-specific term – it is calculated as follows:
Less: Interest Expense
Less: Maintenance Capital Expeditures
= Distributable Cash Flow (“DCF”)
Since DCF is a non-GAAP measure, companies have some discretion as to what constitutes a proper EBITDA adjustment and what constitutes a maintenance capital expenditure. The following table illustrates the relevant calculations from Linn’s Q1 – Q3 2012 financial packages.
The key to understanding how Linn overstates Adj. EBITDA and DCF lies in understanding how Linn treats gains and losses from derivatives. Ignoring for a moment the bevy of other adjustments, Linn adds back “Unrealized (gains) losses on commodity derivatives” to net income in order to calculate Adj. EBITDA. The impact of this is that Adj. EBITDA includes “Realized gains (losses) on commodity derivatives.” This follows directly from the accounting equality below and since “Total gains (losses) on commodity derivatives” is included in net income.
Realized Gains (Losses) + Unrealized Gains (Losses) = Total Gains (Losses)
This allows Linn to include just the realized gains (losses) in Adj. EBITDA for the period, which should be their goal since they want to match earnings from hedges with the underlying hedged production. It is easier to think about their Adj. EBITDA as follows:
Open EBITDA (pre-hedges) + Realized Gains (Losses) on Hedges = Adj. EBITDA (with hedges)
The Definition of Realized Gain
So far Linn’s calculation of Adj. EBITDA makes sense. One takes the EBITDA generated by the oil and gas activities (Open EBITDA) and then adds in the realized gains from the hedge portfolio.
What does not make sense, however, is Linn’s definition of “realized gain.”
Linn has redefined “realized gain” – a fundamental accounting concept – to be equal to the total amount of cash they received upon settling a derivatives contract instead of the amount in excess of their cost basis. An example:
When you buy a derivative for $1.00 and later settle it for $2.00, there is only $1.00 of true realized gain associated with the transaction. This is generally considered a profit. Linn recognizes the entire $2.00 as “realized gain” and includes it in Adj. EBITDA and DCF.
This results in a significant overstatement of DCF given Linn’s propensity to purchase deep in-the-money derivatives contracts.
The following example with one put contract illustrates the difference between Linn’s accounting and GAAP and the ensuing impact on Adj. EBITDA. The steps are as follows:
1) In Period 1, we purchase a put option for $1
2) Our put option appreciates to $2 due to a change in commodity prices in Period 2. GAAP requires that we mark our derivative asset to fair value so we record an unrealized gain of $1.
3) In Period 3 we decide to settle our put contract for $2. This results in a cash inflow of $2 as our derivative asset is settled and marked to $0.
4) Since there was no change in the fair value of the put option during the period, our income statement reflects no net gains or losses in Period 3. However, we must reverse our previously recorded unrealized gain of $1 and record a realized gain of $1. You will see this shown in the GAAP example below.
Based on the transaction described, anyone can tell that the aggregate profit is exactly $1. You will note that the GAAP example below shows exactly $1 of cumulative net income and Adj. EBITDA.
However, since Linn has redefined “realized gain” to be equal to the cash they receive upon settling the derivatives transaction – in this example $2 – they record $2 of “profit” in their calculation of Adj. EBITDA, resulting in a significant overstatement. In other words, they reported $1 of extra “fake" Adj. EBITDA.
One final nuance that will be referenced later: Note that the $1.00 of extra “fake” realized gains – by necessity – results in $(1.00) of “fake” unrealized losses associated with derivatives contracts that no longer exist. This is shown in the cumulative column below – clearly there should not be unresolved unrealized losses since we have settled all contracts.
The simplest way to explain this is that in order for Linn’s books to balance they have to offset the “fake” realized gains with another account – they use “fake” unrealized losses. As you will see in a later section, by tracking the unrealized loss account we are able to quantify the magnitude of Linn’s overstatement.
I provided a similar example to Linn’s Chief Accounting Officer, who has confirmed that it accurately depicts their accounting policies.
By utilizing this misleading accounting, Linn can “purchase” Adj. EBITDA and DCF by buying in-the-money derivatives contracts. Linn’s characterization of “realized gain” converts dollar for dollar the intrinsic value of the derivatives (as opposed to the time value) into future Adj. EBITDA assuming no price changes in the commodity. This is exactly what Linn does when they purchase deep in-the-money derivatives contracts.
