Description

Linn Energy LLC (LINE)/LinnCo LLC (LNCO)

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Fact #1: LINE's February 15, 2013 8-K makes it indisputable that the quantity, strike and duration of LINE's put purchases directly affect the company's reported non-GAAP Adjusted EBTIDA and Distributable Cash Flow (DCF).  In an extreme example, given LINE's accounting methodology quoted below, if LINE were to choose to buy $100 million of one-day in the money $100 strike puts, LINE would record an increase of $100 million to both its Adjusted EBITDA and DCF the next day upon expiration of these puts despite the fact that there was zero economic value created in this transaction.

From the 8-K:

 “Amortization of puts is a non-cash expense and should not be deducted from EBITDA (hence the definition of EBITDA; earnings before interest, taxes, depreciation and AMORTIZATION) [emphasis added by the company).  LINN considers the cost of puts as a “capital” investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that “depreciation” of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a “capital” expense, and the company views puts the same way.  When LINN purchases puts, the company pays 100% of the cost in upfront cash and capitalizes them as an asset on the balance sheet.”

Fact #2: Given that LINE treats its puts as a “capital asset”, then there must be a corresponding “capital expense” that needs to impact its calculation of DCF since puts expire and need to be repurchased in order to maintain a hedged position – this is analogous to a “maintenance capex” cost.  From LINE’s most recent 8-K we know that the company spent $583 million to purchase puts in 2012, but only $320 million went towards buying puts related to their 2012 acquisitions.  Using LINE’s own analogy, the company spent $263 million of “maintenance capex” to maintain its put positions in 2012.  Were this amount subtracted from DCF, LINE’s distribution coverage would drop to 0.7x from the 1.14x it has guided to for 2012.      

Fact #3:  In the February 15, 2013 8-K LINE states:

 “In evaluating this issue, LINN has identified other publicly traded partnerships that purchase derivatives, and all of these companies account for derivatives the same way LINN does. In fact, LINN has yet to identify any publicly traded partnerships that account for it differently.” 

After evaluating MLP peers including BBEP, EVEP, VNR, LGCY, LRE, QRE, ARP, MCEP, MEMP, CEP, and PSE we have found that only BBEP, QRE, and ARP own long duration puts, though we note that they represent a much lower percentage of production volume than LINE and/or much lower strikes.  Relating to accounting for their long-term puts, QRE, arguably the closest peer in terms of using puts as hedges, states in their most recent 10-Q, “These deferred premiums will be paid to the counterparty with each monthly settlement (January 2015 - December 2017) and recognized as an adjustment of realized gain (loss) on derivative instrument.” We find this disclosure likely at odds with the categorical statement made by LINE above.  As a reminder, LINE treats all cash settlements of options as “realized gains” and does not adjust for the premiums paid.    

Fact #4:  LINE states: 

 “LINN does not issue debt and equity securities to pay its distribution.

Since the company’s inception, LINN has issued approximately $12 billion of debt and equity securities:

~$10 billion to finance acquisitions

~$1 billion to finance puts (roughly 10% of the cost of the acquisitions)

~$1 billion primarily to repay higher cost debt

Since its IPO, LINN has paid $2.4 billion in distributions. The only way that would be possible is by earning a sufficient amount of cash to pay the distribution, which LINN clearly did.”

Among other things, what this calculation fails to include is the $1.3 billion in cash settlements the company has received from the puts it spent over $1 billion on.  This is analogous to putting money in the bank and pulling it out later.  In other words, the company issued equity and debt to buy $1B worth of puts (the vast majority above the prevailing spot price on the day of purchase) and then when the puts settled LINE has used those proceeds to pay over 54% of distributions to date ($1.3 billion / $2.4 billion).  

Our in-depth discussion follows:

We believe Linn Energy (LINE/LNCO) does not generate sufficient Free Cash Flow to cover its current distribution.  Investors believe the exact opposite because LINE utilizes deceptive non-GAAP accounting metrics to materially overstate its cash flow-generating abilities.  LINE tells investors to focus on a non-GAAP metric called Distributable Cash Flow (DCF) which should approximate Free Cash Flow over time but in LINE’s case does not due to a number of issues with LINE’s accounting and business practices.  The most blatant issue is how the company handles accounting for its put option purchases.  Wall Street, which has been paid over $350 million in financing fees over the last seven years by LINE, has looked the other way despite glaring holes in LINE’s cash flow statements.

LINE’s business model is to acquire mature, stable oil and natural gas production assets and then hedge their commodity exposure by entering into long duration derivatives contracts.  Lenders generally require that 70% of production be hedged with long duration swaps, leaving LINE free to hedge the balance of its production however it chooses.  LINE has chosen to hedge the balance of its production using put options.  Why?  Because LINE has a unique definition of ‘realized gains’ which it treats the same as ‘cash settlements’.  If LINE purchases a derivative for $1 and sells it upon expiration for $2, despite generating an economic gain of $1, they will book it as $2 of realized gains.  LINE is able to utilize this unusual accounting because it considers its put purchases as a capital investment and amortizes the cost of its puts over the life of the contracts through an account titled ‘unrealized losses on derivatives’.  These ‘unrealized losses,’ despite representing a real cash outflow, are then added back to GAAP Net Income to create an inflated non-GAAP measure called Adjusted EBITDA which is the major component of Distributable Cash Flow (DCF).  The result is that one hundred percent of the cost of LINE’s purchased puts never impacts Adjusted EBITDA and Distributable Cash Flow (DCF).  The company can thus ‘manufacture’ higher reported Adjusted EBITDA and DCF by purchasing puts with higher strike prices.  It is an incredible accounting maneuver that has allowed LINE to materially overstate its financial strength on unsuspecting retail investors. 

