Penn Virginia Resource Partners Changing For The Better

By Stephen D. Simpson, CFA | May 01, 2012 AAA

Given how well the Street reacted to Penn Virginia Resource Partners' (NYSE:PVR) announcement that it was acquiring Chief Gathering in a transformative $1 billion deal, the time between now and closing will probably seem to drag a bit. After all, few investors are keen on thermal coal at all right now, and especially the Appalachian coal that makes up so much of PVR's asset base. Luckily for new investors, there still seems to be room for further appreciation, though it comes with added execution risk.

SEE: Mergers and Acquisitions: Understanding Takeovers.

A Sluggish Q1
All in all, PVR had a pretty sluggish first quarter. Coal revenue declined 15% as an 18% drop in volume more than outweighed the benefits of a 4% increase in per-ton royalties. Midstream gas revenue was flat, as the 55% increase in daily throughput volume was minimized by adverse pricing.

Not surprisingly, operating income also suffered. Although PVR management held the line on costs in the coal business, there was just no way to outrun the revenue erosion and operating income from coal fell 18%. Costs were likewise higher in the gas business and even reversing an impairment charge still points to a nearly one-third drop in operating income.

SEE: A Primer on Coal.

The Dividend Still Safe for Now
Some investors may worry about the balance of cash flows moving in and out of the company. That's reasonable, seeing as how the primary reason to own stocks like PVR, Alliance Resource Partners (Nasdaq:ARLP), Natural Resource Partners (NYSE:NRP), Energy Transfer Partners (NYSE:ETP) or Magellan Midstream (NYSE:MMP) is for the distribution income.

With $75 million going out to capex expansion and $40 million in distributions, PVR clearly outspent the $45 million it brought in during the first quarter. The good news here is that not only does the company have access to sufficient credit facilities, but also that management sets distributions based on its capex plans and its liquidity position, and arguably under-pays so as to make sure they do not have to claw it back with subsequent distribution reductions. Admittedly this comes down to "trust us," but I would argue that management's track record (no distribution cuts in five years) supports that.

And Now For the Execution
One of the biggest perks to the Chief deal will be the fact that the company will go from having a minority of its midstream revenue on a fee basis to having a majority of it on a fee basis - which will reduce the risk to shareholders, but also reduce some of the potential gains. With the deal, though, the company is going to have quite a number of organic expansion projects to manage, as well as a much different business model. That increases the execution risk - PVR has done a good job so far with its midstream business, but the new business is different and there is a risk of mismanaging these assets.

The Bottom Line
There is some risk that Penn Virginia Resource Partners becomes an unappealing hybrid partnership company - too much gas to please investors who want coal assets, and too much coal for those who want a pure midstream gas play. I'd argue that it's actually a beneficial mix, especially since the coal business is arguably undervalued today on the poor current thermal coal environment. Nevertheless, investors who want a purer play on coal would do better to consider switching over to Peabody (NYSE:BTU), Alliance or NRP.

Valuation on PVR is a little quirky today because of the huge impact of the upcoming Chief deal close and integration. On its own merits today, PVR looks to be worth about $28-$30 as a dual coal/gas entity. Factoring in Chief, though, pushes that fair value into the low $30s on an EBITDA basis, and the long-term distributable cash flow analysis backs that up. With more than 20% undervaluation and an 8% dividend yield, these shares are worth a look.

SEE: Dividend Tax Rates: What Investors Need to Know

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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