Vermilion Energy — 14% dividend yield and FY20 growth covered

Vermilion has production assets in a range of mature basins and developed economies: Canada, the US, France, the Netherlands, Ireland, Germany and Australia. Management reported production of 87kboed in FY18, growing to 100–101kboed in FY19 based on company guidance (Edison: 100.8kboed). Based on our commodity price assumptions, this will drive fund flows from operations (FFO) from C$834m in FY18 to an Edison estimate of C$947m in FY19. Vermilion was recently rated AA in MSCI’s annual ESG rankings for FY19, meaning Vermilion Energy is considered a company leading its industry in managing the most significant ESG risks and opportunities. This rating is an improvement from A in the previous two years and reflects management determination to be the leader in ESG in the energy industry.

Our blended valuation approach uses fundamental and market metrics, where we look across a peer group of 105 global listed E&Ps to establish comparable multiples and operational metrics for companies with similar levels of production and market capitalisation. We find that on the basis of FY20e cash flow (Bloomberg consensus), valuations range up to 8.4x depending on the company’s growth profile, development pipeline, contingent resource base and the extent of financial leverage. Given this wide range in peer group cash flow multiples, we have valued Vermilion on the basis of levered and unlevered cash flow metrics, using the Gordon growth dividend discount model and a sum-of-the-parts (SOTP) valuation basis that incorporates maintenance free cash flow (FCF) and the NPV10 of identified growth projects. Our valuation range extends from a low of C$26.3/share to C$38.3/share, with a midpoint of C$32.3/share. We believe Vermilion should trade towards the top end of this range based on its defensive qualities, high netbacks, low F&D costs and OECD operations with low subsurface risk.

Low financial leverage, capital discipline and cost reductions have enabled Vermilion to sustain dividend payments for over 15 years despite commodity price volatility. Many of its peers have had to resort to recapitalisations and/or reductions in dividend payments as oil prices fell in 2014/15. Vermilion’s monthly dividend has never been reduced: it has increased four times since 2003 and most recently was increased to C$0.23/month on 1 March 2018, effective with the April 2018 dividend. We tested Vermilion’s dividend sustainability, and we believe it is covered for FY19 and FY20. Vermilion’s low financial leverage allows the company to resort to external financing in a low commodity price environment if required.

In this note, we update our valuation. The fundamental component remains virtually unchanged, but we have adjusted the peer-based component to reflect lower equity valuations for the sector. Our valuation uses the same weighting for fundamental and market components. This brings our current valuation to C$38.3/share (vs C$47.5/share previously). A key sensitivity to our valuation is that of commodity pricing. A 10% increase in our commodity price assumptions for FY20 would increase our valuation to C$42.4/share and a 10% decrease would take this down to C$34.8/share. Political risks remain present and pertain to changes in fiscal terms, planning and operating regulations, and government perspectives on the hydrocarbon sector.

Vermilion is a global E&P with operations spanning developed economies including Europe, North America and Australia. A detailed description of Vermilion’s diverse asset base can be found in our initiation note and Spartan acquisition note. Commodity price exposure is also diversified, with realisations spread across several global oil and gas benchmarks including Brent, WTI, Henry Hub, TTF and NBP.

Vermilion has grown organically and inorganically through a series of new country entries. Management chose to focus on three regions that offer relatively stable political, fiscal and regulatory regimes: Europe, North America and Australia. In 2019, Vermilion expanded its Central and Eastern Europe (CEE) presence after being awarded two exploration licences in Ukraine in partnership with Ukrgazvydobuvannya (UGV, a Ukrainian state-owned gas producer) in the Dnieper-Donets Basin. For 2020, management estimates that the contributions to FCF from oil (Brent), European gas and oil/condensate (WTI) will be 26%, 26% and 48%, respectively. Geographically, it estimates the 2020 breakdown to be Canada 42%, France 15%, Ireland 14%, Netherlands 11%, Australia 10%, US 6% and Germany 2%.

Over the past decade, Vermilion has demonstrated its ability to consistently grow production while replacing produced reserves through-cycle. Momentum has accelerated in recent years, despite the downturn in commodity markets, through new country entries and acquisitions. Management intends to continue to grow production through self-funded selective organic and inorganic investments, which should support further growth in shareholder distributions.

Vermilion believes it has an important role to play in the energy transition. Mindful that oil and gas consumption will continue during the transition, the company strategy focuses on reducing the environmental impacts of traditional energy production while developing renewable energy projects closely related to Vermilion’s core competencies.