 Before we continue, some fast facts:

1)             LINE has generated $2.5 billion in “distributable free cash flow” (DCF) since inception

2)             LINE has reported $1.3 billion in cumulative “realized gains, net” on its derivatives since inception

3)             LINE has reported $470 million in cumulative “unrealized losses, net” on its derivatives since inception

4)             LINE has purchased $1.4 billion in put premiums since inception

The table below summarizes LINE’s reported data as well as what that same data would look like without the benefit of two key Adjusted EBITDA Add-Backs: 1) the amortization of put premiums and 2) purchased operating cash flow from its M&A activity.  As you can see, we estimate that this mischaracterization has overstated Adjusted EBITDA by nearly 39% and Distributable Cash Flow (DCF) by 134% over the past nine months.  Our discussion examining these issues follows.

DISCLAIMER: The author is short LINE and LNCO.  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read LINE/LNCO public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of LINE and/or LNCO without notice.  

Company Overview:

Linn Energy, LLC (LINE) is an independent oil and natural gas E&P MLP that engages in the acquisition and development of oil and gas properties.  LINE is the 8^th largest MLP and the 11^th largest independent E&P company in theUS.  The company’s properties are primarily located in theUnited States: Mid-Continent,Permian Basin,Michigan,California and theWillistonBasin.  LINE is different from its E&P MLP peers because it hedges 100% of its production approximately five years into the future, much of it with naked puts.

Discussion:

LINE has grown rapidly since its $250m IPO in 2006.  The company has grown primarily by raising equity (over $5B since 2006) from retail investors and using the funds to acquire oil & gas properties from sophisticated sellers such as BP (BP), Anadarko Petroleum (APC), Dominion Resources (D) and Plains Exploration and Production (PXP).  LINE focuses on purchasing older, more stable assets that they deem worthy to be placed in an MLP which requires steady cash flows in order to support its quarterly distributions.  What is odd is that LINE currently generates no taxable income and has stated publicly that they do not anticipate generating taxable income for another five years.  Thus, there is currently no tax advantage to operating in an MLP structure.  The real advantage comes from the high multiple the market currently places on MLP distribution streams. 

Those cash distributions, over $2B since 2006, are supposed to be supported by the oil and gas produced and sold by LINE’s assets.  The problem is that LINE’s assets (including its very successful hedging operation) have produced free cash flow (operating cash flow less maintenance capital expenditures) since 2006 of just under $700m.  So how exactly does LINE claim that they generate enough distributable cash flow to cover their distribution?  The answer is in the company’s definition of realized gains and unrealized losses.

LINE’s Adjusted EBITDA Accounting:

First, let’s start by looking at the method by which LINE calculates Adjusted EBITDA.  It starts with GAAP Net Income and then adds back numerous supposedly non-cash items in order to calculate Adjusted EBITDA.  Additionally, Adjusted EBITDA is the biggest component of Distributable Cash Flow (“DCF”) which is also a non-GAAP measure.  The DCF calculation that LINE uses is the same one used across the MLP industry:

Adjusted EBITDA

Less: Interest Expense

Less: Maintenance Capital Expenditures

= Distributable Cash Flow (DCF)

DCF is paramount in the minds of MLP investors as it is supposed to represent the cash flow available to support the quarterly distribution.  Our concerns surround LINE’s definition of Adjusted EBITDA.  The last fifteen quarters’ of the company’s calculation is shown on the next page for illustration; this reconciliation table is shown in the MD&A section of every 10-Q and 10-K.  Street analysts across the board follow the company’s definition exactly as shown.

The key is that LINE backs out ‘Unrealized losses on commodity derivatives,’ which reduces GAAP Net Income, from Adjusted EBITDA.  This actually makes sense; the mark-to-market fluctuations in LINE’s hedge book are non-cash and thus should be eliminated from the Adjusted EBITDA calculation which is supposed to reflect the company’s cash flow generation capabilities.  The problem lies in what the company defines as a realized gain and an unrealized loss.  These re-definitions enable LINE to purchase hundreds of millions of dollars of derivatives and never have the cost of ‘premiums paid for derivatives’ impact Adjusted EBITDA and DCF. 

Realized Gains = Cash Settlement:

LINE defines realized gains very differently than you or I would, especially when it comes to the gain generated by a put exercised in-the-money.  LINE defines a realized gain as the cash settlement proceeds it receives upon settlement of a derivative (strike price minus settlement price, aka intrinsic value).  For instance, if LINE purchases a put for $1 and sells it upon expiration for $2 they book $2 in realized gains – despite the fact that their economic gain is just $1.  Most investors would define a realized gain as strike price minus settlement price minus premium paid.  This discrepancy becomes particularly egregious if the put is originally purchased deep in-the-money with substantial intrinsic value because there is a high likelihood the put will expire in-the-money.

