LINE Under Attack but Thesis Has Not Changed; SB1 Rating
Recommendation:While we are admittedly surprised by the length of the bear raid on LINN
Energy, in our view, we are in the last inning which is likely to result in a large short covering
rally. Given the significant accretion that we expect from its pending Berry Petroleum (BRY)
acquisition, LINN’s newly implemented monthly distribution policy (which should limit short
selling speculation), the pending 6% sequential distribution increase in 3Q13, and encouraging
early results on the company’s Hogshooter acreage in Oklahoma, in our view LINN is a
compelling growth stock. As such, we reiterate our Strong Buy rating.
♦ Barrons Takes Another Swing at LINN’s Business Model:On Saturday, Barrons wrote its
third negative article on LINN Energy. Once again claiming the partnership’s cash flow was
overstated and that LINN does not cover its distribution. The surprising new claim was
that LinnCo has a large tax liability that becomes due in 2016. While it is unfortunate the
article does not take the time to deeply go through these issues, and seems to be backing a
negative agenda, we will oncetry to correct the misinformation in the marketplace.
♦ Put Derivatives – Nothing New but Happy to Revisit It:We have already written
numerous research reports about this issue. As we describe in detail on the following
page, LINN’s hedging strategy has been essentially in place since the partnership went
public in 2006. LINN has historically viewedputs as a capital costs associated with
acquisitions. It is important to remember the discussion isabout non-cash charges that
have no future impediment on LINN’s ability to pay its distribution. Also that management
has stated they no longer intend to buy puts given the frustration in the market place.
Sentiment: Strong Buy
1Q13 Light on Production Impact;
Our View: Despite a quarter light to expectations with infrastructure
constraints and ethane rejection that lowered volumes and realizations,
we believe LINE remains well positioned to capitalize on accretive
growth opportunities offered by the strong A&D market. Its competitive
advantages, track record, optionality and catalyst-rich asset base warrant
an Outperform rating.
1Q13 Results Below Estimates.LINE reported 1Q13 production of 796
MMcfe/d, 3.6% and 3.8% below our 826MMcfe/d and the Street’s
827.4MMCfe/d. EBITDAX of $356MM was 7.1% and 4.9% below our
$383MM and the Street’s $374.6MM. DCFPU of $0.64 was 22.9% below
our $0.83 and 20% below the Street’s $0.80. Lower production due to
severe weather and infrastructure curtailment was compounded by
ethane rejection leading to lower realized prices.
Widening LINE-LNCO Spread Due to Contract.We believe that the
technical drivers of the spread will alleviate once the Berry Petroleum
Encouraging Operational Update in the Oklahoma Hogshooter.Activity
shifted to the Mayfield area in Oklahoma where the first four wells
delivered solid results, averaging 24h IP rates of 3,375 boe/d with 72%
liquids and early EUR of 250 Mboe.
Reduced Anadarko Basin Foothold With a $220MM Divestiture. LINE
sold the majority of its Anadarko Basin properties. Price metrics appear
reasonable at $15/boe in the ground and $68,750/(boe/d).
Recent Presentation Aims to Address Recent Weakness. Management
reiterated its comments to put in perspective the exaggerated concerns
of the market in light of recent stock weakness.
Balance Sheet & Liquidity.As of March 31st, 2013, $2.9B was available
on the revolver whose borrowing base, pro forma the Berry acquisition,
is $6 billion.
Adjusting Estimates.Based on company guidance regarding the BRY
acquisition, we are increasing 2013E production 15.4% to 156.5 Mboe/d,
decreasing EBITDAX 21.7% to $1,812MM an
A number of factors converged to contribute to weaker-than-expected first quarter
results. Those results included a 0.9x coverage ratio inthe quarter. We expect
coverage to strengthen upon completion of the proposed Berry Petroleum merger.
We are trimming our price target to $42(from $44) to reflect a bump in our
distribution capitalization rate to 7.50% from 7.00%.
