Vermilion Energy Inc (VET) is a Canada based, global oil and gas producer with operations in North America, Europe and Australia. The company’s stock trades both in Canada as well as the US. In this article, we analyze it asset mix, growth and income prospects, balance sheet, risks associated and finally conclude with our opinion on whether the company’s valuation offers attractive risk-reward.
Note: This article was originally released to members-only on Oct 26.
Overview:
Vermilion Energy Inc is a Calgary, Alberta based oil & gas company that undertakes production of oil & gas resources. Geographically, the company’s key assets lie in North America, Europe and Australia. As of Dec 31, 2018, the company had 192 MMboe of proved developed producing (PDP) reserves. Out of the existing reserves, crude oil accounts for 55%, natural gas 34% and NGL 11%.
Below is a breakdown of the company’s revenue and cashflows by country:
A rare combination of small/mid cap style growth and large cap style diversification
The company is highly diversified for a SMID Oil & Gas company with Canada, the top contributor accounting for just 40% of the company’s revenues. The company has grown its non-Canadian presence primarily via acquisition. In fact, the company made its first international acquisition within 3 years of its founding when it acquired assets in France from Exxon for $45 million. Apart from regional diversification, the company has also focused on diversifying its hydrocarbon mix with nearly 43% of its production in the form of gas as well as exposure to Brent pricing. The diversified product portfolio reduces volatility in earnings for the company as its fate is not a function of a particular country’s production and taxation trend.
Source: Vermilion Energy
Global crude oil and natural gas pricing advantage
The company’s operations in Europe provide it exposure to premium priced oil & gas markets. Europe’s oil sales are indexed to Brent which trades a premium to WTI (YTD: $5/bbl premium). Additionally, European Gas trades at a premium as well. Not surprisingly, while oil indexed to Brent accounts for 18% of the company’s production, it accounts for nearly 30% of the FCF. Similarly, while European Gas accounts for 19% of the company’s production, it accounts for nearly 31% of company FCF. The premium priced oil & gas exposure leads to better FCF margins for the company as compared to other Canadian peers. Additionally, the company doesn’t have any exposure to heavy Canadian crude which is priced at a deep discount to WTI (YTD: $13/bbl).
Source: Vermilion Energy
Consistent track record of production and reserve growth
Since 2014, the company has seen strong growth in production both as a result of organic drilling activity as well as acquisitions. Going forward, the company should be able to grow production by around 8% which coupled with a dividend yield of nearly 14% is a very impressive return dynamic for investors.
Source: Vermilion Energy and Blue Harbinger Research
Sustainable, growing monthly dividend stream
It is quite remarkable and rare for a SMID oil & gas producer (not midstream company) to have maintained and grown dividends during what has been a tumultuous period for the industry due to erosion in oil & gas prices. Further, the company has achieved this without using leverage or major asset sales.
Source: Vermilion Energy and Blue Harbinger Research
Additionally, unlike majority of the dividend paying universe, the company pays monthly dividends to investors which is appealing to investors who would prefer a higher frequency of income than quarterly or annual. Apart from higher frequency, monthly dividends could also amount to higher returns over the longer term due to the impact of compounding.
Despite aggressive production growth and associated growth capex, the company has largely funded its growing dividend from internally generated cash flows when excluding M&A activity. Please note that the company has a dividend reinvestment plan that allows shareholders to opt for stock instead of cash hence the actual cash dividends can differ from dividends declared.
Source: Vermilion Energy and Blue Harbinger Research
Finally, the company’s dividends payable to US shareholders are treated as “qualified” dividends which are taxed as at a lower capital gains tax rate rather than the ordinary tax rate, further amplifying after tax dividend yield as compared to companies that pay non-qualified dividends.
Balance sheet is in good order
Vermillion’s net debt to annualized FFO at 2.2x at the end of Q2 2019 is below the median of the peer group. The increase in leverage since 2014 has primarily happened due to reduction in earnings power from lower oil & gas prices as well as partial debt funding of the recent acquisition of Spartan Energy which owns light oil assets in Saskatchewan, Alberta and Manitoba. Management aims to bring the ratio down to 1.5x overtime. Regardless, the company is in a comfortable position in terms of debt servicing as its Interest coverage is close to 13.9 times as compared to covenant requirement of 2.5x while Debt to EBITDA is 1.8x as compared to covenant requirement of 4x.
Source: Vermillion Energy and Blue Harbinger Research
Valuation is at attractive levels
Due to one-time hit to volumes from weather events and shutdowns as well as weak gas pricing in 2019, the company’s FFO in Q2 2019 declined 12% sequentially from Q1 2019. As a result, the company’s stock has taken a hit and dividend yield has expanded to 12.5% (more recently 13.6%). This has led to a unique situation in which the company’s production growth and dividend yield % both lead its peer set.
Source: Blue Harbinger Research, Yahoo Finance
The company’s CEO in a recent Bloomberg interview talked about dividend and capital program for 2019 being fully funded internally. Additionally, he talked about cutting capex before any reductions are made to the dividend in the worst case scenario.
Risks
Volatility in oil & gas prices: Despite commodity hedging activity that isolates the company partially from oil & gas price volatility, the company remains vulnerable to a significant and protracted decline in oil & gas prices.
Strength in Canadian Dollar: Given significant part of the company’s cost structure is in CAD while revenues are in USD, a significant appreciation in CAD without proportional increases in oil & gas prices could lead to earnings pressure.
Conclusion
Vermilion energy at its current stock price level offers a unique combination of production growth as well as highly attractive dividend yield with below average financial leverage. The company has a history of self-funding capital programs as well as net dividends despite oil and gas price volatility as a result of attractive economics of its assets coupled with proactive hedging activities to reduce volatility. If you are looking for a unique high income investment, Vermilion is worth considering.