We can prove that LINE defines realized gains as cash settlements three ways:

First, investors can compare realized gains (losses) on commodity derivatives (ex. canceled derivatives) to cash settlements of commodity derivatives (ex. canceled derivatives) since 2006.  The cumulative totals are extremely close; on a total gross base of $1.3B, the cumulative difference between the two accounts is $5.4m which implies equivalency.  Another way to analyze the equivalency is to understand that if LINE’s accounting is correct, then the difference between realized gains and cash settlements (just $5.4m) equals the cost basis of the derivatives exercised and settled for cash.  Think about that: LINE’s unusual definition of realized gains implies that they only spent $5.4m to purchase derivatives used to hedge hundreds of millions of dollars of production.  This clearly cannot be the case so we know that the company treats realized gains the same as cash settlement.

Second, investors can note that every single quarter in which LINE reports a realized gain on canceled derivatives, their cash settlement on canceled derivatives is exactly the same.  The below is data taken directly from their SEC filings. 

Third, on LINE’s Cash Flow Statement there is a section of the Operating Cash Flows (OCF) labeled ‘Mark-to-market on derivatives.’ This section reconciles the cash impact derivatives have on the company; it begins by (subtracting)/adding the ‘Total (gains)/losses on commodity derivatives’ from GAAP Net income (the first line of the OCF reconciliation) and then adds back ‘Cash settlements’.  We know that Realized gains = Cash settlements simply because the company used to report the line item now titled ‘Cash settlements’ as ‘Realized gains (losses)’.  This was the case from the IPO in 2006 until the 2007 10-K was filed.  Since then ‘Realized gains (losses)’ have been replaced by ‘Cash settlements’ on the Statement of Cash Flows. 

LINE’s Adjusted EBITDA and DCF are directly impacted by realized gains; our principal concern is that those realized gains are directly related to the company’s choice of strike of its put portfolio.  According to LINE’s accounting, if natural gas is at $3 and the company settles a $5 strike put they will record $3 in revenue from the sale of natural gas and $2 in realized gains from the cash settlement of the put contract.  LINE’s Adjusted EBITDA and DCF would include that $2 of realized gains but never include the original cost of the put.  If the put’s strike had instead been $50 then the realized gain would have been $47 and Adjusted EBITDA and DCF would have been $45 higher than the first example.  In other words, LINE can ‘manufacture’ whatever Adjusted EBITDA and DCF they want by purchasing puts that are varying degrees of in-the-money.

To conclude, the result of this method of accounting is that LINE excludes the original cost of the put when booking a realized gain, which the company defines as strike price minus settlement price.  But the original cost of the put must go somewhere.  For LINE, the cost goes into unrealized losses and stays there permanently. 

Cost of Premiums Paid for Derivatives Amortized Through Unrealized Losses:

Note: we use the term amortization to reflect the ratable expense of the put premium over time; this cost never shows up in ‘Depreciation, depletion and amortization’.  Rather, the amortized cost of put premiums runs through the unrealized loss account. 

LINE treats its put options as a depreciable asset and amortizes one hundred percent of the cost of the put over the life of the contract through unrealized losses.  LINE never before disclosed this accounting treatment until they filed an 8-K on February 15, 2013.  These unrealized losses related to the amortization of put premiums are excluded from Adjusted EBITDA.  Even when the put is exercised, the amortized cost of the put, run through unrealized losses, is never converted into a realized loss that impacts Adjusted EBITDA.  This is by necessity due to the company’s curious definition of realized gain; the company must book the cost of put premiums into unrealized losses in order for their accounts to balance properly.  Think about it: the company buys hundreds of millions of dollars of puts (over $650m worth the last four quarters) and the expense never hits their Adjusted EBITDA and Distributable Cash Flow (DCF) calculation!

Furthermore, LINE’s curious definition of realized gains and subsequent unrealized losses means that the company can ‘purchase’ Adjusted EBITDA and DCF by purchasing deep in-the-money puts with significant intrinsic value which will likely still have significant intrinsic value upon exercise.  The company acknowledged in the February 15, 2013 8-K that they have purchased in-the-money put options in the past.  They noted that, “out of 40+ hedging transactions over the last 10 years, only 7 were purchased “in the money.”  They do not disclose, however, the magnitude of the puts purchased in-the-money vs. those purchased at- or out-of-the-money.  Furthermore, the company believes that purchasing a put on natural gas with a $5.00 strike price when the spot price for natural gas is $2.00, “could hardly be considered ‘deeply in the money’ when compared to the 5 year average market price [of $4.50].” The long term average price of natural gas is irrelevant to whether or not the purchased put is in-the-money, especially when it comes to accounting for realized gains and unrealized losses today.  To conclude, we reiterate that one hundred percent of the intrinsic value of any exercised put is placed into realized gains while one hundred percent of that put’s cost is placed into unrealized losses.