Guidance – Excluding the pending acquisition of Berry Petroleum, management
lowered FY13 production guidance to 774-860 MMcfe/d from 820–910 MMcfe/d and
provided a 2Q13 estimate of 780-820 MMcfe/d (relatively flat to 1Q13 volumes at the
midpoint). Including a six-month contribution from the acquisition, management
lowered FY13 production guidance to890-986 MMcfe/d from 935–1,035 MMcfe/d.
Capital Spending – Management lowered its standalone 2013 capital budget to $1.05
billion from $1.1 billion, reflecting the pending asset sale as well as the shift to lower
working interest oil development in Oklahoma. Capital spending and allocation will be
reevaluated upon completion of the Berry transaction.
Granite Wash – Underperformance by some recent Texas Panhandle Hogshooter wells
has caused LINE to reallocate some capital to the Mayfield area of Western Oklahoma
where LINE has participated in four operated and non-operated Hogshooter wells with
an average initial rate of 3,375 BOE/d (72% liquids).
Distribution – LINE and LNCO announced a change to a monthly distribution and
dividend policy. The first monthly paymentsare expected to be in mid-July for the
month of April. LINE intends to raise its monthly distribution for July to $0.2566 ($3.08
annualized) from $0.2416 ($2.90 annualized) currently following the completion of its
acquisition of Berry Petroleum. The increased distribution will be payable in October.
Scare Tactics Shift to LinnCo: The next step to stop the highly accretive LinnCo/Berry deal
from happening, the short sellers are now questioning the deferred tax liability held at
LinnCo. As we discuss in this note, LINN generates plenty of tax shield to cover the liability
in future years. Keep in mind the tax shieldgenerated at the LINN Energy level has been
well north of 150% per year for the last three years. In our view, outside the alternative
minimum tax potential (2-5%) there is not likely to be any additional tax liability at the
♦ “Be Greedy When Others Are Fearful”: Despite a solid balance sheet, visible future
distribution coverage, and a strong hedge book, LINN Energy’s stock has declined by ~12%
over the last four weeks. Given that we believe the fear campaign is near an end, in our
view, this is a perfect time for investors to actively follow Warren Buffets famous advice.
Valuation:Our target price of $44 per share is based on a ~9.5x multiple to our 2014 EBITDA
estimate, within the traditional Upstream MLP range of 7-10x, and is further supported by a
targeted yield of 7% to our 2014 distribution forecast. We maintain our Strong Buy rating
Wells Fargo -
• Key Takeaways.We believe LINE/LNCO has comeunder selling pressure today
on market speculation that LNCO could realize a large tax liability in 2016. We do
not believe this assessment is accurate. Weexpect LNCO’s tax liability will remain
minimal into the foreseeable future inthe 2-5% range (i.e. in line with
management’s guidance for 2013-15). As a reminder, LNCO benefits from
minimal taxes at the C-Corp level due to LINE’s high tax deferral shield (i.e. in
excess of 100%), which is primarily generated by LINE’s robust drilling program.
Hypothetically, LNCO’s tax obligations could increase if LINE significantly
curtailed drilling activity (as noted in our initiation report); however, we do not
see this scenario developing in the foreseeable future. Notably, based on our
meetings with management at the NAPTP conference last month, we believe
LINE is likely to maintain its current capex spending level into the foreseeable
future. While we believe short selling could result in continued unit price
volatility in the near term, we continue tobelieve the closing of the BRY merger in
Q3’13 will act as a meaningful catalyst for LINE/LNCO shares. We remain
comfortable with our Outperform ratings on LINE and LNCO. To note, CEO
Mark Ellis and COO Arden Walker purchased 10,000 units and 5,000 units of
LINE, respectively, on 6/14/13, underscoring management’s confidence in
LINE/LNCO’s business model.
• Distribution Increase Still Anticipated For H2’13.We continue to believe
LINE is on pace to deliver a 6.2% sequential distribution increase later this year
(i.e. to a quarterly distribution of $0.77 per unit) based on anticipated accretion
from the BRY acquisition. However, since the BRY merger has been slightly
delayed from its originally anticipated closing date (i.e. we believe mid-August
versus early July previously), we anticipate LINE’s distribution increase could
occur later in the year than originally anticipated (i.e. in conjunct