Linn Energy - Is there any value in the equity?

A few years ago, a number of bloggers pointed out Linn's Ponzi-like financial structure, with a strong bear case spelled out by Bronte Capital, Hedgeye, and James Kostohryz on Seeking Alpha (links to these blogs are in the footnotes).  While Linn has since declined significantly since then, but the worst may be yet to come.

Linn’s Ponzi Like Returns

Looking at Linn’s characterization of distributions for the past two years would indicate that the payouts were predominantly a return of capital and therefore not taxable.  While this might sound appealing, the reason these distributions are not taxable is because Linn is not making money, they are simply returning shareholder money back to shareholders.  However, paying your investors returns from their own capital, rather than from profits sounds quite a bit like the definition of a Ponzi scheme as provided below:

 “A Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator.”

Let’s say a business takes money from investors, and returns that money to investors in the amount of 10% a year.  Well after 10 years that business would be out of money to return to investors and fold, unless of course that business is a Ponzi scheme which successfully attracts capital from new investors to return to old investors.  As Bernie Madoff proved, given a level of obfuscation, Ponzi schemes can go undetected for a while and even grow quite large before inevitably imploding.  Madoff successfully obfuscated his Ponzi scheme behind a large trading operation.  In the case of Linn energy, the Ponzi like financial structure is obfuscated in the form of an oil and gas company. 

To illustrate, let’s think about how a Ponzi scheme works:

Step 1: Raise money from investors

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since profits are small to non-existent, most of the distributions are a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue paying old investors from fresh capital.

Step 4: Repeats steps 2 and 3 until investors stop giving you money

Linn energy effectively works the same way, but with a few additional steps.

Step 1: Raise money from investors

Step 1a: Convert that money into oil and gas reserves by buying energy assets

Step 1b: Produce from those reserves, converting the oil and gas back to cash

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since actual profits are small, and in recent years non-existent, most of the distributions have been a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue buying more oil reserves, allowing you to continue paying distributions to investors.

Step 4: Repeats steps 1a through 3 until investors stop giving you money

Now I call Linn Ponzi like rather than a straight out Ponzi scheme, because there are actually a couple of ways this business model can work.

1.  Oil prices rise faster than the rate the company is paying out distributions.
2. The company is unbelievably good at generating value from acquisitions.

If you believe either of the above to be true, then it might be possible for Linn to offer a sustainable return to investors. Case 1 is easy enough to address - if you believe that the price of oil will rise faster than Linn’s distribution yield, you would better off putting your money in the commodity as opposed to Linn equity.  Case 2 requires a little thought.

When it comes to making acquisitions, every transaction has both a buyer and a seller and information is asymmetric.  Typically, the seller knows much more about the asset he’s selling then the buyer and is unlikely to take less than market value except in distressed situations. Furthermore, the transaction costs involved in buying and selling energy assets are significant as, much like in real estate, there are all sorts of middlemen, such as investment bankers and lawyers, who need to be paid off.  These transaction fees can easily add another 5% to the price of an acquisition. Finally, acquisitions must often be made at a premium to gain support from shareholders of the selling company. For these reasons, it is very hard to create value in acquisitions except in the following situations:

1. Situations where there are significant synergies created due to the combination of entities.
2. Strategic situations where the buyer is acquiring a company for access to technology or new markets.
3. When the buyer has a lower cost of capital than the seller and can finance growth in the acquired company.
4.  Distressed asset acquisitions..

None of Linn's acquisitions really appear to have created major synergies for the company.  Linn may argue that the assets bought from Devon had significant operational overlap, but this in itself does not mean much in the way of synergies.  Certainly not enough to justify the price Linn paid for Devon’s assets.

It also does not appear that any of Linn’s acquisitions provided Linn with new technologies it could use elsewhere in its portfolio, nor did any of Linn’s acquisitions provide the company with new markets.

Early in Linn’s history, Linn may indeed have had a lower cost of capital than the companies it was buying, due to the marked up valuations of MLPs.  But this is not a sustainable advantage because as company issues more shares and more debt its liabilities rise until the cost of capital difference deteriorates.  As Linn's cost of capital has risen, it's ability to generate value in this way has evaporated.

Far from picking up assets at distressed valuations, it actually appears the Linn has been selling or otherwise shedding assets at distressed levels.  Linn needed to sell its Granite Wash assets to shore up liquidity and did so at a price that may have been lower than similar transactions in the area, and the DrillCo JV appears to be distressed financing deal in disguise.

