Time to fill (TTF) the void in Canadian energy portfolios through exposure to skyrocketing European natural gas prices
The Desjardins Takeaway
We are reiterating our Buy thesis on Vermilion following its in-line 2Q21 financial results. The company is rapidly trimming debt with support from stronger commodity prices, particularly European natural gas benchmarks that are setting fresh record highs on a near-daily basis, including again yesterday. As a result, we believe that VET is well- positioned to resume its dividend payout at some point next year, ideally on the back of a strategic acquisition that accelerates balance sheet deleveraging.
Highlights
Time to fill (TTF) the void in Canadian energy portfolios. Despite in-line quarterly results from our vantage point, the stock underperformed yesterday, which could reflect some disappointment from retail investors—patiently awaiting the return of what was once one of the most lucrative (and reliable) payouts in the Canadian energy sector —at the lack of a dividend announcement. However, barring the announcement of a strategic acquisition, which alas was not forthcoming yesterday, we frankly would have been surprised to see the resumption of the dividend at this juncture.
While the company has made great strides in repairing its balance sheet through disciplined capital allocation, having now slashed ~C$327m (or 14%) of net debt since the end of 2Q20, there is still considerable work to be done to meet the internal D/ CF target of 1.5x. For reference, we still expect that milestone to occur at some point in mid-2022, highlighting that we now see VET generating nearly C$300m of free cash flow through the balance of 2021 and another ~C$515m next year based on current strip prices, which translates into a ~17% FCF yield.
The other potential headwind for the stock yesterday may have been the increase in the company’s reported net debt figure, which conservatively includes unrealized current hedging losses. We note that this metric has increased substantially in recent quarters, due in large part to skyrocketing European natural gas prices, which have negatively impacted the implied value of the hedge book. That said, VET still provides significant exposure to spot European gas prices, with ~50% of forecast continental volumes remaining unhedged from 3Q21–4Q22.
Valuation
Our C$13.00 target implies 3.1x EV/DACF (2022E), which is significantly below the stock’s historical consensus multiple of 6.8x, reflecting elevated debt levels.
Recommendation
We maintain our Buy rating.