Vermilion’s track record of reducing emissions while optimising production, and its use of geothermal energy, set it apart in the industry. Vermilion was recently rated AA in MSCI’s annual ESG rankings for 2019, placing the company in the top 19% of oil and gas companies worldwide. This rating is an improvement from A in the previous two years. MSCI ESG Research is the world’s largest provider of ESG ratings and research. Vermilion’s rating is the result of improving company ESG performance and enhanced disclosure on topics relevant to MSCI’s detailed assessment process.

In the current investment environment, ranking high in ESG has become a priority as more and more investors look at these metrics to aid with investment decisions.

At group level, Vermilion production decreased 5.6% from 103.0kboed in Q219 to 97.2kboed in Q319. This was largely driven by a number of turnarounds during the quarter, unplanned downtime and weather delays. Production increased in the US from organic growth and in France as production returned to near full capacity following the impact of a refinery outage in Q219. The increase was more than offset by the decreases in Canada, the Netherlands and Ireland. As a consequence of two consecutive quarters with production in the low-end or below guidance, management updated full year guidance from 101–106kboed to 100–101kboed.

Q319 results were slightly below our estimates We have reviewed our forecasts for FY19 and FY20. Key changes include:

The net impact of these changes on FFO is largely driven by commodity price forecasts and lower production, with our forecast FFO for FY20 down 15% to C$901m. These figures are highly leveraged to underlying commodity prices.

Our production forecasts by country and commodity are provided below. We have updated these to incorporate Q219 and Q319 results and FY20 guidance. Key moving parts include:

Key company-specific risks and sensitivities include:

Key sector-specific sensitivities include:

Lorenzo Donadeo: Chairman: Mr Donadeo has more than 35 years’ experience in the oil and gas business, including mergers and acquisitions, gas marketing, production, exploitation, and field operations in western Canada and internationally in Australia, France, the Netherlands, Germany, Ireland, Trinidad and Tobago. He was a co-founder of Vermilion Resources (1994), now Vermilion Energy, and currently serves as chairman of the board. In 2015, Mr Donadeo was recognised for his outstanding service to France with official appointment to the National Order of the Legion of Honour at the rank of Chevalier.

Anthony Marino: President and CEO: Mr Marino is an accomplished senior executive with a proven track record of high shareholder returns during his over 35 years career in the energy industry. He joined Vermilion in June 2012 as chief operating officer and was appointed president in March 2014. He became Vermilion’s CEO in March 2016. Prior to joining Vermilion, Mr Marino held the position of president and CEO of Baytex Energy Corporation, after initially serving as Baytex’s COO. Previously, he held the role of president and CEO of Dominion Exploration Canada, a division of Dominion Resources. Earlier in his career, Mr Marino held a variety of technical and management positions with AEC Oil and Gas (USA) Inc, Santa Fe Snyder Corp and Atlantic Richfield Company. He brings a wide range of experience in operations management, business development and capital markets to his role as CEO of Vermilion.

Michael Kaluza: Executive Vice President and COO: Mr Kaluza has spent over 32 years delivering results in North America and overseas in the energy business. Mr Kaluza joined Vermilion in 2013, as director, Canada Business Unit and prior to that he was vice president, corporate development and planning at Baytex Energy. In 2016, he was appointed executive vice president & chief operating officer of Vermilion Energy Inc. Mr Kaluza’s earlier roles included chief operating officer at Delphi Energy and various technical and management positions at Dominion E&P / Dominion Exploration Canada and Phillips Petroleum Company.

Lars Glemser: Vice President and CFO: Mr Glemser has over 15 years of experience, primarily in the financial area of oil and gas operations. Mr Glemser joined Vermilion in 2015 as operations controller and moved into an investor relations role in 2017 before advancing to director of finance in January 2018. In April 2018, he was appointed vice president and chief financial officer. He has more than a decade of industry experience with diverse roles in finance/treasury, corporate planning and corporate development with Vermilion and previously with Lightstream Resources and Tristar Oil & Gas.

We believe that Vermilion’s asset base and range, its funded production and covered dividend is not captured in the current share value, and our valuation of the group’s strong fundamentals remains essentially unchanged (down 5%). However, our overall blended valuation, averaging a combination of FY20e P/CF, FY20e EV/EBIDAX, DDM and FCF (plus growth projects) declines from C$47.5/share to C$38.3/share (down 19%). This reflects the effect of a lower peer group valuation of oil and gas companies (down 36%), predominantly observed in North America, and we have consequently reduced our FY20e P/CF and FY20e EV/EBIDAX range limits, as can be seen in Exhibits 8 and 9. We assume that commodity prices remain stable and that Vermilion maintains positive free cash flow generation. Taking all these into account, we arrive at a valuation range of C$26.3/share to C$38.3/share. Supported by Vermilion’s peer-leading dividend yield, growth rate and low historical F&D costs, we believe that a valuation at the top end of this range is justified.

