In the current challenging oil and gas environment, stock prices of many Canadian producers got hammered over the last several months. Among those producers, some pay a heavy dividend.

The graph below shows the market now offers many opportunities at TTM (Trailing Twelve Months) dividend yields between 8% and 11%.

Data by YCharts

In previous articles, I discussed these dividends were sustainable at current oil and gas prices (here, here, here, and here).

But Vermilion Energy’s (VET) dividend yield is outstanding, even in the context of 8%+ dividend yield opportunities. Over the last several months, the dividend yield was in line with the other producers I listed in the graph above. But, recently, the stock price dropped even further and the dividend yield increased to 14.56%, widening the gap with its competitors.

So, the doubts about the sustainability of such a high dividend are valid. In this article, I’ll address this question and I’ll discuss Vermilion as a potential investment proposition.

Onshore oil and gas productionImage source: DrillingEngineer via Pixabay

Note: All the numbers in the article are in Canadian dollars unless otherwise noted.

Is the dividend sustainable?

A small part of the shareholders (which represented 6% of the shares this year) decided to take part in the DRIP (Dividend Reinvestment Plan). But, for simplification, I assume the dividend is fully paid in cash. This assumption is actually close to reality as management initiated an NCIB program to offset the effect of the dilution from the DRIP. Thus, I assume the monthly dividend of C$0.23 per share represents an annual cash outflow of about C$428 million.

During Q2, FFO (Funds From Operations) was C$222.8 million, which corresponds to an annualized FFO of C$891.2 million. At Q2 oil and gas prices, the dividend is sustainable if the sustaining capex is below C$891.2 million – C$428 million = C$463.2 million.

During the latest earnings call, management said the sustaining program to hold 2018 production flat was C$365 million. Then, I calculate the sustaining costs as C$365 million / (87,270 boe/d * 365 days) = C$11.46/boe.

Applying these costs to the midpoint of the 2019 production range would correspond to a sustaining capex of C$11.46/boe * 103,500 boe/d * 365 days = C$432.9 million.

Thus, at Q2 oil and gas prices, the free cash flow covers the dividend. But there’s not much cash left for other capital allocation decisions (production growth, share buybacks, and debt reduction).

A different Canadian producer

Beyond the sustainability of the dividend based on Q2 results, it’s worth considering how the company differs from its competitors.

Due to its diversification to European markets, Vermilion isn’t the typical North American producer. About 38% of its expected production in 2019 is located in Europe and Australia.

Thus, the company has some exposure to European gas and Brent oil prices. Also, due to its overseas operations, royalty and tax costs are different compared to North American producers.

For instance, I compare Vermilion to the producer Enerplus (ERF) that has assets in the U.S. and in Canada. Both companies operate a similar product mix and their production volume is close to 100,000 boe/d.

Vermilion Energy Q2: producgt mix

The table below shows Vermilion’s royalty and tax cost advantage.

Vermilion Energy Q2: costs and netbacks

Source: Author, based on company reports

Besides, due to the Brent oil and European gas prices, Vermilion generated a better total netback despite higher operating, G&A, and interest costs.

Vermilion Energy Q2: strip prices assumptions

Source: Investor presentation August 2019

Vermilion also benefits from the low decline rate of its assets outside of Canada.

Vermilion Energy: decline rates

Source: Investor presentation August 2019

The recent drop in the stock price may be due to the collapse of the European gas price that impacted the FFO, though.

Vermilion Energy gas prices

Source: Q2 2019 MD&A

Also, Vermilion’s leverage isn’t conservative. The net debt to annualized FFO ratio was 2.19x at the end of Q2. Management confirmed the goal of reducing the ratio to 1.5x. But, as most of the free cash flow is paid out as a dividend, deleveraging to this level will take several years.

Valuation at a discount

Management confirmed 2019 production guidance in the range of 101,000 boe/d to 106,000 boe/d. Taking into account the midpoint of the production guidance, the market values Vermilion’s flowing barrels at C$47,243/boe/d.

The premium to Enerplus’ valuation is significant despite the similar product mix. Also, Enerplus’ capital structure is safer due to its low net debt. But Vermilion generates much higher netbacks due to its European and Australian assets.

Vermilion Energy Q2: flowing barrel valuation

Source: Author, based on company reports

Both producers don’t own huge quantity of reserves. Based on the midpoint of the 2019 forecasted production, Vermilion’s 2P RLI (Reserve Life Index) is less than 13 years.

Source: Author, based on company reports

Consistent with the flowing barrel valuation, the market values Vermilion’s reserves at about twice the price as Enerplus’ reserves. The reason is the same: Vermilion’s reserves generate higher total netbacks.

The intrinsic valuation shows the market values Vermilion at a 41% discount to my estimates. I assume the company will generate a total netback of C$11/boe over the long term, as it did during Q2. Then, I apply a 12x multiple to the corresponding flat production.

Vermilion Energy Q2: intrinsic valuation

Source: Author, based on company reports

The 41% discount and the 14%+ dividend yield are attractive. But the market currently offers higher free cash flow yield opportunities. I wrote about some of them here, here, and here.

Also, considering the discount, buying back shares instead of paying a dividend would increase value to shareholders. And given the leverage above 2x, I’d also prefer the company to reduce its net debt.

Thus, despite the attractive valuation, I stay on the sidelines. The company is interesting for dividend-oriented investors, though. And the production outside of North America provides some diversification.

Conclusion

At current oil and gas prices, the impressive 14%+ dividend yield is sustainable and the market values the company at an important discount.

But, considering the low valuation and the leverage, I’d prefer the company to reduce its net debt and repurchase shares instead of paying such a high dividend.

Thus, while the company is interesting for dividend-oriented shareholders, I prefer to stay on the sidelines.

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Disclosure: I am/we are long BTE, CPG, CRLFF. 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.

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2019-09-06