The Lessons of Linn Energy

Linn Energy (Nasdaq: LINE) was a Growth Portfolio holding for a bit over four years, and over that span subscribers who invested alongside us doubled their money.

Of course, that’s no consolation to anyone who only caught the tail end of that rollercoaster ride, which ended Tuesday with a 19 percent plunge in the unit price and our advice to sell the MLP, after it revealed a preliminary Securities and Exchanges Commission probe into its accounting. Despite Monday’s bounce, the call spared subscribers steeper losses.

But whether one won or lost on Linn overall, the story of its rise and fall holds lessons all MLP investors would do well to heed.

Start with the yield, which after all is the main selling point of master limited partnerships. Linn boasted a yield of more than 12 percent when it was added to the portfolio in 2009, and that payout proved an excellent predictor of the rapid capital gains that followed over the next two years. More recently, the stock’s decline pushed the yield back into double digits again, but of course that proved no defense once the SEC started asking questions.

The lesson here is that a high yield — the only metric some investors bother with in these yield-challenged times — offers no assurance of safety or value on its own.  In fact, as I’ve argued previously in regards to Linn, it’s evidence of risk, as safer MLPs pay out much less on their equity.

One thing a high yield does is make it that much more attractive to issue debt, which often has a much lower cost of capital, especially with interest rates so low for so long. Linn was recently able to borrow below 7 percent, and its debt ballooned nearly four-fold to $6 billion by the end of 2012 as the partnership kept levering up to pursue ever bigger acquisitions.

There’s nothing wrong with seeking to lower one’s cost of capital via debt. But heavy borrowing can certainly help sustain a higher payout than business fundamentals warrant and an enviable record of distribution increases as well. This is why some MLPs and energy companies calculate shareholder returns in debt-adjusted terms – they understand that those returns are simply borrowing from the future if they come at the expense of a deteriorating balance sheet.

Linn’s distributions in 2010-2012 exceeded cash flow from operations by 25 percent, one reason unit holders have vested so much hope in the Berry Petroleum (NYSE: BRY) acquisition and the accretive cash flow it’s supposed to deliver.

One reason operating cash flow wasn’t higher is that Linn spent liberally ($583 million last year alone) on commodity derivatives to lock in prices for future output. It also spent $1 billion last year and $1.8 billion over  the last three on capital expenditures excluding acquisitions. There is nothing wrong with financing investment in future growth with borrowed money, especially for MLPs, which are expected to pay out much of the operating cash flow to unit holders. But between the hedges and the capex and the distributions, Linn was borrowing heavily, perhaps too heavily for a partnership that claims a long record of advantageous acquisitions.

This naturally raised the issue of why such advantageous prior acquisitions didn’t generate enough cash flow to finance more of the recent growth. This was really the short-sellers’ most effective argument, much more so than complaints about the options accounting or the non-GAAP financials. (Generally Accepted Accounting Principles seldom do justice to most energy companies, because of the heavy non-cash allowances for depreciation, depletion and amortization.)

If Linn had stronger cash flow it wouldn’t be under so much pressure to make more accretive acquisitions. Moreover, unit holders would have a greater margin of safety to ride out the accounting controversy. Ultimately, there wasn’t enough margin of safety here to wait out the SEC probe and its potential effect on future acquisitions, and not enough confidence that Linn doesn’t need more acquisitions to make ends meet.

Linn has borrowed its way into investors’ good graces for a long time, and absent a crashing unit price and a nosy SEC there was no reason to believe it couldn’t continue to do so, at least long enough to offer a better exit opportunity. But heavy borrowers often don’t get to choose when  they will be called to account, and the SEC probe is a real monkey wrench in Linn’s plans to grow its way out of past deficiencies.

This is why pipeline giants like Enterprise Products Partners (NYSE: EPD) and Kinder Morgan Partners (NYSE: KMP), with their investment-grade credit ratings and a healthy share of retained operating profits to invest in future growth, offer better risk-adjusted returns despite yields less than half as large as Linn’s. Not only do we know that they’re not paying distributions with borrowed money, we can be reasonably sure that those distributions will grow predictably as the organic growth projects are completed.

But even yield, solid distribution growth and strong balance sheets don’t fully insure MLP investors against financial fudging. Because distributable cash flow is a non-GAAP measure, MLPs have wide latitude in how they define it, if they do. Linn, for example, preferred to report adjusted EBITDA, that is earnings before interest, taxes, depreciation and amortization. Unusually among MLPs, it doesn’t consider cash interest expense in determining how much to pay out in distributions. Perhaps that’s caught the SEC’s attention.

Note too that MLPs also have wide discretion to estimate maintenance capital expenditures that come out of the cash available for distribution, as opposed to growth capex that can be financed via debt and equity. One of the charges levied by Linn’s critics is that maintenance capex was unusually low on a couple of occasions when operating cash flow looked especially pinched.

This has been going on for a long time and as of two weeks ago, even as I noted Linn’s aggressive accounting, there was no reason to believe it couldn’t go on considerably longer.

Perhaps it still can. The SEC might find nothing wrong or might content itself with a slap on the wrist, and for all we know the Berry merger might still happen and help Linn raise its distribution yet again. It’s not beyond the realm of possibility that units will trade at $35 again.

But we appreciate Linn’s balance sheet risks much better now to gamble on that outcome — and critics who’ve raised those red flags deserve some credit, even if other charges they’ve levied are less persuasive.

We understand, even if others still don’t, that Linn’s adjusted EBITDA, with its blind eye to interest and equity compensation costs, is a far less reliable performance measure than free cash flow.

We know that no single metric, be it yield, distribution growth, debt, coverage ratio or a proprietary rating system, can capture all the risks investors face.

These are lessons worth applying to every investment. Those who do so will find that even a loss on Linn was ultimately money well spent.

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