Bank of America Upgrades Linn Energy Amid SEC Review

Updated from 9:38 a.m. ET top reflect closing share prices and additional analyst commentary throughout.

NEW YORK ( TheStreet) -- Bank of America Merrill Lynch analysts on Monday said they don't believe the accounting practices of Linn Energy ( LINE) have inflated or distorted the cash flow the embattled oil and gas driller pays to its investors through dividends.

In a Monday upgrade of Linn Energy, the BAML analysts said Linn Energy's accounting for derivatives used to hedge its oil and gas production and the capital expenditure it sets aside to maintain energy output haven't misled investors or put the company's high dividend at risk.

BAML's analysis centers on the non-generally accepted accounting practices (GAAP) Linn Energy reports to its shareholders, and in particular, its so-called "distributable cash flow," or DCF.

Linn Energy uses non-GAAP measures such as DCF to support a current monthly cash distribution to shareholders of 24 cents, one of the highest dividend-yields among Master Limited Partnerships (MLP) in the oil and gas sector. Linn Energy's DCF covered 88% of its recently increased dividend payments, even as the company reported a net loss in its most recent quarter.

The Houston-based oil company's accounting practices and the non-GAAP metrics that drives its dividend have come under scrutiny in recent months from Barron's and independent research firm Hedgeye Risk Management.

Both Barron's and Hedgeye argue Linn has used non-GAAP accounting to overstate the cash flow it can pay out to shareholders and under-report expenses tied to its hedging practices and capital expenditure. The scrutiny comes at a crucial time for Linn Energy, which is seeking to acquire Berry Petroleum ( BRY) in a stock merger that the company expects will significantly bolster its energy assets and lead to an increased annual dividend of $3.08 a share.

Questions on the transparency of Linn's non-GAAP accounting practices were heightened when the company disclosed in early July that the Securities and Exchange Commission had opened an informal review into its non-GAAP financial reporting and its hedging strategies. The SEC also requested the preservation of communications relevant to the company's proposed merger with Berry Petroleum; however, the regulator has not made an opinion on Linn Energy's accounting practices.

While the BAML analysts said Monday they aren't attempting to call an outcome of the SEC's informal review, they did give a clear affirmation of the company's most controversial accounting practices.

"We do not believe LINN's stated distribution coverage would be materially impaired had the put strategy not been employed while we 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," the analysts wrote in their Monday note to clients.

Linn Energy has been criticized for capitalizing and not expensing the costs of put contracts it uses to hedge its oil and gas production. Since the derivative contracts are capitalized, they are not included in Linn's reconciliations from non-GAAP earnings before interest, taxes depreciation and amortization (Ebitda) such as DCF.

After a sharp sell-off in the wake of Linn's disclosure of the SEC's review, the BAML analysts upgraded the company's shares to 'Buy' from 'Neutral.' Linn Energy shares gained over 8% to $25.13 in Monday trading. The shares have fallen nearly 25% in the past month. Berry Petroleum shares gained over 1% to $40.43.

Still, the BAML analysts lowered their price target for Linn Energy from $41 a share to $30 a share, citing the company's elevated risk profile amid investor scrutiny and an uncertain outcome of the SEC's review.

A handful of analysts downgraded their ratings and price targets for Linn Energy in early July, however, few expressed concern over the company's long-term earnings or its accounting practices.

Prior to Linn's disclosure of the SEC's review, some prominent Linn Energy shareholders had supported the company's accounting practices and the sustainability of its dividend payouts.

In the wake of Hedgeye's analysis, TheStreet first reported Leon Cooperman-run hedge fund Omega Advisors was continuing to support Linn Energy as its leading outside shareholder.

In a letter sent to Barron's published on June 22, Cooperman noted that Linn's non-GAAP distributable cash flow metric would, by definition, exclude the costs of its capitalized energy hedges.

In response Barron's said Linn's deduction of those costs from Ebitda and DCF presented an "incomplete and overly optimistic picture" of the company's financial health. It favors GAAP metrics such as Linn's quarterly net loss of $222 million.

Linn Energy hedges its energy price risk about four-to-five years into the future, in an effort to minimize the volatility of its oil and gas production revenue. The company said in recent investor presentations it has stopped entering into new put contracts and will favor costless swaps that historically have made the bulk of of its hedges.

Through a spokesperson, Omega Advisors declined to add further comment on Linn Energy in the wake of the SEC's informal review.

Omega Advisors is Linn Energy's largest outside investor, with a 3.05% holding in the company's shares worth more than $200 million, according to March 31 SEC filings compiled by Bloomberg. Omega also owns 1.96% of LinnCo, the data show.

Jim Cramer, founder of TheStreet and contributor to Real Money Pro, currently owns Linn Energy shares in his Action Alerts PLUS charitable trust, along with co-portfolio manager Stephanie Link. Cramer has supported Linn Energy and invited CEO Mark E. Ellis on his CNBC show Mad Money to rebut Barron's analysis.

On July 2, Link said in a Real Money Pro post that the charitable trust would sell 1,400 Linn Energy shares at $29 apiece given the SEC's informal review.

"Our rules have always been to sell a stock with an SEC investigation -- because we have no edge in knowing what the outcome will be," Link wrote, while noting that the company's net asset value (NAV) remains unchanged at $40 a share and it continues to carry a 8.7% dividend yield.

Link said Action Alerts PLUS would continue to own 1,000 Linn Energy shares after its stake sale, roughly 1.2% of the overall portfolio. Cramer echoed the decision later in the day on Mad Money.

-- Written by Antoine Gara in New York

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