Linn Energy: Bad news or strong buy?
Despite skeptics, this high-yielding energy company keeps growing through acquisitions.
By Roger Conrad, MLP Profits
A big blow came against Linn Energy LLC (LINE) with allegations of accounting irregularities questioning management's hedging strategy and true profitability. The result was selling momentum that took the unit price down as far as $34.27 in February.
Since then, however, bears have been seriously chagrined by two major events. In fact, those who bailed will want to seriously consider taking positions again in this undervalued, fast-growing energy producer in the midstream business.
First, Linn posted another round of solid numbers with its fourth-quarter and full-year earnings release. Average daily production rose 88% for the quarter, reflecting the successful integration of four big acquisitions completed in 2012.
That translated to a boost of 35% in cash flow, adjusted for one-time items. And distributable cash flow covered the payout by a 1.07-to-1 margin for the quarter and 1.14-to-1 for the full year.
The best news, however, was the company's 42% boost in its proven reserves in the ground, as it recorded a reserve-replacement ratio of 869%.
This growth continued Linn's heretofore successful transition from being mostly a gas producer to primarily a liquids-focused company. And it reflected the continued success at its key Granite Wash play.
Linn's biggest news was the blockbuster $4.3 billion all-stock acquisition of Berry Petroleum; the merger continues the consolidation of North America's energy patch, which is enjoying a record drilling boom.
By adding Berry's reserves, which are 75% oil, Linn gets more regional scale as well as long-life, low-decline, mature assets that will immediately raise overall production 30%.
It also increases Linn's proven reserves (which have a 90% or better chance of development) by 34% and increases the liquids portion to 54% of overall assets in the ground.
Linn's current estimate is the Berry purchase will add $0.40 per unit to distributable cash flow. Management announced an immediate flow through to unitholders in a 6.2% distribution increase. That's expected to be effective with the May payment, assuming timely completion of the merger in the first half of 2013.
There's no question hedge accounting adds a layer of complexity for analyzing Linn that's not shared by other energy producer MLPs. And some analysts have looked at Linn's wells and found them to be on balance smaller and less predictable as well.
The Berry merger's scale and the nature of the added assets should answer at least some of the concerns on the second count, as it adds what are generally low-decline wells. That point was made by Moody's, which changed Linn's outlook to "developing" from "negative" following the merger announcement.
As for the hedge accounting, Linn's has been the subject of scrutiny in previous years, but never with anything that stuck. And though wide North American energy-price differentials -- coupled with soft economic growth -- are what amounts to a stress test for all accounting models this year, Linn's appears to be holding up.
Of course, regardless of how much it hedges and how well it does so, Linn is at its core an energy producer. Although it appears to have locked in prices for planned output through 2017, earnings are ultimately affected by commodity prices.
That's a risk all investors who buy the units should keep in mind. But so long as Linn Energy trades under $40 and continues to perform, it's a "strong buy" and a top pick for new money. The stock is a solid value yielding upward of 7% with considerable upside for the rest of 2013.
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