I've been a fan of PVR Partners, LP (NYSE: PVR) (formerly known as Penn Virginia) for quite a while and through the company's migration from an Appalachian coal royalty trust to a more diversified business that now generates about two-thirds of its earnings from midstream natural gas operations. While the company took on a lot of debt to acquire Chief and that business has not ramped up quite as quickly as once hoped, and the company is facing generally slower growth in natural gas than expected, I believe the long-term appeal of this partnership is solid.
Growing Gas Offsetting Weak Coal
Give credit where due – PVR Partners management saw the unfavorable future for Appalachian coal a little while ago and took actions to do something about it. As a result, the company has been able to offset declines in the coal business with growth (both organic and acquired) in natural gas gathering and processing.
Looking back at the first quarter (reported in late April), coal royalty tons declined 21% year-on-year, leading to a 26% decline in adjusted EBITDA. Natural gas EBITDA grew strongly, though, as both Eastern Midstream (up 278%) and Mid-Continent Midstream (up 27%) grew even in the face of weak natural gas drilling and production.
SEE: Income Funds 101
Management also announced that it had reached an agreement with a major producer in the Utica Shale (Ohio) to share costs on a gathering and trunkline system, as well as an agreement with a producer in the Cline Shale (West Texas) to gather and process natural gas at its plant in Hamlin, Texas.
Can Coal Come Back?
There's no question that PVR Partners sees its future in the gas fields. While the death of coal may be at least somewhat exaggerated, it's nevertheless true that Appalachian coal is getting more expensive to produce and has a higher break-even point with natural gas for use in electricity generation. While PVR does have a reasonably diverse reserve base (including the San Juan and Illinois Basins, which are more cost-competitive with gas than Central Appalachian coal), it's getting harder and harder for operators like Arch Coal (NYSE:ACI) to generate positive economic returns in the region. It is important to note, though, that PVR does not operate its coal mines – it leases them to other operators.
I would be surprised if PVR put significant amounts of capital back into its coal business. I do expect coal demand (and pricing) to recover as natural gas prices rise, but there's a huge amount of uncertainty about the timing of that scenario. Luckily for PVR, it's not as though coal spoils over time (though mines do require maintenance).
Managing Growth, Distributions, and Liquidity In Natural Gas
PVR has established a high-quality midstream natural gas business in multiple important plays across the country. Over time, I would expect the company's leading Marcellus dry gas platform to generate solid earnings and cash flow. Unfortunately, dry gas is not an especially profitable business right now, and major PVR customers like Chesapeake (NYSE:CHK), Anadarko (NYSE:APC), and Royal Dutch Shell (NYSE: RDS.A) have cut back on their exploration and production plans until gas prices improve. Even so, though, PVR expects to connect 100 wells in the Marcellus region this year – up from an earlier expectation of 90 wells.
SEE: Oil And Gas Industry Primerhttp://www.investopedia.com/articles/07/oil_gas.asp
While PVR waits for gas prices to improve, managing the balance sheet and unitholder expectations will be important. The company took on quite a bit of debt to grow its midstream business, and carries a debt/EBITDA ratio about 10% higher than the norm among gathering/processing partnerships. Likewise, the company's distribution coverage has slipped below 100% - well below the 125% norm for the group and below comparables like Access Midstream (Nasdaq: ACMP) and MarkWest Energy Partners (NYSE:MWE). As a result, I think distribution growth could be a little weak relative to the growth in the near term, as management looks to rebuild some breathing room and capital flexibility.
The Bottom Line
Although PVR stretched itself to grow its midstream business, I believe the assets will generate good cash flow over time. As a result, I'm still basically bullish on this partnership. That said, investors need to realize that weakness in coal demand and Marcellus production are near-term risks. Likewise, I do have some concerns about how these units will perform in the market as rates head higher.
Discounted distributions and EV/EBITDA provide similar outlooks on valuation. EV/EBITDA (using a 14x multiple) suggests fair value of around $29.50, while a discounted distribution model assuming 5% long-term growth and a required return of 10% suggests a $30 fair value. While investing in LPs is not for everyone and can create issues/complications with taxes, PVR looks like a decent, though maybe not immediately compelling, idea in the LP space.