Additionally, in the February 15, 2013 8-K the company compares the purchase of puts to the purchase of oil and natural gas assets.  They do this to highlight their viewpoint that puts should be treated the same as oil and natural gas assets and capitalized on the balance sheet.  Thus, the company argues, the amortization of puts, which are analogous to depreciation of oil and natural gas assets, should be excluded from Adjusted EBITDA in the same way that depreciation of oil and natural gas is excluded.  We do not share this view with management as puts do not expand the company’s production capacity but for the following exercise let us agree with them and treat puts as a capital expense. 

When LINE purchases oil and natural gas assets there are two major non-operating costs associated with those assets that impact DCF: interest expense and maintenance capital expenditures.  The company notes in the 8-K, “what does flow through to Distributable Cash Flow per Unit is the cost of debt and equity securities (interest and distributions) that were needed to purchase both the oil and natural gas assets and the puts.”  [Emphasis added by the company].  Fair enough, but what about the ‘maintenance capital expenditures’ associated with rolling the put hedge book forward every year?  How big is that expense and why does it not directly impact DCF in the same manner that the maintenance capital expenditures associated with the company’s oil and natural gas assets impact DCF?  Furthermore, if the company considers the purchase of puts to be a capital investment then why does it not show up in the Investing section of the Statement of Cash Flows? 

We can actually answer the question of how large this put-related ‘maintenance capex’ spend was in 2012 by using data provided to us by the company in the February 15, 2013 8-K.  In the 8-K the company notes that during 2012 the company completed approximately $3B in acquisitions and spent $320m on puts to hedge production of the acquired assets for the next 4-6 years.  Using LINE’s own analogy would mean that this $320m spent on puts to hedge acquired production is ‘growth capex.’  The ‘maintenance capex’ portion of puts purchased during 2012 is represented by the balance of the $583m total spent on puts in 2012, $263m ($583m - $320m).  The company notes that this cash outflow, “was used to add puts for 2013 through 2017 for volumes that were not yet hedged.”  These volumes were not yet hedged in 2012 because the previous hedges had rolled off and because another year had passed.  Using LINE’s own viewpoint that puts should be treated as a capitalized asset means that $263m worth of puts purchased in 2012 should be treated as maintenance capex and deducted from Adjusted EBITDA to calculate a revised DCF.  In this case, an increase of maintenance capex of $263m would decrease guided 2012 DCF by the same amount and lower 2012 guided DCF per share to $2.04 per share (vs. the company’s guided $3.31 per share).  This results in a distribution coverage ratio of 0.70x (vs. the company’s guidance of 1.14x).

One other point: the company notes in its February 15, 2012 8-K that part of its hedging strategy is to, “use approximately 70% swaps (fixed price contracts) and 30% puts (floor contracts with unlimited upside).”  The company is naturally long oil and natural gas and benefits when prices rise; that is the ‘unlimited upside.’  The company is also negatively exposed to lower oil and natural gas prices; that is why they buy puts as ‘floor contracts.’  The question we have for the company is: if you want to protect your downside while also offering unlimited upside to your shareholders then why don’t you hedge 100% of your production with cashless swaps and long at-the-money calls?  No doubt at-the-money calls are cheaper than in-the-money puts; put-call parity tell us this fact.

Changes in Derivatives Accounting Disclosure:

The company has reported in its SEC filings numerous times that they mark their derivatives to market (fair value) using the guidance provided in SFAS 133.  In that standard the FASB declares, “fair value is the only relevant measurement attribute for derivatives.  Amortized cost is not a relevant measure for derivatives.”  And yet LINE claims that they amortize the cost of their put premiums.  We note that nowhere in the company’s SEC filings (until the 8-K filed February 15, 2013) does LINE indicate that they capitalize the cost of their puts and amortize the costs over the puts’ life through unrealized losses.  We believe the company should expand its disclosure around put premium amortization to enable investors to better understand how these costs impact Net Income, Adjusted EBITDA and DCF. 

Furthermore, if the company capitalizes the costs of its purchased puts as assets on its balance sheet then how do they mark them to market at fair value?  Certainly the major inputs used to determine the fair value of a commodity put – the spot price of the underlying, implied volatility, interest rates – do not follow a rigid schedule such as one produced by straight line amortization.

We would like to highlight the fact that the company’s disclosure surrounding which FASB standard governs their derivatives accounting has changed meaningfully over the years and yet there is never one mention of amortizing the cost of put premiums (until February 15, 2013).  The original S-1 filed June 3, 2005 declared [emphasis added]:

“We periodically use derivative financial instruments to achieve a more predictable cash flow from our natural gas production by reducing our exposure to price fluctuations. Currently, these transactions are swaps. Additionally, we use derivative financial instruments in the form of interest rate swaps to mitigate our interest rate exposure. We account for these activities pursuant to SFAS No. 133 — Accounting for Derivative Instruments and Hedging Activities, as amended. This statement establishes accounting and reporting standards requiring that derivative instruments (including certain derivative instruments embedded in other contracts) be recorded at fair market value and included in the balance sheet as assets or liabilities.  For the derivatives that were established in 2004 and 2003, the instruments were not specifically designated as hedges under SFAS No. 133, even though they protected the company from changes in commodity prices. Therefore, the mark to market of these instruments was recorded in our current earnings. Subsequent to March 31, 2005, we anticipate that the new derivative agreements will be designated and effective as hedges and the mark to market will no longer be recorded in current earnings. Further, these amounts represent non-cash charges.” 