The rationale for playing such a game is obvious. Spend one dollar today and receive a dollar in the future that is ascribed a 13x multiple by unwary investors (13x = 1 / 7.8% yield).
Does anyone know about this?
I suspect few investors have caught on to the problem because:
- The other oil and gas companies I have surveyed account for their hedges differently than Linn. When I probed one of Linn’s competitors in the E&P MLP space if everyone accounts for their hedges the same way, he mentioned that Linn works differently and intimated he thought something looked off in their accounts.
- Change in SEC Disclosure Obscures Accounting. Consider the below change in the “Gain (Loss) on Derivatives” footnote from Linn’s 2008 Q1 and Q2 10-Q statements. The Q1 2008 disclosure hints that, despite the name “Realized gain”, Linn’s characterization actually equals the gross cash received upon settling a derivative transaction and not just the gain in excess of basis. This disclosure becomes exceedingly vague in Q2 2008, and the Company removes the supplementary disclosure that begins “Realized gains (losses) in the table above are based…” The juxtaposition of these two sentences in the supplementary disclosure implies that the “realized gain” account and the “cash settlements” accounts are equivalent, except for a small timing mismatch (recognition vs. receipt of proceeds). This is fundamentally the thesis.
How big is the problem?
Since inception, Linn has recorded cumulative realized gains on commodity derivatives of $1,272 million in Adj. EBITDA and DCF. 96% of this occurred in the last four years. Note that Linn reported cumulative DCF since 2009 of ~$1,927 million. Therefore,
63% of Linn’s reported DCF since 2009 has been generated by the hedge portfolio
This alone should give investors pause. Perhaps a portion of the hedge gains deserves to be included, though. Fortunately, we are able to estimate the magnitude of “fake” Adj. EBITDA and DCF generated by Linn’s misleading accounting.
Linn has cumulative unrealized losses of $(499) million since inception (see table below). Only two items sit in the unrealized gain (loss) account:
1) Actual unrealized gains or losses from movements in the value of the hedges, or
2) “Fake” unrealized losses to offset “fake” realized gains
Linn should not have any cumulative unrealized losses from the actual hedge portfolio. In other words, we know that category 1) above does not contribute any cumulative losses – in fact, I believe it contributes a substantial gain.
Linn’s hedge portfolio is substantially in the money – likely in excess of $100 million (by my estimate) – since gas prices are substantially below their hedged levels. Adjusting for the “real” $100 million of unrealized gains in the hedge portfolio implies that Linn has at least $600 million of cumulative “fake” unrealized losses related to derivatives contracts that no longer exist.
$(499) million Unrealized Losses = $100 million Real Unrealized Gains + $(599) million Fake Unrealized Losses
We also know from our previous work that “fake” unrealized losses correspond dollar for dollar with “fake” realized gains, which are included in Adj. EBITDA and DCF.
Therefore, I believe Linn has misreported in excess of $600 million of “fake” Adj. EBITDA and DCF, the bulk of which has likely been recognized in the last two to three years. Since 2009 Linn has generated $1.9 billion of distributable cash flow. Therefore, I believe that “fake” realized gains on derivatives constitutes greater than 30% of Linn’s DCF over this period.
The following table outlines Linn’s historical hedge accounts since inception.
Points of interest in the table above:
- Note the similarity between the “Realized Gains on Commodity Derivatives” (A) and “Cash Settlements of Commodity Derivatives” (B). The core of the thesis is that Linn considers all cash settlements to be realized gains. The fact that on a gross base of ~$1,300 million the cumulative difference between the two accounts is only $17 million corroborates the thesis and implies equivalency.
- For further proof of the equivalency of realized gains (under Linn’s definition) and cash settlements, note that Linn’s realized gains on canceled derivatives (D) equals their cash settlements on canceled derivatives (E) every period.
- Linn has not had a quarterly realized loss on the hedge portfolio since Q3 ’08. Cumulative quarterly gross realized gains of ~$1,300 million compares to gross realized losses of $78 million.
