Walk The LINE

This article was originally published on on June 5th, 2014 at 2:03pm EST

Back in March we posted an article here about how Linn Energy (LINE) was “walking the line” of risk versus reward. At the time we were reading one negative headline after another about Linn, though most of the information stemmed from 2013 accusations by Hedgeye’s Kevin Kaiser about Linn’s financials. These accusations were later deemed to be meritless.

A little over a year ago Hedgeye made a case against Linn’s accounting methods. After an SEC investigation, they contended, Linn’s $4.9 billion and immediately accretive acquisition of Berry Petroleum would be at risk. The stock promptly fell from nearly $40 to the low 20s. It gradually recovered up to about $33 early this year when Barron’s came out with a bearish article, leveraging Hedgeye’s research to conclude that Linn was still overvalued. Barron’s argued that the then-still-ongoing SEC investigation would almost certainly turn up something fishy about how Linn was calculating its distributable cash flow (from which it pays out distributions). The stock fell once more, from $33 to about $27.

The Berry acquisition has since been completed after the SEC gave Linn a clean bill of health from an accounting standpoint, and the stock has stabilized. The question now becomes — how much of the Hedgeye- and Barron’s-induced drop, if any, was warranted?

From the technicals illustrated below, we can see a bullish pattern finally emerging for Linn as its shorter-term moving averages cross above its longer-term moving average:

At the time of our previous publication in March, Linn was trading right at $29 — as of this moment it is getting close to $30, a move of about 3% in price. But don’t forget we have also been collecting nearly 1% per month in distributions. Let’s call it a 5% total return. Not particularly exciting but in line with the 4% return from the S&P 500 over the same period. What looks to be a fairly strong floor may have formed for Linn’s shares.

Below you can see the behavior — both yield and price — for Linn Energy over the past three years. Appetite for LINE’s beefy, double-digit distribution is likely to put downward pressure on its yield (and upward pressure on price) as it has in the past.

As Linn’s price has dropped last year, the corresponding spike in yield (pictured above) was fairly dramatic, since their distribution remained intact. Provided there is no immediate threat to Linn’s distribution — which hasn’t been cut since they went public in 2006, in fact it has nearly doubled — it seems there is a limit to how inexpensive their shares may get. In additional support for the bottom being in for Linn, just two weeks ago they completed an asset swap with ExxonMobil (XOM) that improved Linn’s cash flow without issuing any new debt or equity.

Yield me this

Generally speaking, an MLP trades based on the spread between its distribution yield and the yield on the 10-year Treasury. That spread will differ from MLP to MLP, as each company carries unique risks for which an investor must be compensated. Among others these include: a) The sustainability of its distribution; b) Amount and cost of the company’s debt load; c) Diversification and quality of the MLP’s assets; and d) Forward-looking interest rate expectations. In the case of Linn, that spread is north of 7% (700bps) today, historically high for its shares.

Now that the patient is stabilized, our view is that there is a good deal of room for that spread to shrink — a 700bps spread implies an enormous amount of risk. There are three ways this can happen: 1) The 10-year Treasury yield could spike, 2) LINE could cut its distribution, or 3) An upward move in the stock price, whereby LINE’s effective yield would come down. I think option 3 is the most likely.

If the spread were to narrow from 7% to 5%, for instance, the implied price of LINE units is about $36. That’s 20% higher than today’s price. Along with a 10% current yield, the total return opportunity remains quite attractive.

We think it’s worth walking the LINE…

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on can be found here.

Leave a Reply

Your email address will not be published. Required fields are marked *