This appears unambiguous; the company accounts for its derivatives using mark-to-market accounting and records the fair value of the derivatives at the end of each period on its balance sheet.  Any changes in the value of the derivatives, if they are not deemed cash flow hedges, are recognized in current earnings.  There is no mention of put premium amortization here.

The company’s first 10-K, filed May 31, 2006 expands upon the company’s usage of put options [emphasis added]:

 “A put option requires us to pay the counterparty the fair value of the option at the purchase date and receive from the counterparty the excess, if any, of the fixed floor over the floating market price. The costs incurred to enter into the transactions are expensed as incurred, and the change in fair market value of the instrument is reported in the statement of operations each period.

Here the company notes that the costs to enter into put transactions are expensed as incurred (upon purchase) and yet the company currently claims that it amortizes the costs of purchased put premiums over the length of the contract.  Some change in the company’s accounting must have occurred subsequent to this declaration in the 2005 10-K in order to justify the company’s current accounting for put premiums as an amortized cost but we have been unable to find it.

The 2007 10-K eliminates the following phrase which had been disclosed in the two previous 10-K’s, “The costs incurred to enter into the transactions are expensed as incurred.”  This phrase, in reference to derivatives accounting, never reappears in the company’s SEC filings. 

The 2008 10-K changes the company’s disclosures meaningfully and yet the message is the same; the company marks its derivatives to market.  There is no mention of put premium amortization again.  The company states:

“The Company determines the fair value of its derivative financial instruments in accordance with SFAS 157, which defines fair value and establishes a framework for measuring fair value. The Company utilizes pricing models for significantly similar instruments to determine fair value. The models use a variety of techniques to arrive at fair value, including quotes and pricing analysis. Inputs to the pricing models include publicly available prices and forward curves generated from a compilation of data gathered from third parties.”

We also note that the 2008 10-K is the last we hear about SFAS 133, which governs accounting for derivatives.  The 2009 10-K, filed February 25, 2010, makes no mention of SFAS 133.  In fact, it makes no mention whatsoever about what FASB standard governs the company’s derivatives accounting.  The company simply states in the 2009, 2010 and 2011 10-K’s [emphasis added]:

“Derivative instruments (including certain derivative instruments embedded in other contracts) are recorded at fair value and included on the consolidated balance sheets as assets or liabilities. The Company did not designate these contracts as cash flow hedges; therefore, the changes in fair value of these instruments are recorded in current earnings. The Company determines the fair value of its derivative financial instruments utilizing pricing models for significantly similar instruments. Inputs to the pricing models include publicly available prices and forward price curves generated from a compilation of data gathered from third parties.”

Given the magnitude of the impact the company’s accounting practices for its put contracts has on its financial statements, much more information needs to be fully disclosed so investors will be able to evaluate the sustainability of the current distribution in the future. 

Furthermore, the company noted in its February 15, 2013 8-K that, “LINN has identified other publicly traded partnerships that purchase derivatives, and all of these companies account for derivatives the same way LINN does.  In fact, LINN has yet to identify any publicly traded partnerships that account for it differently.”  Given this categorical statement, we request the company produce a list and show investors the relevant disclosures of publicly traded companies that amortize the cost of puts through unrealized losses and do not include the cost of those puts anywhere in their DCF calculations when communicating its distribution coverage ratio to investors.  The company appears to want to give the impression that their hedging strategy is commonplace in the industry but LINE is the only producer that we found that uses naked puts as a hedging strategy for anything more than a very small amount of its production.  We cover numerous MLP and E&P companies and yet have not found another company that chooses to hedge a significant percentage of its production with in-the-money puts (or naked puts of any kind) or account for its puts as a capitalized cost that is amortized through unrealized losses.  We detail the hedging strategies of 31 companies in our Appendix.

Purchased Adjusted EBITDA Through M&A:

LINE purchases deep in-the-money puts, which are very expensive, to make M&A activity look more accretive than reality.

For example, on February 27, 2012, LINE announced that it was acquiring Hugoton Basin assets from BP.  The price was $1.16B and the deal was expected to close on or before March 30, 2012.  LINE estimated a positive impact to 2012 Adjusted EBITDA of $160m – thus they paid 7.25x for the asset.  LINE trades at a significant premium to this multiple; hence, this deal was accretive. 

What the company did not say is that the $1.16B purchase price excluded $150m to purchase deep in the money puts on natural gas at a strike of $5.00 (spot natural gas at the time was ~$2.50) that were necessary to claim that the asset generated $160m of forward Adjusted EBITDA.  Under BP’s ownership, these assets expected to generate $102m of annual EBITDA.  LINE filed an 8-K/A on April 30, 2012 detailing the audited (by Ernst & Young) financial statements of the Hugoton assets LINE purchased from BP (closing date March 30, 2012). The 8-K/A indicates that the amount of EBITDA (the company terms it ‘excess of revenues over direct operating expenses and third party natural gas purchases’) the Hugoton assets generated in the first three months of 2012 was $25.6m.  Annualized this comes to $102.3m.  So for the company to claim that this asset will generate $160m in annual Adjusted EBITDA in 2012 would require an incremental $58m of Adjusted EBITDA.  Where did the incremental $58m come from?  From the hedge book of course.  We believe the incremental $58m is generated by “gains on hedges.” 