Other Unusual EBITDA Adjustments
In addition to reporting inflated Adjusted EBITDA due to unusual derivative accounting, Linn makes a number of other questionable adjustments to EBITDA and DCF. Collectively, these total $129 million for the LTM period, which equals 19% of reported DCF.
- “Operating Cash Flow from Acquisitions, Effective Date to Closing Date” - On a LTM basis, this adjustment sums to $102 million, which equals 15% of LTM reported DCF. Upon first glance, this seems similar to a typical working capital adjust adjustment one might find in an M&A transaction. However, in Linn’s acquisition purchase agreements they effectively backdate the economics of the transaction – the “Effective Date” is well before the signing date and closing date. What this means is that Linn has agreed to overpay the seller of the asset in exchange for having the right to cash flows generated prior to the transaction closing. This increases the purchase price (a capital cost) while increasing reported DCF for the period, on which Linn receives a multiple.
- “Unit Based Compensation” - $27 million in the LTM period, which equals 4% of LTM reported DCF. Stock or unit based compensation is clearly an expense. The form of compensation – cash or stock – does not impact the true economic cost of the expense. Management adds this back to Adjusted EBITDA using the rationale that it is “non-cash.” Just because it is non-cash does not mean is does not have an economic cost. As a thought experiment, imagine that Linn decided to pay all employees and suppliers in stock, therefore having an entirely “non-cash” expense side of the P&L. Would it be fair to add back all of these expenses to EBITDA and DCF? Of course not.
Understated Maintenance Capital Expenditures
Linn significantly understates its Maintenance Capital Expenditures, which results in overstated DCF. Curiously, I have not been able to find a public document in which Linn defines “Maintenance Capital Expenditure.” Based on my conversations with the Company, this metric is intended to represent the amount of capital expenditures required to hold production flat. In other words, it should represent the amount of capital expenditures that must be spent in order to make DCF represent a recurring cash flow stream, to the extent the Company has reserves and resources (which are by definition finite). This is an essential point, given that Linn’s operations have an organic decline rate of ~20%.
My research indicates that the Company cherry picks all of its highest IRR drilling projects for Maintenance CapEx, instead of Growth CapEx (which is excluded from DCF). This – by definition – results in a material understatement of Maintenance CapEx. The highest IRR drilling projects are often rapid decline rate fracking projects. These will results in the “cheapest” CapEx you can spend to maintain next year’s production, but not hold production steady for an extended period of time. To see why, consider the following example. Project A represents a high IRR fracking project and Project B represents a more conventional drilling opportunity.
Project B produces a higher NPV than Project A. However, due to high initial production rates followed by rapid declines, the fracking project – Project A – generates a substantially higher IRR.
Hypothetically, if the company needed to replace $9 million of production next year in the Maintenance CapEx calculation, it would cost $10 million with Project A and $30 million with Project B (need three Project B’s), despite the fact that Project B has a higher NPV!
How much is Maintenance CapEx understated?
The table below outlines Linn’s reserve replacement costs per the 10-K, DD&A (depletion, depreciation and amortization) per unit of production, and Linn’s reported Maintenance CapEx per unit of production.
- The Company’s reported reserve replacement cost per Mcfe of production is $1.86
- The Company’s DD&A, for which the Company must measure the economic cost of depleting its oil and gas wells for accounting purposes, implies a replacement cost of $2.50 per Mcfe
Since Linn cherry picks the highest IRR projects for Maintenance CapEx, it reports a replacement cost of $1.28 per Mcfe, significantly below the true economic cost of maintaining flat production.
If we normalize Linn’s Maintenance CapEx costs to the low end of the range - $1.86 per Mcfe of production – we realize that Linn’s Maintenance CapEx is understated by $182 million, or approximately 23% of last quarter’s annualized DCF.
Summary of DCF Overstatement
I believe a number of factors drive a significant overstatement of reported DCF, including:
- Derivatives Accounting – “Fake” realized gains from unusual derivatives accounting in excess of $600 million over the last few years
- Unusual EBITDA Adjustments - $129 million overstatement of DCF in the LTM period from including “Operating Cash Flow from Acquisitions, Effective Date to Closing Date” and failing to expense unit based compensation.
- Understated Maintenance CapEx - $182 million overstatement of DCF in the LTM period from cherry picking high IRR projects for inclusion in Maintenance CapEx.