Exhibit 7 shows the differentials in the valuation metrics when we compare the market-based valuation (the first two bars of the exhibit) and the fundamentals-based valuation (the last two bars of the exhibit). Exhibit 8 below shows the changes in metrics since our March 2019 valuation of C$47.5/share. This includes the metrics above and has rolled forward to a FY20e basis (previously FY19e).

In Exhibit 9 below we show the evolution of our valuation of Vermilion since initiation in March 2018 and the change in variation of market and fundamentals ranges over the period. As already mentioned, investors appear not to sufficiently differentiate between Vermilion and the oil and gas market as a whole, as can be seen by the widening gap between both valuation approaches. Vermilion’s current share price corresponds to the low end of our market share of the valuation and even though it trades at a premium to its Canadian Large E&P peers on a market basis, it appears to inject no substantial value for the company fundamentals.

Exhibit 10 below shows the decrease of Vermilion’s share price since October 2018 when commodity prices reached a three-year maximum. However, even though since January 2019 commodity prices have remained relatively stable, oil and gas companies, including Vermilion, have experienced a continuous decrease in market value, reflecting uncertainties, among other things, relating to geopolitics and future commodity pricing

An important sensitivity to our forecasts and valuation lies in the prices of key commodities. Our base case oil price forecasts for FY19 and FY20 are based on EIA October 2019 forecasts. We calculate the sensitivity to these in Exhibit 11 below. If, for example, we were to assume all key commodities (WTI, Brent, NBP, AECO and TTF) were 10% below our base case forecasts, FFO would fall by c 10% post-hedge (after inclusion of the impact of realised hedges to FY19).

Vermilion hedges to manage commodity price exposures and increase the stability of cash flows, providing additional certainty with regard to the execution of its dividend and capital programmes.

Exhibits 12 and 13 show Vermilion’s FY20e P/CF and EV/EBITDA multiples at 3.5x and 5.7x respectively, versus global peers as well as Canadian peers. The valuation is more in line with our ‘rest of the world’ group average of 4.3x FY20e P/CF and FY20e EV/EBITDA.

We believe Vermilion’s premium valuation of 3.5x on the basis of FY20e P/CF reflects its materially higher growth and dividend yield (and its ability to cover this) than its Canadian Large E&P peers, which are currently trading at c 2.8x P/CF. Vermilion’s estimated production growth in FY19e relative to FY18 is largely inorganically driven, and growth for FY20e relative to FY19e is likely to be more in line with the peer group at c 1.6%.

A key investment consideration is that Vermilion is broadly cash flow neutral, its production is funded and the cash dividend is covered. At end December 2018 Vermilion’s balance sheet had net debt of C$1.8bn. For 2019 we forecast operating cash flow of C$853m and funds from operations (FFO) of C$947m (excludes changes in working capital and asset retirement obligations), broadly equivalent to combined cash outflows for capex and cash dividends of C$912m and, with other small outflows we expect year end net debt of C$1.9bn. We expect a similar pattern in FY20e.

A key question for investors is the company’s ability to sustain its growth capex and future dividend levels. In the exhibits below we show that, even at our base case price forecasts, both the sustaining and growth capex and the dividend are fully covered. Even under lower commodity price scenarios, where the cash outflow to fund dividends and capex may not be fully covered, we conclude that Vermilion retains flexibility and has numerous options.

These could easily include taking on debt, which could be achieved while maintaining gearing well below current covenant limits (consolidated total debt to consolidated EBITDA stood at 1.9x as of end Q319 relative to a covenant limit of 4.0x). We have stress tested the low case of a commodity price at a 10% discount to the base case and observe that, in this scenario, Vermilion would need to raise c C$70m to cover maintenance and growth capex and dividends, which would leave it with a net debt to EBITDA ratio in FY20 of 2.5x. The average net debt/EBITDA for Canadian E&Ps in FY18 was 2.0x. This would work as a short-term solution, but may have an impact on growth capex availability and consequently longer-term funding.

Even in the event that reductions in cash outflows were required, we expect management to prioritise the payment of dividends, followed by maintenance capex over growth capex, noting that Vermilion has not decreased its dividend since 2003. In Q319 Vermilion already announced a C$10m reduction in FY19 capex to C$520m and FY20 guidance is more conservative than FY19 at C$450m. However, this analysis shows that, for the current dividend, Vermilion’s balance sheet is highly sensitive to the cash its assets generate, and this level of dividend payout may not be sustainable in the long term, since it could lead to an increase in debt, which might stress Vermilion’s balance sheet. Assuming dividend and maintenance capex remain constant, management of revenue through hedging and growth capex will be essential to protect Vermilion’s balance sheet.