We also note that while the deal was announced on February 27, 2012 and closed March 30, 2012, the effective date for the acquisition according to the company was January 1, 2012.  How could a deal that closes on March 30 actually be effective on January 1?  When two E&P companies complete a deal there is an effective date after which all future cash flows generated by the asset start accruing to the purchaser from then forward.  The deal price is based on the estimated cash flows the asset will generate before and after the effective date, not the closing date.  This is important to LINE as we note that the very first line of the Adjusted EBITDA reconciliation is called “Net operating cash flow from acquisitions & divestitures, effective date through closing date.”  This reconciliation line enables LINE to purchase companies intra-quarter, close the deal before quarter end and add back all of the operating cash flow to Adjusted EBITDA and DCF as of the beginning of the quarter.  This is highly misleading as the company issues debt and equity securities to purchase these assets; to claim that the cash flow generated by the assets between the effective and closing dates boosts Adjusted EBITDA and DCF is remarkable.  To prove this point we highlight a disclosure from the Purchase and Sale Agreement struck between LINE and BP that was filed as an exhibit with the 10-Q on April 26, 2012.  This is important because the Purchase and Sale Agreement makes it very clear that the estimated cash flows generated by the acquired asset after the effective date are taken into account when determining the purchase price of the acquired asset (see 6.2.4 below):

6.2.1 SELLER IS ENTITLED TO ALL REVENUES AND ACCOUNTS RECEIVABLE ATTRIBUTABLE TO THE PROPERTIES IT TRANSFERS, AND IS RESPONSIBLE FOR ALL EXPENSES, ACCOUNTS PAYABLE AND CAPITAL EXPENDITURES ATTRIBUTABLE TO THE PROPERTIES IT TRANSFERS, IN EACH CASE TO THE EXTENT THEY RELATE TO THE PERIOD PRIOR TO THE EFFECTIVE TIME.

6.2.2 SELLER ALSO IS ENTITLED TO THE SUM OF THREE HUNDRED FORTY THOUSAND DOLLARS (US$340,000) PER MONTH (PRORATED ON A DAILY BASIS FOR ANY PARTIAL MONTH) (AS AN AGREED REIMBURSEMENT IN LIEU OF SELLER’S ACTUAL OVERHEAD) FOR THE PERIOD FROM THE EFFECTIVE TIME UNTIL THE CLOSING DATE.

6.2.3 BUYER IS ENTITLED TO ALL REVENUES AND ACCOUNTS RECEIVABLE ATTRIBUTABLE TO THE PROPERTIES IT ACQUIRES, AND IS RESPONSIBLE FOR ALL EXPENSES, ACCOUNTS PAYABLE AND CAPITAL EXPENDITURES ATTRIBUTABLE TO THE PROPERTIES IT ACQUIRES, IN EACH CASE TO THE EXTENT THEY RELATE TO THE PERIOD FROM AND AFTER THE EFFECTIVE TIME.

6.2.4 SELLER SHALL ESTIMATE THE ABOVE AMOUNTS AND INCORPORATE SUCH ESTIMATE INTO THE PRELIMINARY SETTLEMENT STATEMENT. THE ACTUAL AMOUNTS (TO THE EXTENT THE SAME DIFFER FROM THE ESTIMATE INCLUDED IN THE PRELIMINARY SETTLEMENT STATEMENT) SHALL BE ACCOUNTED FOR IN THE FINAL SETTLEMENT STATEMENT.

We also highlight that this deal was not closed until March 30 and yet it generated $39.1m of ‘operating cash flow’ (OCF) that directly boosted Adjusted EBITDA (almost exactly one quarter of the $160m annual run rate the company anticipated).  Remember that the 8-K/A filed on April 30, 2012 indicated that this asset generated EBITDA of $25.6m during this time frame.  Where did the incremental $13.5m come from (calculation: $39.1m reported in Adjusted EBITDA minus $25.6m reported in the 8-K/A)? How did this asset generate this much OCF unless the company hedged its cash flows starting January 1?  Also, the company did not even assume supervision of operations at Hugoton until July 1, 2012.  Finally, we note that this non-GAAP accounting treatment effectively converts debt issuance into Adjusted EBITDA and DCF: LINE issues debt to purchase a company intra-quarter and then adds ALL of the operating cash flow from that acquisition into Adjusted EBITDA despite the fact that the purchase price (funded by debt) clearly reflects the operating cash flow generated from effective date to closing date.

Further, while the Hugoton deal supposedly cost $1.16B and in the original press release was set to be funded via the company’s revolving credit facility, on the same day as the acquisition announcement, LINE announced a private offering of senior notes in the amount of $1.5B, “to fund the pending Hugoton Basin acquisition, repay indebtedness under its revolving credit facility and for general corporate purposes.”  Ultimately, the deal was sized at $1.8B.  The question is: for a $1.16B acquisition, why did the company need to raise $1.8B in debt?  Where did the other $540m go?  We believe that the company needs to issue excess debt and equity in order to cover their distribution; this makes sense given the fact that the company’s free cash flow (operating cash flow less maintenance capex) does not cover the distribution. 

