Article Republished By Javier Troconis
Vermilion Energy Inc. (NYSE:VET) is an energy stock to buy as it remarkably manages to address the risk of its sensitivity to external market price volatility in an advantageous and forward-looking manner. As I will elaborate below, this feature puts VET a cut above its industrial peers.
Vermilion Energy Inc. is a Canadian company that is a large player in the petroleum and natural gas sectors, serving the markets of North America, Europe, and Australia. The company’s business approach is based on acquiring, exploring, developing, and producing natural gas and petroleum to meet global demand. The Vermilion strategy is focused on enhancing its FFO, whilst simultaneously returning value to the capital of shareholders, which it aims to achieve through value-enhancing acquisitions.
The main fundamental driver that is the basis of the company’s financial sustainability is the global commodity market and its price shifts. An increase by a single dollar in the price of crude oil per barrel translates into an additional $16 million in FFO for the company, given the scale at which it supplies the critical fuel. While these conditions presently do make the outlook for the company highly favorable, they also expose its future growth to significant risks, that could be faced even with the slightest fluctuations. The Vermilion business outlook, therefore, is favorable to investors that hold a bullish stance towards the commodities market, as the present inflationary environment reinforces.
Financial Prospects And Performance
In its annual earnings report for FY21, VET reported an FFO figure of $920 million and an FCO figure of $545 million, denoting an increase of 83% and a whopping 304% rise respectively, against the prior year’s comparable figures. The primary catalyst behind these forces was the demand pressures driving up prices of the commodities that Vermilion deals with. 2020 brought a significant slowdown to the global oil market, which resulted in a significant drop in prices, which had made the 2021 recovery so staggering in comparison. The following graph indicates the EPS movement associated with VET over the years:
As can be observed, the company’s earnings surpass not just its pre-Covid performance of 2019, but even during its high-performance period of 2014. The potential investor would rightfully be concerned if such a dramatic increase in earnings, coming directly as a result of commodity price climbs is sustainable looking forward.
To assess the role of increasing commodity prices, it would be more prudent to assess this shift from a different perspective. The growth in financial performance that Vermilion had achieved came despite decreasing its annual production by a further 10% following the slowdown brought in during 2020. This indicates that the surge in earnings by the company had been heavily dependent upon broader market conditions, as opposed to the company’s performance. Therefore, reliance on FFO and FCO growth alone may not suggest financial sustainability, but may hint at the company’s significant exposure to external market volatilities, which could potentially take a flipside turn if macroeconomic conditions take a turn. However, this is a risk not inherent to VET and is faced by every oil and gas player in the global markets, which by its nature performs favorably when the commodity market is on a bullish trajectory.
However, what is impressive from a performance standpoint is Vermilion’s reduction of its long-term debt from $1.93 billion in 2020 to $1.65 billion in 2021. This had been achieved by strategically paying off both its revolving credit facility, as well as the total of its senior unsecured loans, which collectively totaled a net reduction of $365 million. I believe this move sheds a more holistic light on the prospects of the company. Its earnings surge may not have been a result of controllable performance factors, however, employing the advantage of favorable macroeconomic conditions to deleverage its financial position indicates the company’s strategy toward financial sustainability.
Similarly, in November 2021, the company had publicized an agreement with the Corrib Gas Project in Ireland, which would entail the company increasing its working interest by an additional 36.5%. The consideration for this arrangement had totaled $600 million and is expected to return in free cash flow up to $500 million in 2022 alone. This not only is in line with the company strategy of maximizing FFO to return to shareholders, but drastically enhances exposure to the European gas market, and essentially rebalances the company’s international weighting. Most crucially, the move is projected to ensure the company’s total debt is brought down to $1.2 billion by 2022.
These strategic initiatives point to how the company has capitalized on the significant earnings advantage it had received owing to favorable macroeconomic shifts, to strengthen its financial sustainability from a forward-looking perspective. I believe this approach delivers Vermilion a substantial advantage, as it is using the dividends from the current conditions to ensure sustainability despite a dip taking place in the future if the macroeconomic scenario is to take a turn. In essence, the company is utilizing its gains to strengthen its position, making it better able to continue its earnings streak in case commodity prices take a fall.
In late April of 2022, Zacks Equity Research featured Vermilion in its recommendations of high momentum stocks, given its favorable performance and price metrics. The analysts over at Zack further give the stock an A-grade style score, classifying it as a high-value stock, whilst ranking it 31st throughout the entire industry (of 253 peers) and 1st within its sector (of 16 peers). I am inclined to agree with this favorable view, owing to the price-based valuation metrics that VET holds in comparison to similarly priced oil and gas players within the industry:
As can be observed, Vermilion collectively holds the most impressive price-based valuation metrics. Its significantly low PE ratio is an indicator of how VET is priced the lowest in comparison to the earnings it delivers, making it the most efficient investment option from the list of comparable stocks in the industry.
Moreover, its extremely low PEG ratio of 0.14 highlights that the stock’s undervaluation is further emphasized once its earnings growth potential is factored into the calculation. Further metrics of P/S ratios and P/B ratios further indicate the degree to which VET is currently trading at a discount, in comparison to its actual valuation, hence my stance of it being a buy.
One reason why I believe VET is significantly undervalued in comparison to its peers is due to its strategic ability to leverage external advantage in strengthening its financial position. In 2021, its strategic acquisitions enabled Vermilion to enhance its total proved plus probable reserves by 3% on an annual basis and replaced nearly 146% of its production on the 3p system. As a result of this initiative, the company had managed to enhance its probable reserve life index to 15.4 years. This highlights how Vermilion has used its present advantage to secure its future position, making it highly sustainable, and a great investment choice. This potentially positions VET above its peers in the future, when the market may take a potential dip, in the case of which VET would fare significantly better, owing to its long-term forward-looking positions.
Despite the best strategic efforts on the part of the Vermilion management to ensure future risk minimization to volatility, the company faces a substantial risk, which ties to the overall sustainability of the oil and gas industry as a whole. This links to the current efforts of governments pushing toward energy self-sufficiency, with these sentiments exacerbated following the US economic sanctions placed on Russia in early 2022. It rightfully would raise concerns amongst VET investors knowing that governments across the globe are actively pursuing alternative energy sources that are far more sustainable, given their relative protection against global economic shockwaves. This movement is further catalyzed by increasing pressures for industries to turn towards green energy alternatives, to safeguard the climate.
Vermilion, which prizes itself as a sustainability champion, would need to take a proactive strategic stance to overcome this transition, and make the necessary business restructures and transformations if it is to survive post-transition.
Vermilion is in many ways a typical oil and gas company that allows its investors to capitalize on the rising commodity prices, by gaining exposure to these supply and demand-linked factors. However, the crucial differentiating factor with VET is the degree to which it uses favorable macroeconomic conditions to strengthen its financial position, which would ultimately deliver it a safety net in the case the market eventually takes a dip. I believe this is why the stock stands as being significantly undervalued, and why investors would do well to include this in their portfolios.