We recently moved to an Underperform rating for Penn Virginia Resource Partners L.P. (PVR), on expectations of a significant dilution of cash distribution stemming from the partnership’s announcement to merge with its general partner, Penn Virginia GP Holdings L.P. (PVG).
Despite this near-term fear of dilution, we like Penn Virginia Resources for its diverse coal reserves and leases, located in four different producing basins: Central Appalachia (73%), Illinois (20%), Northern Appalachia (3%) and the San Juan Basin of New Mexico (4%).
Penn Virginia Resource’s coal-royalty business generates revenues by leasing its coal reserves for a royalty payment. Additionally, we favor earnings from the partnership’s Midstream business, which helps diversify its low-risk coal royalty business, benefiting from its hedging strategy.
We believe the partnership’s royalty structure allows for asset and producer diversification, while it eliminates the direct exposure risks that coal mining companies typically face, namely mine operating costs and risks, environmental liabilities and labor relations challenges.
Penn Virginia GP Holdings holds a 37.6% stake in Penn Virginia Resources. The merger between the two partnerships involves completion of 100% equity consideration. The merger transaction would result in PVR owning its general partner and the cancellation of PVG’s incentive distribution rights (IDRs) and L.P. units owned. Furthermore, the merger involves the issue of roughly 38.3 million new PVR limited partnership units and the cancellation of about 19.6 million PVR limited partnership units owned by PVG.
In the long term, the merger is expected to place the partnership in a better position to compete for acquisitions, increasing returns on future transactions.
Though the merger would reap profits for PVR in the long term and benefit from significant reduction in the cost of capital, we expect the transaction to be dilutive to the partnership’s distributions in the near term, affecting investor sentiments. As a result, we expect the share price to lose much of its sheen in the near-term, keeping investors away from the stock for the time being.