More recently, LINE announced a $1.025B acquisition of properties in the Jonah Field from BP on June 25, 2012.  In conjunction with the deal, the company increased the size of its revolver from $2B to $3B in order to pay for the acquisition.  The very same day, LINE filed an S-1 registration statement for the upcoming IPO of LinnCo (LNCO), an entity designed to do one thing: hold shares of LINE and pay out ordinary dividends to institutional holders who ordinarily stay away from MLPs due to K-1 tax issues.  LNCO ultimately raised $1.2B, net from the initial offering, which was fully subscribed, which it used to purchase LINE shares during Q412.  The question is: for a $1.025B deal, why did the company need to increase its revolver by $1B AND raise equity of $1.2B?   

Magnitude:

Since 2006 LINE has generated cumulative net realized gains on derivatives of $1.3B which have gone right into Adjusted EBITDA and Distributable Cash Flow (DCF).  DCF over this same period was $2.5B – thus 52% of Linn’s DCF since inception has been generated by the derivatives portfolio.  A portion of these realized gains are legitimate as the company purchased puts and swaps that moved in the company’s favor and have been exercised in the money for legitimate hedging gains.  Due to the fact that the company must book ‘manufactured’ unrealized losses related to the cost of its puts to balance their inflated realized gains we can parse out what proportion of these realized gains are generated by the company’s unique accounting by tracking the unrealized loss account over time.  Before we get to the calculation, we assume that LINE does not have meaningful cumulative unrealized losses since the hedge portfolio is undoubtedly in the money (could be as much as $150m per our estimate); current natural gas prices are considerably below LINE’s hedged levels according to their SEC filings.  Further, we know that the swap portfolio is almost entirely in the money because the company’s net derivatives liability is extremely small ($10m as of Q312) – floating-to-fixed swaps create a derivative instruments liability on the balance sheet if the price of the underlying rises after inception of the swap. 

Since inception, LINE has cumulative unrealized losses of $471m.  There are two items that make up this account: actual unrealized gains or losses from the fluctuations of the derivatives portfolio and ‘manufactured’ unrealized losses related to the amortization of put premiums.  We believe the hedge portfolio is substantially in the money but for this exercise let’s assume that there are zero legitimate unrealized gains currently in the portfolio.  As a result, we believe that LINE has added back at least $471m of put-related expenses to Adjusted EBITDA and DCF since inception.  This $471m represents 19% of the company’s $2.5B of Distributable Cash Flow generated by the company since inception.  Simply, we believe that in the best case put premium amortization alone has generated 19% of DCF since 2006. This overstatement has been climbing rapidly recently due to the large derivatives purchases the past year ($658m total); we estimate over $80m of put premium amortization has been run through unrealized losses in each of the past two quarters.

We feel a better way to estimate the magnitude of Adjusted EBITDA add-backs related to LINE’s amortization of derivative premiums is to take LINE’s reported put premiums paid and estimate quarterly amortization over a five year period (the company hedges production out five years on average) with an assumed average put life of 2.5 years (LINE purchases OTC puts in a five year strip designed to hedge quarterly production).  This exercise enables us to more closely estimate on a quarterly basis how much LINE is likely overstating Adjusted EBITDA.  It also does not penalize LINE for derivatives purchased today which have utility in the future.  Using this approach, we assume that every quarter in which LINE buys derivatives they amortize the cost of those puts straight line over a five year period.  Our analysis follows on the next page and we have attached a more detailed analysis in the appendix.  In summary, we estimate LINE has added back $860m to Adjusted EBITDA and DCF since inception related to amortization of put premium; this represents 34% of DCF generated since 2006.

In our analysis on page 10 we also adjust for LINE’s ‘Net operating cash flow from acquisitions & divestitures, effective date through closing date’ (please see our previous section titled ‘Purchased Adjusted EBITDA Through M&A’).  We detailed our thoughts on this issue on pages 7-8: the crux of the issue is that LINE purchases new assets intra-quarter and takes credit for all of the Adjusted EBITDA the company generated before the deal actually closes.  We adjust this line item down to zero as LINE’s purchase price of these assets undoubtedly reflects the cash generated by the assets between the effective and closing dates of the acquisition.  Since 2006 LINE has added back $186.2m to Adjusted EBITDA related to ‘Net OCF from acquisitions & divestitures, effective date through closing date.’  This represents 4.3% of Adjusted EBITDA generated since 2006 and more importantly 7.3% of DCF generated since 2006.  The problem is even more acute recently: ‘Net OCF from acquisitions and divestitures, effective date through closing date’ over the past three quarters was $81.6m which represents 7.8% of Adjusted EBITDA and 16.1% of DCF over that time period.  

This analysis yields a very different looking picture of Adjusted EBITDA, DCF and DCF coverage ratio compared to the one presented per the company’s accounting on page 3.  Specifically, we calculate that LINE’s 2011 Distribution Coverage Ratio was 0.86x – a far cry from the 1.21x reported to investors.  More recent data looks worse – we calculate that the Coverage Ratio was just 0.51x over the last nine months. 