History of Manipulation
Linn has manipulated their flawed calculation of Adj. EBITDA and DCF for their own benefit on a number of occasions.
- Canceled Derivatives – Linn excludes realized gains and losses on “canceled derivatives” from their calculation of Adj. EBITDA and DCF. The Company’s rationale is that these derivatives do not relate to current period production and therefore shouldn’t be factored into earnings. However, as shown in the table above, the Company has cumulative realized losses on canceled derivatives of $168 million. In other words, if Linn’s hedges turn into winners they take them into Adj. EBITDA. If they turn out to be losers, they cancel them early and exclude them from Adj. EBITDA.
- Increasing Strike Prices on Hedges – Not only does Linn like to ignore their losing bets, they like to recognize their winners how and when they want. As you will see in the following disclosure from the Company’s 2011 10-K, Linn canceled oil and gas swaps for 2016 (who wants to wait that long?) and used the $27 million of proceeds to increase swap prices for 2012. In other words, this takes $27 million that would be recognized as Adj. EBITDA and DCF in 2016 and instead causes it to be recognized in 2012. I believe there is no economic rationale for such a maneuver and therefore conclude that the company was intentionally manipulating its Adj. EBITDA.
Moreover, the Company paid $55 million in the aggregate ($33 million plus $22 million) to increase the prices on put options for 2012 and 2013. Since these puts were already in the money, this maneuver converts $55 million today into ~$55 million of future Adj. EBITDA.
Cumulatively, these three transactions alone result in an overstatement of 2012 and 2013 Adj. EBITDA and DCF of $82 million (and I think this is only a small part of the overstatement).
Linn engaged in the same type of transaction in 2009. See below for the relevant section of the 10K. This transaction resulted in an overstatement of 2010 and 2011 Adj. EBITDA and DCF of $94 million.
- Purchasing Deep In-The-Money Contracts – Linn purchases deep in-the-money put options so as to report an acceptable Adj. EBITDA and DCF. Purchasing deep in-the-money put options requires significant out of pocket expense – fortunately for Linn, based on their accounting this high upfront costs converts almost dollar for dollar into future Adj. EBITDA. As I will show below, Linn utilizes these put options to overstate anticipated Adj. EBITDA and understate acquisition purchase multiples, therefore misleading “the street” as to how accretive their acquisitions actually are.
Misrepresented Acquisition Economics: BP Hugoton Case Study
During March 2012 Linn acquired certain Hugoton Basin assets from BP. The Company told investors that they paid $1,200 million for the assets and expected year one Adj. EBITDA of $160 million, implying a purchase multiple of 7.3x Adj. EBITDA. With Linn trading at a significant premium to this level, investors immediately judged the acquisition as highly accretive. See below for a snippet from Linn’s acquisition presentation dated February 28, 2012 (available on Linn’s website).
What Linn did not say about the acquisition…
The simplest way to value Linn is to separately value Linn’s operating assets and the hedge portfolio. There is no need to debate the appropriate multiple for the portion of Linn’s earnings from the hedge portfolio – we know exactly how much the hedges are worth since they must be marked at fair value on the balance sheet.
I adjust the enterprise value calculation for the fair value of the hedge portfolio in the table below. Moreover, I adjust Linn’s EBITDA to compensate for the difference between current prices and the commodity strip (the strip is above the Company’s realized prices before hedges over the last year – this adjustment helps them). Linn trades for:
- 9.5x Open EBITDA
- 16.2x Open EBITDA – Maintenance CapEx
- 2.0x PV-10 per share
- 1.8x book value per share
I calculate an economic DCF of $2.14 / unit. At a 1.2x coverage ratio, this implies a distribution of $1.78 / unit, compared to the current distribution of $2.90 / share.
The reader should note that this distribution is NOT comparable to other MLPs with stable assets like pipelines, this distribution is guaranteed to decline an organic basis and therefore does not deserve a comparable multiple.
All that, for a company with highly volatile underlying cash flows (it is a collection of oil and gas wells, after all) that are guaranteed to decline over time. The Company’s existing production base has an average annual decline rate of ~20%.
Comparable oil and gas companies trade for ~3-5x EBITDA. These companies generally have valuable non-producing acreage.