In a recent report Bank of America Merrill Lynch (BAML) noted that review of the financial outlook for Linn Energy LLC (NASDAQ:LINE) leads them to conclude the outlook and sustainability of Linn Energy LLC (NASDAQ:LINE)’s cash distributions should not carry a materially higher risk, implied by the recent collapse in the unit price. On a forward basis, BAML believse distributable cash flow will continue to cover distributions and on this basis they believe the recent sell off is overdone.
A material offset is the announced informal inquiry by the SEC and uncertain impact on the outcome and timeline of the pending Berry transaction. They think this demands that Linn Energy LLC (NASDAQ:LINE) is viewed as a high risk stock with elevated unit price volatility until this is resolved. However, they believe the risk is being appropriately reflected by an inflated yield and the collapse in the share price since the hedging controversy emerged earlier in the year.
Addressing the Controversies
BAML believes the Linn Energy LLC (NASDAQ:LINE) controversy is primarily an issue of interpretation around two issues – whether the chosen options strategy employed by LINN management and associated accounting is misleading and whether maintenance capital is being appropriately deducted in the calculation of distributable cash flow. BAML’s conclusion is that they do not believe Linn Energy LLC (NASDAQ:LINE)’s stated distribution coverage would be materially impaired had the put strategy not been employed, while they believe LINN’s stated level of maintenance capital is entirely consistent with reserve replacement cost and peer company results for those operating in similar regions.
Linn Energy Defines Maintenance Capital
The table below summarizes Linn Energy LLC (NASDAQ:LINE)’s distributable cash flow. The key number on this table is maintenance capital. Linn Energy LLC (NASDAQ:LINE) defines maintenance capital as that which is required to hold production flat, and replace produced reserves on an annual basis. It has further provided guidance that maintenance capital is around 25%-30% of EBITDA. By BAML estimates this equates to around $9.23 / boe ($1.54 / mmcfe) – which is consistent with historical spending associated with maintenance.
Linn Energy Acquisitions
Notable is that absolute spending is a function of production – so that as Linn Energy LLC (NASDAQ:LINE) has made acquisitions, the call on maintenance capital moves up. However, assuming the underlying decline rates are broadly consistent with acquired assets versus existing assets, BAML would not expect unit spending to materially change. The two charts below show production, absolute spending and per boe spending since 2009.
Versus peers, Linn Energy LLC (NASDAQ:LINE) is currently trading at a 15 percent discount on distribution yield with a prospective yield of 12.4 percent versus the sector average at 10.7 percent (ex LINE). On EV/EBITDA, Linn Energy LLC (NASDAQ:LINE) trades at a 14 percent discount to peers with a forward 2013 EV/EBITDA multiple of 7.6x versus the sector at 8.4x. BAML believes that a target price is reasonable at ~$30 / share, implying upside of ~25 percent from current levels.