Vermilion Energy — Dividend suspended to protect balance sheet

In Q120, Vermilion production averaged 97.2kboed, representing a decrease of 1% compared to the previous quarter, with minor effects from the COVID-19 pandemic (see discussion below). Production in Canada averaged 59.5kboed in the quarter, an increase of 2% from the previous period, reflecting contributions from new well start-ups, and multiple wells in Mannville and south-east Saskatchewan performing ahead of expectations. Q120 financial results were already affected by lower realised prices. Vermilion recorded a net loss of C$1,319m in the quarter, primarily driven by an increase in impairment charges of C$1,519m as a result of the reduction in forecast commodity prices.

In response to COVID-19, Vermilion made adjustments to its operating practices providing for both the safety and continuity of its operations, and as at the time of this report, no confirmed COVID-19 cases have been reported in the company’s global workforce. Currently, production impacts have only been observed due to the limited third-party service interruptions and a refinery outage in France. The Grandpuits refinery in the Paris Basin is expected to remain offline until mid-July 2020. The shut-in impact is estimated to amount to an annualised 2.0kboed of Vermilion’s production.

Management’s financial and operational responses to protect the company’s balance sheet from the current macroeconomic headwinds included the suspension of the monthly dividend. In March, the board reduced the monthly dividend by 50% to C$0.115/share in response to the COVID-19 pandemic as a measure to strengthen the company’s financial position. However, the prevailing weak commodity prices and current expectations led management to suspend the monthly dividend from April 2020. In this note we update our valuation and estimates taking these measures into consideration as well as the following points:

The net impact of these changes on fund flows from operations (FFO) is largely driven by commodity price forecasts (Brent 24%), with our forecast FFO for FY20 falling 9% to C$456m and FY21 to C$541. The impact of low commodity prices is somewhat mitigated by the hedging programme the company has in place.

We use a blended approach when valuing Vermilion. This includes a combination of FY20e P/CF, EV/EBITDA and free cash flow (FCF) (plus growth projects). Previously we have also included the valuation based on a dividend discount model (DDM). However, since the dividend is currently suspended and there is no clarity on the future dividend policy, for now, we have excluded the DDM valuation from our methodology. All in all, we have arrived at a valuation range of C$6.7/share to C$10.9/share resulting in an average blended valuation of C$8.8/share (down 8%). This reflects the effects of our lower commodity price assumptions versus our previous note. The current low oil price environment led management to suspend the monthly dividend following capital expenditure adjustments for FY20 to C$360m from an initial guidance of C$450m. Exhibit 2 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 bar of the exhibit).

Exhibit 3 below shows the changes in valuation metrics since our March 2020 valuation of C$9.7/share, which already took into consideration the first wave of the COVID-19 pandemic’s impact on global energy markets. We have updated the P/CF and EV/EBITDA ranges from 2.0–4.0x to 3.0–4.5x and 4.0–6.0x to 5.5–7.0x, respectively, to reflect the current market-based metrics for Vermilion’s peer group, which saw a slight upturn since our last note (see Exhibit 4).

An important sensitivity to our forecasts and valuation lies in the prices of key commodities. Oil prices experienced a drastic decrease on 9 March 2020 (down c 60% from January 2020), as can be seen in Exhibit 4. As mentioned above, we have updated our short-term base case oil price forecasts for FY20 and FY21 to align them with the current market sentiment, as per EIA 7 April 2020 guidance.

We also note that since mid-March 2020, following the initial reaction to the coronavirus pandemic and the low oil prices, oil and gas companies’ market capitalisations have slightly recovered, despite the continuous decline in oil prices (see Exhibit 4). This shows that the market is reacting positively to the industry response to lower commodity prices, including measures such as capex and dividend cuts/suspension to protect their balance sheets as well as possible OPEC+ production cuts.

In Exhibit 5 we provide sensitivities to commodity prices to reflect various oil price scenarios. We note that a 10% reduction in all key commodities (WTI, Brent, NBP, AECO and TTF) vs our base case forecasts would result in a c 9% fall in Vermilion’s FFO after the inclusion of the impact of realised hedges on FY20.

In Exhibit 6 we provide a peer group valuation as at 30 April 2020, which reflects the impact of the macroeconomic headwinds the oil and gas industry is facing. The table shows that Vermilion’s FY20e P/CF and EV/EBITDA multiples currently are at 1.8x and 5.5x, respectively. Vermilion’s EV/EBITDA multiples for FY20 are in line with its Canadian intermediate peers and rest of the world group, which trade at 5.4x and 5.6x, respectively. On a P/CF basis for FY20, we see that Vermilion trades at a significant discount at 1.8x, with peers trading at 3.0x and 4.6x, respectively. However, this might be justified by Vermilion’s relatively high leverage metrics such as a net debt to EBITDA ratio of 3.6x for FY20e, while peers trade at lower multiples of 3.2x and 1.9x.

In March 2020, Vermilion reduced its monthly dividend by 50% to C$0.115/share, as an initial response to weakness in commodity prices and global economic activity following the coronavirus outbreak. However, following the Russia/Saudi Arabia oil price war coupled with the prospects of lower global oil demand for FY20, the company decided to further reduce its monthly dividend to C$0.02 per share on 16 March 2020. On 15 April 2020, however, the board of directors decided to suspend the monthly dividend to protect the company’s balance sheet and preserve cash. This results in a cash dividend of c C$100m for the year so far. For 2020, we forecast operating cash flow of C$553m and funds from operations (FFO) of C$456m (which excludes changes in working capital and asset retirement obligations), which just almost cover the combined cash outflows for sustaining capex and cash dividends of C$460m, and with other small outflows we expect year end net debt of c C$1.9n.

In Exhibit 7 below we show that at a 10% discount to our current commodity price assumptions, cash dividends already paid are covered; however, management might need to take further measures to cover the planned sustaining capital. These measures could include additional cuts to sustaining capex and/or taking on more debt, although Vermilion needs to maintain gearing below current covenant limits (consolidated total debt to consolidated EBITDA covenant limit of 4.0x). We have stress tested our model for a commodity price at a 10% discount to the base case and observe that, in this scenario, Vermilion would need to raise c C$46m to cover the current dividends and sustaining capex, or cut capex by the same amount. This would result in a net debt to EBITDA ratio in FY20 of 4.0x. The average net debt/EBITDA for Canadian E&Ps in FY19 was 2.3x.

In Exhibit 8 we model the stress test for Vermilion’s net debt/EBITDA at a 10% discount to our base case commodity price scenario, corresponding to a realised Brent price of US$30/bbl average for FY20, driving net debt/EBITDA to 4.0x. We also stress test the balance sheet at a 40% discount to our base case commodity price scenario, corresponding to a realised Brent price of c US$20/bbl average for the year, which is the lowest level Brent has reached in 2020 (US$19.33/bbl on 21 April 2020). Without any cuts in sustaining capex, this would drive net debt/EBITDA to 5.6x. This analysis shows that, even after the recent capex reduction and dividend suspension, Vermilion’s balance sheet is highly sensitive to oil price assumptions. At the low commodity price levels, the company’s gearing multiples exceed the current total debt to EBITDA covenants. However, the company has room to cut capex and/or renegotiate debt and respective covenants.