Linn Energy, LLC

Buy Price: $15.77

History / Profile:

Linn Energy is an independent oil and gas company focused on the development and acquisition of long life properties in the United States. They operate in the following regions:

• Mid-Continent — core operating areas in the Texas Panhandle and Oklahoma; and
• Western — the Brea Olinda Field of the Los Angeles Basin in California.

The Financials:

Income Statement:

Linn Energy hedges nearly 100% of their production for up to five years, and all hedging income (losses) are reported on the quarterly and annual income statements, creating a jumbled mess when it comes to trying to figure out recognized income for a period. We try to analyze current earnings as going rate commodity prices plus/minus recognized gains/losses on hedges to arrive at the quarterly revenues, stripping out gains/losses on future hedges, under the assumption that we will pick those up in future periods. Linn operates under the tenet that constant cash flows are better the volatile ones. We tend to agree with this philosophy. Under our revenues model, we have calculated LINN recognized revenues for the past four quarters as:

Q1 - $195m unhedged, $185m hedged

Q2 - $255m unhedged, $230m hedged

Q3 - $240m unhedged, $218m hedged

Q4 est. - $150-$170m unhedged, $175-$201m hedged.

In the first three quarters, operating income was approximately 36%, 48%, and 39% of hedged revenues, respectively. We expect Q4 to be in the 30%-36% range, producing between $55-$75m of EBIT. Overall, with the hedging mechanisms in place, we believe that this income stream will definitely continue into the future, and grow substantially based on Linn’s management acumen, commodity price rebounds, capacity increases, or any combination thereof.

Cash Flow Statement:

Linn consistently produces positive operating cash flows based on realized income levels, and investments into future hedging devices. As an oil and natural gas company it requires substantial investment in fixed assets.

Linn’s current dividend policy is set at 62.5 cents per quarter or $2.52 per unit. Earnings at the partnership level are not taxed (Energy MLP), but this payout is taxed at the investor level (ordinary income) and totals approx. $290m a year. On income of $200m this is a bit worrisome, and we don’t foresee this level into the distant future, unless of course commodity prices rebound dramatically, and income rises sharply, which would be great news for LINN owners. However, I feel the dividend will eventually decrease to a more sustainable level closer to 100% payout ratio.

Balance Sheet:

See Valuation section below.

Overall Picture:

On the institutional side, Baupost Group, an investment vehicle run by the extraordinary value investor Seth Klarman has a substantial stake in LINN Energy (might actually be his largest holding) which based on his historic results bodes well for our decision to purchase. We don’t necessarily decide to invest just because a respected institution is “all-in” but it definitely makes us take a detailed look.

In the current market conditions, we see substantial value in energy stocks in general. Does anyone believe that commodities will remain at their current levels indefinitely? Where will they be in five years? Linn has taken most of the market uncertainty out of the equation. We can calculate a relatively stable revenue stream and earnings for five years. Where else can you find this in the current market?

Valuation:

P/E Valuation: $3.3B or $28.60 per share

We estimate total year realized income of approx. $200m in FY 2008 and a conservative 5% growth rate, a CAPM discount rate of approximately 11% produces an earnings multiplier of 16.6 (keep in mind, we are calculating based on realized income only, which is very different than GAAP earnings) and a total enterprise valuation of $3.3B, which is a 74% premium to what it is trading at today.

Book Value Valuation: N/A

As of Sep. 30, Linn had assets of $4.0B and liabilities of $1.9B, therefore a book value of approximately $2.1B a slight premium to its market cap ($1.9B). Most ($3.6B) is tied up on PP&E which makes sense given the industry. Due to the subjectivity in valuation of the PP&E , we do not have an interest in speculating on the book value multiple it should be trading at (as it would take expertise on the side of valuing natural resources). We are intrigued by the company trading at below book value, but do not weigh this metric as heavily as cash flows or earnings.

Risks:

With a new democratic president in office, there is a risk that the tax-free status of energy partnerships will disappear. This could have a major effect on the income of LINN Energy (decreasing it by 40%). In addition, commodity prices have been highly volatile, and could continue to be highly volatile in the future.

The Bottom Line:

Long 5%

We are allocating 5% of our portfolio to purchasing LINN Energy. We will continue to monitor going forward.