Linn Energy, LLC (LINE)

The Thesis

Linn Energy (LINN) is a gas-weighted LLC-structure oil & gas producer. Since their IPO in early 2006 they have been very acquisitive & their original asset base in Appalachia now represents less than 15% of total reserves. Since these acquisitions were funded primarily via PIPEs, there is a large overhang of unregistered units that are just starting to come to market. As large acquisitions start to drive distribution growth, sales of newly registered PIPE shares are depressing unit price, leading to a great opportunity to purchase tax-advantaged cash flows. LINE will pay distributions of at least $2.52 in 2008 & trade at a 9% yield forward by 3q08 generating an IRR in excess of 40%.

The Company

LINE is an LLC-structured oil & gas company that employs about 600 people. They IPOed in early 2006 with an asset base of 99% gas reserves in Appalachia. Later, the company acquired assets in California's Brea Olinda field, which are primarily (89%) oil weighted & roughly doubled reserves. In the latter part of 3q07, the LINE gold fish swallowed a Dominion whale by purchasing Dominion's Mid-Continent assets, which now represent 74% of the company's reserves. See below for more details about each of these asset bases.

In case you're keeping track, those are some kind of largish acquisitions for a newish kind of company. Since their IPO the company has done $3B+ of acquisitions. A large chunk of those acquisition dollars have been crammed into the August 2007 acquisition of Dominion's Mid-Continent assets. $2.7B of that $3B+ acquisition price tag was funded with equity & most of that equity was distributed via PIPE offerings.

Consider that LINE came public with a headline offering of 11.75MM units. Before their last registration became effective on 20nov07 the company had 114MM units outstanding & 86MM of them were unregistered. After the 20nov07 registration LINE still has 48MM unregistered units, or about 42% of all outstanding units. That's a big overhang of PIPE units that have been looking for a home.

LINE management have said several times they would like their unitholder base to be about 70% retail & 30% institutional. Most institutional investors that participated in the PIPES are doing their best to help LINE meet that 70/30 objective based on recent unit price action. The units have fallen from just a shade below 40 to the mid $23 range & short interest has gone from 650k units in the middle of July to about 2.5MM units in the middle of November.

Tax Advantaged, Secure Yield

LINE is an LLC so it enjoys some profound tax benefits. In 2006, LINE distributions were 100% tax shielded. During their 3q07 conference call, LINE management indicated 2007 distributions were likely to be 100% tax shielded once again.

Also, 95% of 2008 production is hedged via swaps & puts at a blended price of $8.35 per mcf equivalent. Similar volumes are hedged through 2011 at $8.17+ per mcfe. Part of Linn Energy's acquisition strategy has been to lock in financial returns via hedges at the time of purchase. Meaning if they say they can support a distribution of 63 cents per quarter there's tremendous visibility into 2008 cashflow to back that up.

Consider Jane Investor who is in the 25% tax bracket & holds securities in a taxable account. To achieve after tax yield equivalence Jane would have to find a qualified dividend security yielding 12.5%. To achieve after tax yield equivalence with a BDC or REIT, Jane would have to find a security yielding in excess of 14%. It might be possible to find those yields but not at the risk profile that LINE provides. So, good luck Jane!

Finally, notice that LINE is an LLC, not an MLP. There are no incentive distribution rights, or IDRs. With MLPs that have IDR, once total distributable cash meets or exceeds certain target amounts the General Partner gets an increasing share of incremental cash flows. Typically the GP starts out getting 2% of distributable cash & ends up getting 50% of incremental distributable cash. Often after very nominal 25% to 35% increases in absolute distributions to the limited partners. Not so at Linn Energy. Management participates exactly like unitholders do. Obviously, that means more money in unitholder's pockets but for a roll-up vehicle like LLC/MLPs it also means faster distribution growth, which means a higher stock price, which means more accretive acquisitions.

The Properties

Linn Energy has about 1.6tcf of proved reserves spread out over three asset bases. The company operates over 7500 oil & gas wells & operates or participates in over 8500 oil & gas wells. In aggregate, their assets have a reserve life index of 20 years. LINE have over 5000 drilling locations, or about a decade of drilling inventory, that they believe will drive 7% organic growth for many years to come.

The original asset LINE came public with is Appalachia. This region currently represents 14% of reserves & 12% of production. Production here is almost all gas & characterized by a very long reserve life index of 25+ years. So it's no surprise that there are scads of drilling opportunities in inventory...over 1100.

