Vermilion Energy Inc (TSX: VET) is an international energy producer that seeks to create value through the acquisition, exploration, development and optimization of producing assets in North America, Europe and Australia. The company’s business model emphasizes organic production growth augmented with value-adding acquisitions, along with returning capital to investors when economically warranted. Vermilion’s operations are focused on the exploitation of light oil and liquids-rich natural gas conventional resource plays in North America and the exploration and development of conventional natural gas and oil opportunities in Europe and Australia. 

Investment Rationale

• Generated Solid Free Cash Flow: During Q1 2021, Free cash flow increased by CAD 142.2 million from Q1 2020, mainly due to lower capital spending in Q1 2021 as a result of a more level-loaded drilling program in our North America core region.

• Higher Commodity Realization Prices to Bolster Financial Health in Q2FY21: WTI Crude prices are up 47% on a YTD basis, and Natural gas prices soared up by 42% in the same period, implies higher underlying commodity realization prices, which is going to bolstered group’s financial health in coming quarters as well. Crude oil prices increased in Q1 2021 relative to Q1 2020 due to continued global demand recovery, a coordinated supply cut from the OPEC+ group, and lower US shale production. Further, an elevated crude oil price is going to further improve the financial health of the company in the upcoming quarters.

• Generating Higher Return on Shareholder Money: The company is generating a solid return on shareholder’s equity with a Return on Equity (ROE) of 23.5%, whereas the median Peer’s average ROE is approximately 4.1%.

• Trading at a Discounted Valuation: From the Trailing Twelve Month Price to Earnings multiple standpoints, VET shares are trading at a steeply discounted valuation against the peer’s median. VET shares are available at a TTM P/E multiple of 5.03x against the Industry Median of 20.5x. This implies that VET shares are available at a 75% discount to the industry median.

• Robust Financial Risk Profile: VET has significantly deleveraged its balance sheet in the quarter just gone by, with a Debt/Equity ratio of 1.4x as compared to 2.17x at the end of the Q4FY20. On a YoY basis, Net Debt has reduced by 7% at the end of the Q1FY21 to CAD 1,996.67 million as compared to CAD 2,155.62 million at the end of the Q1FY20. Further debt protection metrics improved with the ratio of net debt to four quarter trailing fund flows from operations decreased to 4.04x as of March 31, 2021, as compared to 4.19x at the end of December 2020.

• Focus on Debt Reduction: The group is beginning to make meaningful progress towards their debt reduction targets, having reduced the amount outstanding under the revolving credit facility by over CAD 190 million or 11% since Q2 2020. Debt reduction remains a priority as they are committed to ultimately achieving our debt-to-cash flow leverage target of 1.5 times or less.

• Outlook- Stable: The economic outlook has significantly improved compared to what it was acing at this time last year. As the global economy continues to recover from the devastating impacts of the COVID-19 pandemic, the company is starting to see increased demand for oil and natural gas, which is being reflected in higher benchmark prices for these commodities. VET continues to identify and implement cost and operating efficiencies across the business and would continue to drive this initiative going forward. Based on the current forward strip, VET continues to forecast FCF in excess of CAD 350 million for 2021 while also retaining significant leverage to rising commodity prices.
  

• Risk Associated with Investment: The company’s operations and financial performance are directly correlated to the demand and price of crude oil. Any volatility in prices of crude oil or change in demand dynamics would affect the group’s financial performance.

Financial Highlights: Q1FY21:

• Consolidated average production of 86,276 boe/d in Q1 2021 represented a decrease of 11% from Q1 2020 production of 97,154 boe/d. Production decreases were mainly in Canada of 7,130 boe/d, in Ireland of 1,206 boe/d, and in the Netherlands of 1,137 boe/d primarily attributable to natural decline.
• The group generated CAD 79 million of free cash flow in Q1 2021 after investing CAD 83 million in exploration and development capital expenditures, resulting in a payout ratio of 56%, including reclamation and abandonment expenditures.
• The company recorded Fund flows from operations of CAD 162 million in Q1 2021, an increase of 20% from the prior quarter. The increase was primarily due to higher commodity prices, most notably global crude oil and European natural gas benchmarks, which represent the company’s two most dominant products from a revenue-generating perspective.
• The company recorded net earnings of CAD 500.0 million (CAD 3.15/basic share) for Q1 2021 compared to a net loss of CAD 1,318.5 million (CAD 8.42/basic share) in Q1 2020. The increase was primarily driven by an impairment reversal of CAD 662.9 million in Q1 2021 compared to impairment charges of CAD 1,564.9 million in Q1 2020.
• Net debt decreased to CAD 2.0 billion as of March 31, 2021, from CAD 2.1 billion as of December 31, 2020.
• In North America core region, capital expenditures of CAD 59.1 million were incurred during Q1 2021. In Canada, CAD 54.3 million was incurred primarily related to drilling and completions activity where the company drilled ten (9.7 net) Mannville wells and completed 15.0 (14.7 net) Mannville wells.
• In the International core region, capital expenditures of CAD 24.3 million were incurred during Q1 2021. VET activities internationally included the drilling of 1.0 (0.5 net) wells in the Netherlands.

Top-10 Shareholders

Top-10 Shareholder together holds approximately 13.41% stake in the company, with The Vanguard Group, Inc. and Donadeo (Lorenzo) are major shareholders with an outstanding position of 2.74% and 2.01%, respectively. Institutional ownership in the company stood at 23.32%, whereas strategic shareholding stood at 3.02%.  

Valuation Methodology (Illustrative): EV to Sales Based valuation Metrics

Note: Premium (discount) is based on our assessment of the company’s growth drivers, economic moat, competitive advantage, stock’s current and historical multiple against peer group average/median and investment risks.

Stock Recommendation: Crude prices and Natural gas prices are rising consistently due to continued global demand recovery, a coordinated supply cut from the OPEC+ group, and lower US shale production. Elevated crude oil prices would help the group in delivering improved performance in the coming quarters.

VET continues to identify and implement cost and operating efficiencies across the business and will continue to drive this initiative going forward. The group is beginning to make meaningful progress towards its debt reduction targets, having reduced the amount outstanding under the revolving credit facility by over CAD 190 million or 11% since Q2 2020. Debt reduction remains a priority as the company is committed to ultimately achieving its debt-to-cash flow leverage target of 1.5 times or less. Based on the current forward strip, VET continues to forecast FCF in excess of CAD 350 million for 2021 while also retaining significant leverage to rising commodity prices.

Along with deleveraging of the balance sheet, the debt protection metrics has improved with the ratio of net debt to four quarter trailing fund flows from operations decreased to 4.04x as of March 31, 2021, as compared to 4.19x at the end of December 2020.

Therefore, based on the above rationale and valuation, we recommend a “Buy” rating on the stock at the closing price of CAD 9.26 on July 15, 2021.

*Depending upon the risk tolerance, investors may consider unwinding their positions in a respective stock once the estimated target price is reached.

Technical Analysis Summary

1-Year Price Chart (as on July 15, 2021). Source: REFINITIV, Analysis by Kalkine Group

*The reference data in this report has been partly sourced from REFINITIV.

*Recommendation is valid at July 16, 2021 price as well.

Disclaimer

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