While researching portfolios for an experiment comparing High Yield investing vs. Dividend Growth investing, (you can see my portfolios here and here) I came across what I consider to be one of the best managed exploration and production MLPs in America, Vanguard Natural Resources, (NASDAQ:VNR). This company has a solid history of responsible growth and yields 8.5%, paid monthly, with distributions growing at a 4.53% annualized rate over the last 5 years. Not only is VNR a great high income stock, but recent activity by the company is setting it up to be a great dividend growth stock. Given that the market has been valuing VNR only as a slow growing, high yielding company, the recent shift in strategy might mean the company is greatly undervalued.
On Dec 31, 2013, Vanguard announced an acquisition of natural gas assets in Southwestern Wyoming. To long term shareholders, an acquisition from VNR is not surprising, given the fact that they have purchased 18 companies for $3 billion over their history. What may come as a shock is the size of the purchase, $581 million, about 3X the average size of their previous purchases.
The Southwestern Wyoming assets represent an 80% increase in energy reserves and 55% potential increase in production over VNR's current levels. The current daily production of the purchased assets is 113.4 MCFE (Million Cubic Feet)/day, with estimated total reserves of 857 Billion Cubic Feet, [BCFE] giving an estimated reserve lifetime of 20 years. The company paid about 5 times projected 2014 cash flows, about .$67/MCFE, which means they got these valuable assets for a very good price.
What is perhaps more interesting for investors is management's' announcement that they are shifting strategy from sustaining production and slowly growing distributions, to aggressively attempting to increase production and grow distributions accordingly. In 2014, capital expenditure, (investment in their business) will be more than doubled from $40 million to $90 million. Wall Street analysts are expecting close to a 100% increase in revenues from $310 million in 2013 to $604 million in 2015 due to this increased production. In addition, analysts are anticipating a 15% growth in earnings off of 50% increase in 2014 revenues, indicating a margin of 30%, which is on the low side of what management believes they can produce the new reserves at, (30-60%).
There is one further exciting thing for investors to consider when it comes to this latest acquisition. Management says they intend to hedge 70-90% of production through 2017-2018, using no cost collar options. This means that they are locking in the price for natural gas at recent and near term future prices, which due to the cold winter, should reach $5.4/million BTUs by mid April. This represents the highest price for natural gas since June of 2011 and should give VNR excellent, dependable and high margin revenue over the next 3-4 years, which will allow for an increase in the distribution growth rate.
Which brings me to my original thesis for this article that VNR is potentially undervalued given its new emphasis on production, revenue and distribution growth. To model this, I will use a discounted revenue growth model coupled with a discounted dividend growth model. The combination of which will give us a reasonable approximation of VNR's current fair value, both as a high yielding income stock and a dividend growth stock.
First allow me to explain my modeling method. I am a long term income investor. So I model a company out 5 years. I try to determine what the company's future earnings, as well as dividends, are worth today. I do this by discounting this combined price by the S&P 500's historical 6.62% annual growth, (since its inception in 1957). This compares our predicted returns against the "safe" returns we would get if we simply parked our cash in a S&P500 index fund and reinvested the dividends. In other words, we get an estimate of the fair value of earnings and dividend growth that VNR represents over the next 5 years and an estimate for what kind of returns we can expect over that time.
However, as any long term investor in MLPs knows, EPS are often meaningless. The businesses are capital intensive and legally operate as cash flow pass throughs to shareholders. This means that in order to grow, the companies must take on debt and or sell additional shares. Due to this as well as the nature of the industry, these MLPs operate in, EPS is often negative, or very low, yielding PE ratios that seem astronomically high. Since the purpose of the MLP is the distribution, which is paid out of cash flow, then a discounted cash flow model is more appropriate for valuation purposes. However, finding data on projected 5 year growth in cash flow can prove very difficult, and so substituting revenue growth seems appropriate. Consider that revenue growth and cash flow growth are so tightly correlated, and for the purpose of valuation we can use the Price/Sales ratio to determine future stock prices.
Modeling the revenue growth over the next 5 years is a bit tricky, given that revenues are typically only projected out 2 years. However, by looking back to 2008 as well as projecting forward 2 years, we find 8 years of data on revenues, allowing us to calculate a compound annual growth rate, [CAGR] of 24.9%. This is a reasonable assumption of 5 years of growth, 5 years of 25% growth amount to a tripling of revenues to about $930 million by the end of 2018. Revenues in 2015 are estimated at $604 million, which requires just 15.47% CAGR from 2016-2018. VNR has grown revenues by 35% CAGR the last 5 years, and the company is likely to continue to make acquisitions over the next 5 years, given its history and its $500 million remaining line of credit.
Future purchases are also likely to focus on undervalued assets that are accretive to cash flows, with increased cap-ex to increase production and grow revenues, cash flows and distributions. I think a growth rate of 24.9% is reasonable given management's new emphasis on growth and accounting for future acquisitions. Discounting the above revenue growth rate by 6.62% results in a projected growth rate of 23.34%. With this, we can project that by the end of 2018, VNR will have approximately $885 million in revenues. To estimate the share price, we look at the average 5 year P/S which was 4.55. Multiplying that, we get a market cap of $4.023 Billion, giving us a commensurate fair value of $51.65/share. This indicates that VNR is trading at a 41.84% discount according to my model.
In terms of valuing the distributions of the next 5 years, we must look at the historical distribution growth rate and see if it needs adjusting. Over the last 5 years, the CAGR of VNR's dividend has been 4.53%. Given management's new aggressive stance on increased production, I believe a 50% increase in this growth rate is reasonable. Once we discount this growth rate, I model 6.73% distribution growth annually over the next 5 years and anticipate $14.27 in distributions/share through 2018. Of note is the fact that many dividend growth favorites such as Chevron (NYSE:CVX) and Johnson & Johnson (NYSE:JNJ) have dividend growth rates of about 7%, supporting my claim that VNR should now be considered a dividend growth stock as well.
This gives a final fair value/share of $65.92 (including distributions) and indicates that VNR is currently trading at a 54.43% discount to fair value according to my model. Thus I anticipate 119.44% upside over the next 5 years, with a 5 year price target of $51.65 for a total annualized return of 17.02%. If dividends are reinvested, then that rate increases by 8.5% to 18.47% annualized total return.
In summary, I view Vanguard Natural Resources as one of the market's best managed and most dependable sources of high monthly income. Given management's recent change in strategy towards more aggressive growth in production, revenues and distributions, I feel that both high yield investors and dividend growth investors stand to benefit from an undervalued and high quality investment such as VNR.