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Introduction

Cheap can get cheaper. This is one lesson that this market is trying very hard to repeatedly teach investors. While this does take a deep test of one’s patience, it also throws abnormally exceptional opportunities our way! Today we take a deeper dive into one of them which we believe only comes around once a generation. We are talking about Vermilion Energy (VET) and its rather extraordinary 14.7% plus dividend yield. VET has pulled back over 55% over the past 12 months due to negative investor sentiment on the energy sector, opening the door for a unique buying opportunity:

The Business

VET is a globally diversified energy producer with assets in North America, Europe, and Australia. https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668199880885787.pngSource: VET Aug Presentation

While Australia is a small part of the production base it provides more than 10% of the free cash flow due to the low capex requirements.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668201412634196.png

Source: VET Aug Presentation

VET’s goal has been to provide its investors with a stable and growing dividend via annual organic production growth. We will look at where the numbers stand today and figure out if this huge yield can be maintained in this environment of recessionary fears.

History & recent Spartan Energy acquisition

VET has been around since 1994 and has steadily expanded overseas by entering different countries over time.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668202912403026.png

Source: VET Aug Presentation

VET has focused its efforts on organic growth. At the same time, its great execution has allowed it to capture a higher average multiple than its peers. VET has used this to to acquire select properties at low multiples via share issuance. Most recently this was shown in the case of Spartan Energy. This was quite an extreme bargain purchase. We highlight some key metrics below (emphasis ours).

“Under the terms of the Arrangement, Vermilion has agreed to acquire all of the common shares of Spartan issued and outstanding at the effective time of the Arrangement (the “Acquisition”). Spartan shareholders will receive 0.1476 of a Vermilion share for each Spartan common share. Based on Vermilion’s closing price of $44.04 on April 13, 2018, the exchange ratio translates to $6.50 per Spartan common share, representing a 5% premium to Spartan’s closing price.

Making no deduction for undeveloped land value, transaction metrics equate to $12.33 per boe of proved plus probable (“2P”) reserves (based on Spartan’s reserve report(1)), and $60,900 per flowing barrel of production. Based on April 13, 2018 WTI strip pricing of US$65.19/bbl, the operating netback for the acquired assets is estimated at approximately $38.42 per boe. Using a 2P finding, development and acquisition cost of $19.48 per boe (including future development capital) based on the Acquisition consideration and Spartan’s reserve report, the acquired assets are expected to deliver a 2P operating recycle ratio of 2.0 times (including the Acquisition cost).

Using the same strip pricing assumption, the total Acquisition cost (including assumed debt) is approximately 4.7 times estimated annualized 2018 fund flows from operations (“FFO”), after deducting incremental interest expense.”

Source: Newswire

We can see the big jump in production in 2018 as this was completed.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-1566821741778338.png

Source: VET Aug Presentation

At the time VET funds were trading at over 7X FFO. Issuing shares at 7X plus FFO to purchase a company at less than 5X FFO is incredibly accretive and this boosted reserves as well as FFO per share quite nicely.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668217661217556.png

Source: VET Aug Presentation

Looking at longer term, what is also notable in the above figure is that VET has been able to grow production and reserves per share rather notably during times when commodity prices have been low.

The monthly dividend

What differentiates VET from most other energy plays is its monthly dividend. VET has paid out huge amounts over the years but more importantly, maintained dividends through two major oil price drops.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668235890332613.png

Source: VET Aug Presentation

Both cases are highly instructive to look at what we might see from VET going forward. In 2007, VET had just raised its dividend (called trust distribution back then) and while the front half of 2008 proved fantastic, the back half of 2008 and most of 2009 was rather horrifying. VET stuck through that time frame paying the dividend, even as its payout ratio ballooned. In fact 2010 total payout ratio which included growth capex went as high as 162%.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668237930213778.png

Source: VET Aug Presentation

That extremely high payout ratio which was heavily equity financed, dropped production per share by 10% but VET stuck through that era knowing its capital projects would eventually bail it out. VET was able to deliver that and slowly but surely production per share stabilized and started rising.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668239870956438.png

Source: VET Aug Presentation

While that was impressive, remember that 2008-2009 price drop was rather brief. The 2014-2017 time frame was far more challenging. Prices dropped 75% from the peak and unlike the big rebound of 2009-2010, prices stayed depressed. VET did one better this time. It not only maintained the dividend but raised it in 2018 and also grew production per share.

How was this possible?

There were two key reasons in our view. The first being that VET’s production base has matured and the base decline rates continue to fall. As a result the amount VET spends in maintaining production has been falling and was far lower in 2016 than it was in 2010.

The second reason is that when oil prices fall, energy service costs fall as well. This acts as an offset for all companies and VET has been able to leverage this rather nicely during downturns.

Our point from all of this is that while no one can predict exactly when the next recession will strike, VET appears to be one of the best equipped to maintain their dividends and sustain production.

