In Debt to Linn’s Example
In an article last week (No Regrets on Linn Energy) I reviewed our history here with Linn Energy. In brief, we dropped Linn from our portfolios at MLP Profits and The Energy Strategist in July 2013 while it was still trading at $27/unit. Earlier this month, under the weight of crushing debt, Linn was forced to file for Chapter 11 bankruptcy protection. In fact, today as I write this Linn Energy makes its debut on the pink sheets.
It was quite a dramatic fall for the largest of the upstream (i.e., oil and gas producing) partnerships. Two years ago Linn sported a market capitalization of about $10 billion and an enterprise value (market cap plus net debt) of nearly $20 billion.
Ever since we recommended the sale of Linn, we have been frequently asked whether it was time to get back in, or whether other upstream MLPs were worth considering. Our answers have been almost always “No,” and today I want to elaborate by looking at the debt levels for all of the upstream MLPs.
I include Linn Energy in this analysis with data from its last day on the Nasdaq. It provides a pretty good explanation for Linn’s bankruptcy. Here are the companies in my database that are listed as upstream partnerships, along with certain important financial metrics:
- EV = Enterprise value as of May 23
- EBITDA = Earnings before interest, tax, depreciation and amortization for the trailing 12 months (TTM)
- Debt = Net debt at the end of the most recent fiscal quarter
- FCF = Free cash flow for the TTM
- CR = Current ratio, current assets divided by current liabilities for the previous quarter
Linn Energy’s strong free cash flow over the past year might pique an investor’s interest, but a little digging will show that history is unlikely to foretell the future in this case. Linn has historically had a strong hedging program, which has helped maintain FCF as oil prices fell. But as those hedges roll off, it becomes much more expensive to replace them. Or, they have to be replaced at much lower contract prices. In either case it would mean that last year’s FCF could not continue.
There are two major red flags for Linn in the table above. The net debt/EBITDA ratio is extremely high. For reference, the 10 largest conventional oil and gas producers have an average net debt/EBITDA ratio of 3.3. For me, even that is a little on the high side for comfort. Note that all of these upstream MLPs except for Mid-Con Energy Partners (NASDAQ: MCEP) are well above that number.
Incidentally, MCEP is thus far 2016’s top-performer across the MLP space with a year-to-date return of 175%. Rising oil prices are naturally going to improve the fortunes of the upstream MLP space, but many of the names in the table are candidates for bankruptcy with those debt levels. In fact Breitburn Energy Partners (NASDAQ: BBEP) did file for Chapter 11 protection following Linn’s filing. At least in the case of MCEP it looks likely that it will survive this downturn in oil prices, so it has attracted the attention of investors. And with an EV/EBITDA ratio of 5.2, it is still well below the group’s average despite this year’s huge runup in price.
Of course there are some significant differences between MLPs and corporations that offer some justification for the higher leverage of MLPs. Still, I wouldn’t be personally comfortable with the net debt/EBITDA multiple of any MLP in the table other than MCEP.
Another red flag for Linn is the current ratio (CR). If the CR is less than 1, it means the company’s liabilities exceed its assets. Two companies on the list, including Linn, are in that category. This is a red flag for MCEP as well, as its ratio is just barely above 1.
Hopefully this exercise explains why we have steered clear of the upstream MLP space. At the right multiple anything can be a buy, but we believe there are much better values for MLP investors. To find out where we currently see value, consider joining us at MLP Profits.