Vanguard Natural Resources (NASDAQ: VNR) is a favorite MLP of income investors for its high monthly yield (7.9%). The gas producer has a consistent history of growing its distribution at a compounded rate of 4.9%, more than triple the average rate of inflation in 2014.
Source: Vanguard Natural Resources August 19, 2014 Investor Presentation
However, in the last three quarters the partnership has failed to cover its distribution with distributable cash flow, or DCF, reporting coverage ratios of .88x, .83x, and .9x, respectively for Q4, Q1, and Q2. In fact, in the last six months Vanguard has had a coverage ratio of .87x, compared to 1.03x for the same time period last year.
Drilling into these numbers
As the above image shows, Vanguard has a long track record of successfully growing both its reserves (62% annually) and its production (61% annually). Why are those reserve and production growth numbers so much larger than Vanguard's distribution growth numbers? The reason lies in the nature of exploration and production MLPs, which pay out nearly all their earnings as distributions and are forced to grow through accretive acquisitions or organic investment, paid for with either debt or issuing new equity. One can see this with Vanguard's unit count, which has grown by 40.5% annually since 2008.
VNR Shares Outstanding data by YCharts
Discerning investors will notice from the above chart that Vanguard's unit count has historically jumped up in large steps, until recently. This is because the partnership began an "at the market" program, in which management sells new units when it feels prices are favorable, a little at a time, rather than in large secondary offerings. This prevents sharp price drops and helps Vanguard raise capital for its growth plans. However, thus far this year Vanguard has sold 4.4 million units in this fashion for $133 million, resulting in 5.6% dilution.
In July the partnership raised $32.6 million through the ATM program, which represents $391.2 million on an annualized basis and which would result in 16% dilution if continued over 12 months.
Why is Vanguard raising funds in this dilutionary manner when it has $807 million available through its $1.52 billion borrowing base?
The answer lies with the management's new strategy for growth, which involves heavy capital investment to increase production from its recently acquired Pinedale and Jonah Wyoming gas fields. Vanguard bought these assets at the end of 2013 for $581 million to increase its reserves and production by 80% and 55% respectively.
The high cost of production growth
This was the first full quarter of operations after the close of the Wyoming purchase and capital expenditures were up sharply as Vanguard partners with Ultra Petroleum and QEP to increase production. Indeed the plan is working, with production up 44% for the quarter, compared to last year. This resulted in a 23% increase in adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). Unfortunately, because capital expenditures (for drilling new wells) were up 146% over last year, DCF actually declined by 4%. Thanks to the larger number of units outstanding, DCF/unit decreased 12.4%, thus the inability to cover the distribution.
In its last conference call management stated its plan to spend $65 million-$70 million (about the same level as this quarter) for the rest of the year, 60% of which will go to expanding its Wyoming gas production.
Another problem for Vanguard
In addition to much higher capital expenditures this quarter Vanguard was hit with decreased gas prices.
Henry Hub Natural Gas Spot Price data by YCharts
Though Vanguard actively hedges its production, the average price it received for its gas and oil over the last six months declined by 7.8% and 14% respectively. Thus it was a combination of higher spending on production growth as well as lower prices for its oil and gas that has hurt Vanguard's ability to cover its distribution.
What management is doing to fix the problem
Vanguard's response to its distribution coverage problem is two-fold: continued accretive acquisitions and targeting higher hedging prices for its production.
On July 30, Vanguard purchased 23,000 net acres of natural gas and oil properties in North Louisiana and East Texas for $278 million. These acres are producing 17.5 million cubic feet/day of gas equivalent (a 4.6% increase in production) but are only 57% developed. In addition, their decline rate is a low 10% which will help lower the partnership's overall decline rate and reduce maintenance capital requirements (how much it costs to keep production the same) going forward.
The second strategy to increase DCF going forward and secure the distribution is to achieve higher hedged prices for its gas production.
Source: Vanguard Natural Resources August 19, 2014 Investor Presentation
In the last quarter Vanguard received an average of $3.48 per MMbtu for its gas. As its older hedges end, its new hedges, which are priced 27% higher, will help greatly increase DCF and secure the distribution for the long term.
Foolish takeaway
Vanguard Natural Resources remains one of the best managed E&P MLPs in America and a great choice for those seeking monthly income. The distribution is secure due to Vanguard's large available liquidity however, investors need to be vigilant and keep an eye on the coverage ratio moving forward, to make sure management can execute on its strategy of aggressive organic growth and close the DCF gap.
