Despite the poor performance of the stock during the past few months, and in the wake of this report, I see no fundamental cause for concern about Linn. In fact, with a yield approaching 10 percent, Linn looks like a real bargain at current levels.

The figure most widely reported on the newswires was that Linn lost 94 cents per unit (share) in the fourth quarter; most news services compared that to consensus analyst expectations for a profit of 31 cents per unit.

But these reports are comparing apples to oranges: The earnings-per-unit (EPU) figure that the news services picked up on is based on Generally Accepted Accounting Principles (GAAP), but the consensus estimates discussed in those same stories aren’t. The biggest discrepancy between the two is related to the way Linn accounts for oil and natural gas hedges.

Linn has extensively hedged its expected oil and gas production through the end of 2012. In other words, Linn’s mature fields offer relatively predictable production; however, commodity prices are wholly unpredictable. If Linn were to simply sell its production at available prices, then its cash flows would be just as volatile as commodity prices.

This situation is unacceptable. Publicly traded partnerships (PTP) need stable, predictable cash flows to back up their distributions to shareholders. Most E&P partnerships use hedges, but Linn is more hedged than your average PTP. Ninety-eight percent of the PTP’s 2008 production is already locked into hedges at attractive prices, and an average of about 90 percent is locked through 2010.

Under GAAP rules, a company must mark all its hedges to the fair market price each and every quarter. By definition, the value of Linn’s hedge position rises when the price of oil and gas falls; hedges lose value when commodity prices rise.

Therefore, in times when oil and gas prices rise, the value of all of Linn’s hedges will fall. That means not just hedges covering 2007 production but its entire hedge position covering expected production to 2012.

The important point to note is that this loss isn’t a cash charge; it’s entirely an accounting entry.

In the third quarter, Linn’s GAAP results included an $83.4 million loss because the falling value of the company’s hedge book. Because its total GAAP loss was $76.2 million, this single, noncash charge accounted for most of the discrepancy between estimates and GAAP results.

A more appropriate way to account for hedges is to only book gains or losses on hedges pertaining to production in a particular quarter. That’s what Linn does.

Looking at GAAP earnings figures at all for Linn is a meaningless endeavor. Earnings include a wide variety of additional noncash charges, such as depletion and depreciation.

The real figure to watch is distributable cash flow (DCF), a measure of how much cash the partnership actually generates for distribution. By our calculations, Linn’s DCF was healthy for the quarter, more than enough to cover its 57-cent distribution, paid Nov. 14.

Overhang of PIPE Transactions

But there are other factors that have been influencing Linn’s stock in recent weeks. One is an unusually large overhang of unregistered shares–a total of around 86 million unregistered shares issued as part of PIPE deals.

PIPE stands for Private Investment in Public Equity. PIPEs are a way that many PTPs raise capital quickly to fund acquisitions.

In such a deal, the PTP sells additional units to so-called “qualified” investors, typically institutions. Such units aren’t registered for trading on the major exchanges, and there’s no ready public market for these shares.

But in a typical PIPE deal, the PTP will agree to register these privately issued units at some time in the future, allowing those units to be traded on the exchange just like any other unit. PIPE deals aren’t dilutive to current unitholders as long as the capital is used to purchase new assets that generate cash.

In Linn’s case, the PIPE deals it’s undertaken have been used to make acquisitions, such as its recent purchase of Dominion Energy’s gas-producing fields in Texas and Oklahoma. That acquisition actually doubled Linn’s reserve base. The cash generated from these assets is enough to more than offset any dilution caused by issuing more units.

But Linn is now in the process of registering these shares. In its call, Linn announced that the first 48 million shares will be registered by the end of this month, with the remaining 38 million to come by the first quarter of 2008.

Keep in mind that these units already exist, and these unregistered unitholders are already receiving distributions just like those of us that hold publicly traded units. The only difference is that, until they’re registered, these investors can’t sell their shares.

Linn’s total base of unregistered shares represents about three-quarters of its 114 million total shares outstanding. The fear is that some of these investors may choose to sell their units as soon as they’re registered, putting additional pressure on the stock.

These fears are overblown. First, many of the PIPE investors are dedicated master limited partnership (MLP) funds who bought the units to build their stake in Linn at attractive prices. These are long-term holders.

Most of these PIPE buyers are sophisticated investors who are well aware that dumping units would cause Linn’s stock to drop. As owners, they have no more interest in that happening than you or I do.

Second, even if these holders did sell, it would have no effect on Linn’s cash flows whatsoever. The company has already received the capital from the PIPE transactions and has closed the acquisitions.

Even if the stock did come under pressure, it would have no effect on Linn’s ability to pay its distributions. If such artificial selling does push down Linn’s stock, its yield would quickly rise into the teens. Such a move should attract buyers.

More Positives

A few additional points are worth mentioning. First, Linn has partnered with an unnamed third party to farm out drilling activity on some of its newly acquired reserves in the mid-continent. Linn estimates that it would take it more than 20 years to drill all the obvious locations on its vast landholding in the region.

By farming out development of certain parts of its reserves, Linn has the opportunity to accelerate development of the field. Management was prohibited from offering many details because of a confidentiality agreement. But based on its comments, it appears that Linn would have the opportunity but not the obligation to directly participate in any projects the third-party firm undertakes on its land. This sounds like an attractive deal.

And second, Linn believes that it has myriad opportunities for small acquisitions in and around its existing properties. With nearly $500 million in credit available on its existing lines, Linn could finance several smaller transactions without issuing new debt or undertaking more PIPE deals. The company estimates that each $100 million in acquisitions adds roughly 5 cents to its DCF.

Bottom line: Linn offers by far the highest yield of any of the E&P-focused PTP in our coverage universe, approaching 10 percent based on its planned fourth quarter dividend payout (paid in February) of 63 cents per share ($2.52 annualized). That’s nearly 2 percentage points above average for E&P PTPs. This strong yield offers downside protection.

And management estimates that distributable cash flow will cover that payout between one and 1.1 times in 2008. Using small, bolt-on acquisitions, Linn could easily push its distribution far higher than that while maintaining its payout coverage.

Finally, it’s worth noting that 100 percent of Linn’s 2006 dividend was taxed as a return of capital by the IRS, and management expects the same for 2007. That means that your entire tax liability on distributions can be deferred. Buy Linn Energy.