To offset nearly-all-gas Appalachia, LINE acquired nearly-all-oil Brea-Olinda in the LA Basin. This asset represents 12% of total reserves & 7% of total production. Production here is 89% oil & has a reserve life index in excess of 40 years. Oil here is so heavy it barely qualifies as liquid. However, LINE separates liquids from gas production & uses it to upgrade crude from 21 API to 24 or 25 API. Meaning they can upgrade product from 'heavy crude' to 'medium crude'.

The crown jewels are the Mid Continent assets, representing 74% of total reserves & 81% of total production. This great gob of acreage & production was purchased from Dominion in August of 2007 for a couple billion dollars. LINE already purchased over 500MM of assets in the Texas Panhandle earlier in the year, so they're really reaching critical mass in that region of the country. LINE have interests in over 4700 wells in the mid continent region and a production profile that is about 90% gas & reserve life indices vary from 11 years in the Granite Wash to 17 years in the Anadarko Basin to 18 years in the OK-KS shallow gas.

Most of Linn Energy's capital budget will be dedicated to the mid continent assets in 2008. Eleven of the 14 rigs LINE employs are working in the mid continent region. Doing the math, LINE have over 3500 drilling locations in their mid continent asset, so 11 rigs can stay busy a long time in the area.

But there is some hidden production in the mid continent asset that won't require one red cent of capital to develop. Dominion had retained a volumetric production payment contract associated with the property. This contract transferred with the sale of the asset, but it expires in April of 2008. What it boils down to is 16mmcfe of production that LINE does NOT get. After the VPP contract expires in April they will get that production. The company entered 4q07 producing about 200mmcfe per day so that represents an 8% production increase free & clear.

Valuation

LINE BOD will meet the second week of December & at that meeting management will recommend to the board that they approve a quarterly distribution of 63 cents per unit. That's $2.52 annually, or about 10.5% yield based on a $20.68 unit price. Given Linn Energy's hedged position for the next 5 years & the tax-advantaged nature of their distribution that is a very attractive yield.

Since 1996, the Alerian Master Limited Partnership index has traded at a mean yield of 7.77% with standard deviation of about 1.24%. In other words, in 84% of all trading days since January of 1996 MLPs in aggregate traded at 9% yield or better. Once the distribution is increased to 63 cents and the overhang of PIPE units wears off, LINE will trade within one standard deviation of historic MLP yields, or 9%. Further, they will meet their organic growth target of 7% in 2008, leading to a distribution increase of two cents by 3q08. That will result in an IRR of over 44%.

If you don't like relative valuation models, take a look at a simple dividend discount model. Assume a current distribution rate of $2.52, discount rate of 11%, and constant growth rate of 2%.

IV = $2.52/(11%-2%) = $31.50

Or more than 30% above today's price. We already know from LINE management that they have the drilling inventory to grow 7% every year organically. A two-stage DDM using a 5% organic growth rate over the next decade and 2% thereafter indicates LINE is worth more than $33/unit, or more than 40% above today's price.

Of course, we're not dealing with an asset that can operate in perpetuity. Even an acquisitive oil & gas company like LINE can't grow production per share forever. Eventually suitable acquisitions run out, decline sets in, and production reaches a level that is no longer economic. Any decent model should contemplate this. Linn Energy claim to have a drilling inventory that will allow them to grow production organically at 7% for the next decade. Let's assume they are able to do 6% distributable cash flow growth per unit, either by the bit or by acquisition, over the next 10 years. After that they are able to scratch and claw to maintain level distributable cash flow growth for another decade. Finally, production declines 6% per year over the next 15 years & unitholders get nothing in the end.

Using those assumptions & discounting at 11%, present value is >$30.50. Or more than 29% over a $23.68 unit price.

Bottom line, LINE is anywhere from well to fantastically undervalued at current levels. Especially given it's growth prospects, tax-advantaged nature, and unitholder friendly structure.