Financials and Valuation

Today production and reserves per share are at all-time highs while valuation has compressed to an all-time low. For 2019 VET has guided for production of 101,000-106,000 BOE per day. At the midpoint of 103,500 that is a big jump over 2018 production of 87,270 boe per day. However the Spartan Energy acquisition which occurred at the end of Q2-2019 has distorted this comparability. A better number to benchmark this against would be the Q3-2018 production which would be the first full quarter after the Spartan Energy acquisition. Q3-2018 numbers showed 96,222 BOE/day.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668225466813161.png

Source: VET Q4-2018 financials

We want to stress this number as this gives us good insight into the sustainability of the dividend. 2019 average production will be about 7.56% higher than the production achieved in Q3-2018. We are talking about average production as Q3-2019 production likely will be higher than the 7.56% number shown above. But in any case we think comparing 2019 average production to Q3-2018 exit numbers gives us a good guide on how effective VET’s capex is.

As of Q2-2019, VET is forecasting that it will have an all-in FFO payout ratio of close to 100%. That is, it will be able to:

1) Conduct capex to increase production by 7.56% over Q3-2018 levels.

2) Pay its dividend

Hence the average price that VET expects to receive in 2019 ($57.50 WTI US) is more than sufficient to conduct growth and pay the big dividend. VET has broken this down further in estimating approximately what price of oil is required for it to have just enough FFO to sustain its production.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668231619501753.png

Source: VET Aug Presentation

This number VET estimates to be around $33/barrel. This however excludes the dividend. VET has commented on this in the past and suggested that their base production maintenance capex alongside dividends would be sustainable around $40 WTI price.

The other way of examining the value you are getting is by looking at the price to FFO ratio, which is now under 3X! The price is also significantly under the lows hit when oil was at $26/barrel.

ChartData by YCharts

This is the lowest valuation we have seen on any metric for VET and we believe the shares are pricing in a long term oil price of under $40/barrel. We have previously shown why such numbers are unsustainable and we continue to believe that oil needs to be priced over $60/barrel to balance demand and supply.

Investors may also fret that the company might be over-leveraged; the opposite is true when we look at the debt metrics.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668418239951143.png

Debt to EBITDA will be under 2.0X this year. Interest coverage will be a rather extraordinary 13.9X.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-1566841888338717.png

The bulk of the debt is tied to the bank line and that just got extended out to May 2023.

Hedging

While we did not mention it above, VET was helped in sustaining its dividends through downturns via hedging. It has hedges today as well.

In aggregate, as of July 25, 2019, we currently have 40% of our expected net-of-royalty production hedged for Q3 2019. More than half of our Q3 2019 corporate hedge position consists of two-way collars and three-way structures, which allow participation in price increases up to contract ceilings. For 2020, approximately 70% of our hedge position is in participating structures. We have currently hedged 71% of anticipated European natural gas volumes for Q3 2019. We have also hedged 69% and 65% of our anticipated full year 2019 and 2020 European natural gas volumes, respectively, at prices which are expected to provide for strong project economics and free cash flows. At present, 33% of both our expected Q3 2019 and Q4 2019 oil production is hedged.

While VET has hedged, the oil hedges are on the lower side than in the past suggesting that VET is bullish on prices at the current strip. On the flip side VET has been far more aggressive in hedging its European gas exposure and locked in great prices well into 2021.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-1566825320024016.png

Source: VET Q2-2019 financials

We think VET’s hedging is a good strategy although we would have liked had they used previous oil spikes to hedge a larger percentage of North American oil production.

Insider ownership and change in strategy

VET’s founder still is associated with the company and is currently the chair of the Board of Directors. More importantly he owns about 3 million shares.

https://static.seekingalpha.com/uploads/2019/8/26/47392447-15668401481654618.png

Source: VET 2019 AIF

What that means is he is down $150 million since VET’s peak price and we are certain that he is not too happy with this recent move. VET did get a 5% share buyback authorization recently, but we are reaching such insane levels that possibly the company needs to rethink whether any growth is worth it and whether the capital could be better deployed in buyback shares. We think that at current numbers it is very hard to make a call to increase production when buybacks would result in much better production per share growth. While the thinking has not got there yet, we think it is a matter of time.

On the other hand, someone could scoop this gem up. We saw this with another commodity (lumber) producer, Canfor Corp (OTCPK:CFPZF) where the majority owner waited until every bear lined up against him and then offered a cool 86% premium to buyout the company. Canadian oil producers are cheaper at this point than Canfor was prior to the bid. We think it is also a matter of time someone starts running the very obvious math and buying these out oil companies out.

Tax Note

There is no K-1s here for the dividends. VET provides 1099 tax forms. The dividends will have 15% tax withholding for US citizens, but you are given a tax credit for those amounts. Also, to the best of our knowledge, no taxes are withheld inside IRAs or Roth IRAs.

Conclusion

VET’s price decline has been quite painful for the bulls and we would reiterate that cheap can get cheaper. For investors looking at this here though, the dividend looks quite sustainable and 10 years out we see very little chance of them being disappointed. Management is experienced and has shown ability to leverage their plays. The founder is sitting on a lot of paper losses and we think a change of strategy is highly probable if the stock price does not improve. We love the value here and for income investors, VET is a strong buy with a multiyear horizon. The 14.7% yield alone is very rewarding, and is likely to be one of the biggest winners in your high yield portfolio!

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Disclosure: I am/we are long VET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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2019-09-04