Over the past four quarters LINE has reported Adjusted EBITDA of $1.32B and DCF of $668m.  We estimate their derivative premium amortization over that time frame was approximately $244m.  That means that wholly 37% of the company’s DCF over the past year is due to put amortization and therefore ‘manufactured.’  Similarly, during FY11, we estimate that the company’s derivative premium amortization was $105m vs. DCF of $570m – that means 18% of DCF was generated by put premium amortization. Further, over the last four quarters LINE has ‘generated $102m of EBITDA related to companies purchased and deals closed intra-quarter; that’s 15% of DCF over that time frame.  Similarly, during FY11, Net OCF from acquisitions & divestitures ‘generated’ $58m of EBITDA, or 10% of DCF.  In totality, these two issues boosted DCF artificially over the trailing 12 months and FY11 by 107% and 40%, respectively.

Other Derivatives Issues:

Recently, LINE has increased the strike prices on its hedges.  In September 2011 LINE canceled oil and natural gas contracts for 2016 and used the realized gains (aka cash settlements) of $27m to increase the strike prices on its existing oil and gas swaps for 2012.  Given that the company recognizes the full intrinsic value of a swap when exercised, this maneuver effectively took $27m of Adjusted EBITDA and DCF that was to be recognized in 2016 and moved it into 2012.  LINE addresses this transaction in its February 15, 2013 8-K, “this is extremely rare and the magnitude of the trades is immaterial.”  The company is currently guiding 2012 DCF of $684m; $27m represents 3.9% of that DCF metric.  Given that the company’s target distribution coverage ratio for 2012 is 1.14x, a reduction in DCF of $27m would lower the distribution ratio to 1.09x – hardly immaterial.  Additionally, in Q412 the Company paid $33m in additional premiums to increases prices on existing oil puts for the years 2012 and 2013.  Also in Q412 the company paid $22m to increase the prices on its existing 2012 and 2013 puts.  Thus, the company paid $55m ($33m + $22m) to increase the intrinsic value of their existing puts in order to convert $55m of cash today into $55m of Adjusted EBITDA that will be recognized in 2012 and 2013.  LINE does not address these Q412 transactions in the February 15, 2013 8-K.

One more issue: LINE excludes “realized gains and losses on canceled derivatives” from their Adjusted EBITDA calculation.  The company claims that these canceled derivatives do not impact current production and therefore do not impact cash flow (EBITDA).  The company, however, has cumulative losses on canceled derivatives since inception of $130m.  It would appear that if a derivative contract is in the money at expiration the company exercises it and recognizes it as a realized gain but if not, they cancel it and back it out of Adjusted EBITDA.  The company noted in its February 15, 2013 8-K, “on two occasions the company canceled hedge positions, which happened to be out of the money at the time, to comply with its bank covenants when selling assets.”  We are puzzled by this statement since the company clearly has canceled derivatives on more than two occasions; the company has reported realized gains/(losses) on canceled derivatives in Q208, Q308, Q109, Q209, Q309, Q210, Q310, and Q311.

A New Equity Vehicle: LinnCo (LNCO):

It appears that LINE has largely tapped the retail equityholder market via their core MLP structure; the retail market can only handle so many $700m+ equity deals.  Thus, in order to pursue ever larger deals, the company had to get creative and target the institutional shareholder market by launching LinnCo (LNCO) in October 2012.   The company noted on its Q312 earnings call, “We believe LinnCo has the potential to be a game changer for Linn Energy, as we expect it to expand Linn's investor base by attracting incremental institutions, tax-exempt organizations, and incremental retail investors, including IRA accounts.  Linn's sole purpose is to own Linn units, and shareholders will see the cash dividend in Form 1099 instead of a distribution and scheduled K-1.  Since our inception, Linn has always been on the forefront of creativity and innovation, and our involvement in the creation of LinnCo is no exception, as we believe it is a revolutionary product for the MLP sector.”  We feel the LNCO structure is another way LINE has been able to engineer EBITDA accretive deals in order to increase their distribution.  We note that LNCO trades at about parity with LINE but does trade about 40% as many shares daily as LINE.  The main appeal of LNCO is that its institutional shareholders do not have to deal with the tax issues associated with MLPs. 

Valuation and Price Target:

Our price target is based on what we think a sustainable distribution could look like. We believe that LINE’s sustainable DCF is close to $1.70 per share or about 50% below Street estimates.  At the same distribution yield as the current one, 8.0%, the stock would trade at $21.25 (-41%), much closer to the company’s book value of ~$18.00 per share (the stock currently trades at 2.0x book value).

At a minimum, we believe investors should be made aware of the exact amount of put amortization that LINE runs through Adjusted EBITDA on a quarterly basis as well as Adjusted EBITDA purchased through M&A activity so that investors can judge for themselves the quality and sustainability of LINE’s distribution.

DISCLAIMER: The author is short LINE and LNCO.  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read LINE/LNCO public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of LINE and/or LNCO without notice.  

Appendix:

DISCLAIMER: The author is short LINE and LNCO.  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read LINE/LNCO public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of LINE and/or LNCO without notice.  

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