Reasons to buy LINE:

1. The dividend is 15%. Furthermore, most of this dividend is tax deferred even in an ordinary account. Settlement on the tax-deferred portion occurs when you sell the equity – it is regarded as a return of capital and is an adjustment to your capital gains.
2. Although the company could be affected by changes in the commodity prices of gas and oil, LINE is 100% hedged, at attractive prices, for 2009, 2010 and 2011, and is 67% hedged for 2012. According to the CEO, the price of gas or oil could fluctuate ±15% without affecting the dividend payout.
3. It is the largest public E&P MLP in the country with a 21 year reserve life (which is one of the best in the sector). This gives the partnership more stability in these uncertain markets.
4. The CEO has recently announced that it will buy back up to $100M worth of units because they are significantly undervalued.

The price for LINE was hit hard by the recent downturn. In fact, the bankruptcy of Lehman Brothers affected LINE in two ways. First, Lehman was the largest single holder of MLPs, including LINE, and the liquidation of those holdings drove the prices down dramatically. Second, Lehman was counterparty to LINE’s oil and gas hedges. Fortunately, LINE was able to re-establish those hedges at the same price and for the same duration very quickly before oil and gas commodity prices dropped, but they are seeking to recover $68M from Lehman as a result of having lost the original hedges.

There are consequences to owning an MLP. There are two reasons why it is suggested that MLPs should not be held in tax deferred accounts. The first is that much of the income is already tax deferred as a form of capital gains. The second has to do with “unrelated business taxable income” (UBTI). In a tax deferred account, if the amount of UBTI is greater than $1,000 there is a tax consequence on the excess. UBTI is reported on a K-1 (the 1099 for MLPs).

this company is a recent spin from CNX. They recently acquired large natural gas reserves and are rapidly ramping up production. The distribution has already been raised twice in less than six months and is due to go up again in the next quarter.

This stock has been bouncing around a little bit in a range of about 12.50 and 17.00. With a dividend of $0.63/quarter, it represents a 20% yielder when you buy around $13. The company has hedged oil and gas sales well into 2011 and they claim that there dividend is safe at least for that duration. I personally can't see either of these commodity prices staying where they are now (definitely not through 2011) so I say it is safe long term. They have consistently increased their reserve and hedged to mitigate the volatility of the commodity markets.

I wouldn't spend too much effort trading this, I consider it a long term play, just pick it up when it is cheap. Set it and forget it.

Linn Energy is an independent oil and gas company focused on the development and acquisition of long life properties in the United States. They operate in the following regions:

• Mid-Continent — core operating areas in the Texas Panhandle and Oklahoma; and
• Western — the Brea Olinda Field of the Los Angeles Basin in California.

Linn Energy hedges nearly 100% of their production for up to five years, and all hedging income (losses) are reported on the quarterly and annual income statements, creating a jumbled mess when it comes to trying to figure out recognized income for a period. We try to analyze current earnings as going rate commodity prices plus/minus recognized gains/losses on hedges to arrive at the quarterly revenues, stripping out gains/losses on future hedges, under the assumption that we will pick those up in future periods. Linn operates under the tenet that constant cash flows are better the volatile ones. We tend to agree with this philosophy. Under our revenues model, we have calculated LINN recognized revenues for the past four quarters as:

Q1 - $195m unhedged, $185m hedged

Q2 - $255m unhedged, $230m hedged

Q3 - $240m unhedged, $218m hedged

Q4 est. - $150-$170m unhedged, $175-$201m hedged.

In the first three quarters, operating income was approximately 36%, 48%, and 39% of hedged revenues, respectively. We expect Q4 to be in the 30%-36% range, producing between $55-$75m of EBIT. Overall, with the hedging mechanisms in place, we believe that this income stream will definitely continue into the future, and grow substantially based on Linn’s management acumen, commodity price rebounds, capacity increases, or any combination thereof.

Linn consistently produces positive operating cash flows based on realized income levels, and investments into future hedging devices. As an oil and natural gas company it requires substantial investment in fixed assets.

Linn’s current dividend policy is set at 62.5 cents per quarter or $2.52 per unit. Earnings at the partnership level are not taxed (Energy MLP), but this payout is taxed at the investor level (ordinary income) and totals approx. $290m a year. On income of $200m this is a bit worrisome, and we don’t foresee this level into the distant future, unless of course commodity prices rebound dramatically, and income rises sharply, which would be great news for LINN owners. However, I feel the dividend will eventually decrease to a more sustainable level closer to 100% payout ratio.

On the institutional side, Baupost Group, an investment vehicle run by the extraordinary value investor Seth Klarman has a substantial stake in LINN Energy (might actually be his largest holding) which based on his historic results bodes well for our decision to purchase. We don’t necessarily decide to invest just because a respected institution is “all-in” but it definitely makes us take a detailed look.