DrillCo a bad deal for both shareholders and bondholders

Far from being a vote of confidence in Linn's, Blackstone's DrillCo joint venture appears to be more of an opportunistic distressed financing deal, which effectively results in Blackstone getting a 15% rate of return with Linn's reserves serving as collateral.  Furthermore, the DrillCo deal subordinates existing bondholders and Linn shareholders, as much of the economic value of those reserves will be transferred from Linn to DrillCo as part of the deal.  It's important to note that Linn itself does not even generate 15% returns on a corporate level, so it's hard to see how this deal creates value for the company.

Where things went wrong

I previously noted that there were a couple of situations where Linn’s business model could work.  The first is in an environment of continually rising oil prices and the second is if Linn can consistently make acquisitions that generate value.  The current falling oil price environment is a disaster for Linn, as the company has levered up its balance sheet buying assets that are now worth far less than what Linn paid.  Complicating matters is the fact that Linn’s cost of capital has risen to the point where the company is unable to make the acquisitions required to keep it’s Ponzi like business model going.  Since Linn’s business model has imploded, future growth seems almost out of the question, and the only question left to ask is how much residual value is left in the units?

So how much value is left in the equity?

Answering this question requires a close look at Linn’s valuation and posing the question “If Linn was valued like any other company, what would it be worth?”.

A peer group for Linn might be composed of Anadarko, Apache, Continental Resources, Devon Energy, EOG, among a few others.  The EV/EBITDA ratios of these companies are as follows:

Anadarko – 5.20

Apache – 3.18

Continental – 6.59

Devon – 4.8

EOG – 5.83

Average – 5.12

By comparison, Linn’s EV/EBITDA ratio is 8.26, much higher than the 5.12 average of the companies I listed above.  For Linn to be valued similarly to other E&Ps by this metric, the companies EV would need to drop by roughly 38%.  The unfortunate problem for Linn’s equity holders is that roughly 80% of Linn’s EV is debt.  This means that if Linn was valued as an E&P rather than an MLP, the shares would be worth close to zero.

Bulls may argue that MLPs are valued on their tax advantaged distributions and not their earnings, but this ignores the fact that for distributions to be sustainable they need to come from earnings and not from returning capital to shareholders.  Secondly, bondholders do not receive the same tax advantages as MLP unitholders and don't view the assets any differently.  If all the value of the company is in the debt, as opposed to the equity, the (unwarranted) MLP premium enjoyed by Linn should no longer apply.

Linn’s asset quality is low

I assumed in the above comparison that Linn’s asset quality was on par with its peers, but in reality, Linn’s assets are very marginal.  Given its business model, Linn has been incentivized to make a lot of acquisitions, and it the process the company has accumulated a disjointed portfolio of assets that other oil companies did not want.

• Linn’s assets in the Rockies, while not bad, do not compete against other North American shale plays.
• The assets in the Hugoton basin, Mid-Continent, and Permian are primarily mature wells nearing end of life.  The company did have some prospective wells in these area’s but they were sold (Granite Wash), or traded for more mature wells (Exxon trade).
• The California assets primarily produce thermal heavy oil, not unlike what is being produced in Alberta’s oilsands.  It’s expensive to produce and fetches a discount on the market because it is difficult to refine.
• Linn’s remaining assets in Michigan and East Texas are failed exploration plays that other companies did not see economic potential in.

When you compare Linn’s assets to those of the North American onshore peers I noted above, one would have to think Linn should trade at a discount, rather than a premium, to those companies.  Linn’s assets also make for a poor takeover target.  After all, why would anyone buy a company composed entirely of assets similar to those being jettisoned in favor of core positions in the Bakken or Eagle Ford shales?

(1) http://brontecapital.blogspot.ca/2013/02/linn-energys-queen-gertrude-moment.html
(2) http://brontecapital.blogspot.ca/2013/02/linn-energy-bizarre-definition-of.html
(3) https://app.hedgeye.com/insights/27487-looking-at-linn-energy
(4) http://seekingalpha.com/article/1535352-linn-energy-many-ponzi-like-mlp-blow-ups-to-follow
(5) http://seekingalpha.com/article/1545382-ponzi-or-mlp-linn-energys-unsustainable-distributions

Disclosure: The author is short Linn Energy