Linn Energy produces oil and gas, it’s also accused of aggressive accounting using derivatives — Photo credit: Wikipedia

It hasn’t been a good couple of months for investors in LINN Energy, as the stock has taken a beating after reports that it had been overstating its cash flows and that its high dividends may be unsustainable. The stock was down big time on Tuesday after the company disclosed an SEC inquiry into its use of non-GAAP accounting and its hedging strategy, putting into question the final closing of an acquisition of Berry Petroleum and auguring further downside if any foul play is finally detected.

Oil and natural gas producer LINN Energy has seen its shares fall a dramatic 28.4% since the first days of May, before Barron’s put out an article questioning “aggressive” accounting tactics that masked the underlying financial weakness of the company. Even with the support of Omega’s Leon Cooperman, the stock took a new tumble on Tuesday as it voluntarily disclosed a private SEC investigation. And while LINN’s management suggested their proposed stock-for-stock acquisition of Berry Petroleum is on track. investors are beginning to express their doubts.

LINN spun off LinnCo in October last year, creating an MLP-like entity designed to “enhance [their] ability to raise additional equity capital to execute on its acquisition and growth strategy.” Last February, LINN and Berry announced the former’s intention to acquire the latter for $4.3 billion, including the assumption in debt, paying in stock at a 20% premium, based on the price of LinnCo’s shares as of February 20; those shares are down nearly 10% by Tuesday’s opening price.

The company has hedged 100% of its oil and gas production through 2016 using put options, explained Raymond James’ Kevin Smith, one of the analysts that remain bullish on this battleground stock. In their first quarter earnings report. LINN’s management noted their realized average natural gas and oil prices for the quarter were 35.4% and 2.7% higher due to their hedging strategy respectively.

The problem raised by Barron’s . which was initially pointed out by Kevin Kaiser at HedgeEye. is that LINN is using non-GAAP accounting to mask considerable weakness from a cash flow perspective, which could ultimately have a big impact on the stock as the price is in large portion supported by its juicy dividend yield. LINN posted a net loss of $221.9 million in the first quarter, but through the use of non-GAAP accounting actually delivered positive adjusted EBITDA (which hit $356.1 million) and earnings per share of 16 cents, despite a 96 cent loss on a GAAP basis. LINN chose to exclude unrealized losses on commodity derivatives worth $188.6 million.

At the same time, LINN increased its cash dividend to $0.725 per share, and proposed to raise it even further to $0.77 the quarter immediately following the closing of the Berry acquisition (which was initially expected to close in the third quarter). The sustainability of this dividend has been called into question, with Barron’s noting that distributable cash flow, or essentially the amount of cash destined for dividends, was only $0.64 per unit, or $150 million. Furthermore, LINN chose to exclude the cost of its puts in their measures of cash flow, while including the gains. While the company noted its distribution coverage ratio, or how much of the payments were covered, was 88%, Barron’s claims it was as low as 63% if the cost of the puts (which were only disclosed in a footnote on page 257 of a revised proxy) are included. Spokespeople for LINN weren’t immediately available for comment. ”LINN’s non-GAAP numbers are completely unrealistic,” HedgeEye’ Kaiser told Forbes. adding LINN hid costs worth nearly 30% of their distributable cash flow through unrealized losses.

Another issue has to do with equity issuance, which the company is using to finance its rising dividends, Kaiser said. While Barron’s says LINN rejects this notion, and claims it will cover its distribution this year, the company’s increase in capital stocks has hit $1.2 billion in the past 12 months, while the company burnt through $1.9 million in that time and free cash flow has been negative since fiscal 2010 (dividend payments have been increasing in every fiscal year since at least 2006).

HedgeEye suggests the fair value for LINN is around $8.00 per unit and LinnCo should trade at a slight discount to that, while Barron’s chooses to focus on LINN Energy, which they put at book value of $17.00 per unit. This differs dramatically from what sell-side analysts are saying, with JPMorgan Chase JPMorgan Chase slapping a $35.00 price target on LINN and Raymond James putting it higher at $40.00. Raymond James’ Smith explained his bullishness thus:

While we remain confident in LINN’s overall financial health and the soundness of its financial statements, we cannot ignore the uncertainty that the SEC inquiry has brought to the partnership’s near-term outlook. At this point, we believe the informal inquiry will push out the closing of the Berry acquisition by at least 30 days. However, even without LINN closing the Berry deal, the partnership’s business model and outlook remain sound.

Smith notes LINN’s production is fully hedged out to 2016 and that the company has over $2.5 billion in undrawn capacity from its borrowing base, meaning it doesn’t need to tap the capital markets any time soon. While Smith believes the SEC inquiry will pass, he notes LINN doesn’t actually need to acquire Berry, meaning a derailing of the acquisition isn’t all that bad.

Smith isn’t alone in praising LINN and its financials. He’s actually in really good company. Billionaire Leon Cooperman of Omega Advisors actually wrote a letter to Barron’s noting the oil and gas producer had accurately stated all its GAAP numbers. Cooperman speaks of a group of short-sellers that have interests in bringing the company down; he may have a point, data up to June showed short-interest in LinnCo stood at 16.3% of the float. Cooperman’s Omega, which owns 1.96% of the MLP-like LinnCo and is the third largest hedge fund investor in the company, which is 31.9% owned by said funds. (Read the letter, along with Kaiser’s annotated response, here ).

The major risk is that the SEC inquiry will force LINN to change their math on distribution, which ultimately would result in lower dividend payments. The stock has already taken a hit and, despite the backing of some prominent names, from JPMorgan Chase to Leon Cooperman, is on the SEC’s radar, raising regulatory risk and potentially sending the shares lower.