In the current market conditions, we see substantial value in energy stocks in general. Does anyone believe that commodities will remain at their current levels indefinitely? Where will they be in five years? Linn has taken most of the market uncertainty out of the equation. We can calculate a relatively stable revenue stream and earnings for five years. Where else can you find this in the current market?
Valuation:

We estimate total year realized income of approx. $200m in FY 2008 and a conservative 5% growth rate, a CAPM discount rate of approximately 11% produces an earnings multiplier of 16.6 (keep in mind, we are calculating based on realized income only, which is very different than GAAP earnings) and a total enterprise valuation of $3.3B, which is a 74% premium to what it is trading at today.

As of Sep. 30, Linn had assets of $4.0B and liabilities of $1.9B, therefore a book value of approximately $2.1B a slight premium to its market cap ($1.9B). Most ($3.6B) is tied up on PP&E which makes sense given the industry. Due to the subjectivity in valuation of the PP&E , we do not have an interest in speculating on the book value multiple it should be trading at (as it would take expertise on the side of valuing natural resources). We are intrigued by the company trading at below book value, but do not weigh this metric as heavily as cash flows or earnings.

With a new democratic president in office, there is a risk that the tax-free status of energy partnerships will disappear. This could have a major effect on the income of LINN Energy (decreasing it by 40%). In addition, commodity prices have been highly volatile, and could continue to be highly volatile in the future.
The Bottom Line:

Bullish on their dividend yield.

Conan Holder < 1.5 (bankruptcy risk > 75%), Altman for private companies Z score < 1.23. This company is in bad shape; other companies with valuation problems: BOW, CMS, TRY.B, LUK, LPX, SNSTA, TECUA, XRIT, CAR, VOD, GDP, MDZ, MCF, EPL, VMED, MIC, LINE, BKD ,AAV, EROC.

At this time of extreme volatility in share prices I am looking for a home for my investments that will give me a robust dividend yield.
This is my first foray into MLP's (master limited partnerships) and I have to confess I am still learning about them. In the past I would probably have looked to REIT's to provide a solid ongoing yield but I can't see the real estate sector recovering for a while, whereas energy, though impacted by the recession is still a basic need and is not in as bad a shape as the aforementioned real estate. The current double digit yields make this too good an oppotunity to miss.

Natural gas master partnership has hedged its gas prices around $9 for the next 2 years.... so people think you can't lose with a 17% yield.... but watch you will lose when the hedges run out this thing will barely be profitable.

The market will start discounting that now and it'll just get worse as the years go on.

I heard about them at a recent Lehman Bros. MLP conference and I like the idea behind the business. I really think MLP's are a good way to go as a play on baby boomer retirements who want growth and yield and LINE is a different way to play this sector.

While I've been burned by poor timing in calling an oil and gas rebound too early, I'm still standing buy my thesis that we'll probably see a primary bull market in energy commodities in 2009. OPEC will be cutting production, and political turmoil in places like Nigeria and Russia could cause a run. Also, with a lot of analysts seeing an economic recovery by the end of 2009, the next few months will probably see speculators getting back in to fossil fuels.

Also, I always like to reiterate that one shouldn't read too much in to the new Administration's focus on "renewable energy." Fossil fuels are here to stay for a long time, and no one man or political movement is going to change that.

As someone else indicated, Linn has good financials, a strong, safe yield, and solid management. I always like founder-managed companies, and they seem to have a conservative strategy for acquiring properties. I see them as a miniature, younger version of XTO, which has been one of my favorite stocks. Should be a winner going forward.

Linn Energy looks like a good inflation hedge. The hefty dividend makes this stock worth holding even if its stock price moves sideways for a while.

All glory to The Hypno Toad

100% hedged through 2011 IIRC. This means the dividend is secure until then. Also a mountain of cash, due to selling a hard-to-develop gas field at the top.

This pays a great dividend. Cash flow looks ok but they don't seem to make profits very regularly. It's a gamble but one I'm willing to take.

Pay out seems secure due to good hedges and can survive the uncertain energy policy.

Great Dividend play!!!!

This feels unreal how cheap this stock is...

Part of a long list of stocks to be unfairly beaten down by Lehman liquidating their investment portfolios in bankruptcy.

High maintainable idividend rate