I recently wrote about Vanguard's latest earnings with a specific focus on the partnership's difficulty in covering its distribution. In that article, I explained the reason for the company's lack of distribution coverage, but this week Vanguard announced a major acquisition that could be just what the doctor ordered for not only securing the current yield, but accelerating distribution growth in the future. 

What's Vanguard buying? 

Piceance Basin
Source: EIA.

Vanguard Natural Resources (NASDAQ:VNR) is purchasing 12,000 net acres in the Piceance Basin in Colorado from the Bill Barrett Corporation (NYSE:BBG) for $525 million. The acreage includes an average of 78% interest in 950 wells that are producing 67 million cubic feet/day equivalent of gas. With estimated proved reserves of 389 billion cubic feet of gas equivalent, the land is expected to produce for 16 years at current production levels and exhibit a decline rate of 11% annually. The average cost of production is expected to be $0.80/thousand cubic feet (Mcfe) over the next three years, and Vanguard plans to hedge most of its production, resulting in an estimate gas price of 80% of the Henry Hub spot rate (the benchmark for gas prices).

The acquisition is expected to be immediately accretive to distributable cash flows (DCF) and close before October 1. It is being funded with the company's existing borrowing base, which stood at $807 million prior to the acquisition. 

The Piceance Basin is a tight gas formation, which differs from shale in that it is usually a lower permeability sandstone formation that makes for more difficult economic gas production. However, decline rates are similar to shale gas, which is important to this analysis and will be discussed below. 

What it means for the distribution 
This is Vanguard's 24th acquisition, and it pushes the partnership's total acquisition total to $4.5 billion since its IPO in 2006. 

According to Richard A. Robert, Executive Vice President and Chief Financial Officer, "We are anticipating significant benefits from this transaction including improved distribution coverage and accelerating our ability to resume our slow and steady distribution growth policy." 

Vanguard Distribution
Source: Vanguard Natural Resources August 19, 2014 Investor Presentation

The Piceance basin acquisition is important because, like the recent $278 million August acquisition of 23,000 net acres in North Louisiana and East Texas, the decline rate is very low: 11% in Colorado, 10% in Louisiana and Texas.

With MLPs paying out the vast majority of earnings as distributions, growth of the distribution, which is the strongest driver of capital gains, is dependent on accretive acquisitions or increasing production. Production growth can be tricky since the decline rate for shale/tight gas wells can be as high as 50%-75%, according to Pete Stark, senior research director at IHS Inc.

Vanguard's distribution coverage problem
With Vanguard increasing its capital expenditures by 146% because of its increased drilling in its Pinedale Wyoming field with partners Ultra Petroleum (NASDAQ:UPL)and QEP Resources (NYSE:QEP), the partnership needed to add some acquisitions that included increased production with minimal additional cost.

This is because in the last three quarters, the partnership has posted distribution coverage ratios of 0.88, 0.83 and 0.9 respectively, partially due to the increased capital spending, but also because of the partnership's new "ATM" program. 

VNR Shares Outstanding Chart
VNR Shares Outstanding data by YCharts.

"ATM" stands for "At the Market," and it means Vanguard can issue new units to sell, a little at a time, as opposed to a traditional secondary offering in which a large number of units dilute existing investors all at once. Thus far in 2014, Vanguard has sold 4.4 million units in this fashion, raising $133 million and diluting unit holders by 5.6%. 

There is nothing wrong with this form of financing, as long as what it pays for is accretive to existing investors, meaning the DCF/unit increases.

These two acquisitions, by increasing production by 27% with minimal capital expenditure requirements, are immediately accretive to DCF. 

What's more, the anticipated cost of production, at $0.8/Mcfe in Colorado and $1/Mcfe in Texas and Louisiana, indicates that these acquisitions will greatly help distributable cash flow. This is especially true given the low decline rates and the fact that the Colorado acquisition comes with "established infrastructure in place and multiple pipeline outlets to market our production."

Foolish takeaway
Vanguard's latest acquisition continues its emphasis on already producing, low-decline gas fields and should go a long way to securing the distribution. If management can execute its Pinedale production growth plans effectively, and I believe it will, then the partnership will once again be able to grow the distribution at its historical rate of 4%-5%. Given the current 7.9% yield, that would mean long-term income investors could anticipate market-beating total returns for years to come.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. The Motley Fool has the following options: long January 2016 $25 calls on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.