CA - Vermilion Energy: A Winner In Energy Transition Priced At 4x FCF

2023-09-12 08:00:00 ET

Summary

• To say that Vermilion Energy is cheaply valued doesn't do it justice.
• Vermilion Energy has near-term prospects, while natural gas is emerging as a crucial player in the energy transition.
• The upcoming winter season, with its increased demand for natural gas, offers the potential for a rebound.

Investment Thesis

To say that Vermilion Energy (VET) is cheaply valued with strong prospects doesn't do justice to this investment thesis. Yes, Vermilion is priced around 3x to 4x its 2024 free cash flows. But even that doesn't fully reflect this opportunity.

Think about this. Natural gas plays a pivotal role in power generation for charging EVs and provides a reliable energy source for AI-driven technologies, which require vast computing capabilities. This dual role positions natural gas as a versatile and essential component of the energy transition. In other words, as the world modernizes, the bridge fuel will be natural gas.

And yet, I recognize that an investment in Vermilion does carry some blemishes. However, I still remain bullish on this stock.

Why Back Natural Gas?

Natural gas is emerging as a crucial player in the energy transition towards a more electrified world. As societies increasingly embrace EVs, AI, and electricity-powered households, the demand for clean, reliable, cheap, and abundant energy sources has grown exponentially.

Natural gas, often viewed as a bridge fuel, offers several advantages in this transformative journey. First, it serves as a cleaner alternative to traditional fossil fuels like coal and oil, emitting fewer greenhouse gases when burned. This makes it a viable option to reduce carbon emissions, a key objective in the energy transition that can not be underplayed.

Moreover, natural gas plays a pivotal role in enhancing grid reliability. The intermittency of renewable energy sources like wind and solar can be mitigated by using natural gas-fired power plants as backup generators. These flexible plants can quickly respond to fluctuations in energy supply, ensuring a stable and resilient electricity grid. As the world becomes more electrified, natural gas stands as a versatile and sustainable energy source that can facilitate this transition while reducing environmental impacts.

Further, contrary to common belief, natural gas power generation often boasts higher energy efficiency when compared to wind turbine technology. Natural gas power plants typically operate at thermal efficiencies exceeding 50% , meaning they convert a significant portion of the fuel's energy into electricity. In contrast, wind turbines, while environmentally friendly and renewable, have variable efficiency rates that depend on wind speeds and turbine design. On average, wind turbines tend to operate at lower efficiencies, often hovering around 30-40% . This discrepancy in efficiency underscores the continued relevance of natural gas in meeting electricity demands efficiently, despite the growing emphasis on renewable energy sources in the modern energy landscape.

In the graphic above I highlight investors' sentiment towards Siemens Energy (SMEGF), with its shares once again priced near a multi-year low, as echoing my declaration, that demand for natural gas isn't going to dwindle any time soon.

Whilst I make no argument one way or another about oil, I believe that natural gas and oil are not the same. I maintain that natural gas will in time become a bigger energy source than oil, even if today this thought may seem farfetched in reasoning.

All that being said, the good thing about Vermilion is that we don't have to look too far out. The business' prospects are strong enough now.

Vermilion's Near-Term Prospects

Let's cut to the chase. We are about to enter the high-demand season for natural gas. Natural gas is for the most part used for heating. Last winter, it was abnormally warm. Hence, unless this winter is just as "abnormally warm", we should see natural gas demand mean-revert to normal.

And given that we are already starting from a relatively high base, particularly compared with the pre-Russian invasion, this bodes well for Vermilion.

Vermilion's free cash flow this year was not strong. It was dramatically lower than in 2022, but that has been expected for a while. What matters now is how this winter unfolds.

If we get a normal winter, when taken together with the fact that in 2024 this business will not have to put aside substantial capital for its windfall tax, I believe that in 2024 Vermilion could perhaps return as much as CAD$300 million. This would be around 10% of its market cap.

However, I believe that this figure is a very conservative estimate, and I would not be at all surprised to see Vermilion's return of capital be substantially higher. Vermilion states that it will reach its targeted net debt figure by H1 2024, at which time management will notify investors of its updated capital returns program.

Vermilion maintains that in 2024, it should be on target for CAD$1.4 billion, plus CAD$570 million of capex. This leaves the stock priced at around 4x next year's free cash flow. A figure that is unquestionably cheap. That means that investors getting involved now, only have to wait 4 years at the present rate, and after 4 years, the company's upside is all for free.

Next, let's discuss some bearish aspects.

Risk Factors to be Mindful Of

Irrespective of the narrative, the fact remains that an investment in Vermilion is fully contingent on the price of natural gas. And the price of natural gas is largely tied to the weather.

Vermilion management has in the past been less than transparent with its capital allocation strategy. Investors will undoubtedly be mindful of this consideration and this will mean that Vermilion won't get a "full" premium on its valuation, even if the price of natural gas moves in the right direction.

The Bottom Line

Vermilion presents a compelling investment opportunity as it's undervalued with the growing importance of natural gas in today's energy landscape. While its stock price appears inexpensive, the role of natural gas as a cleaner and versatile energy source in the transition to electrification, driven by EVs, AI technologies, and household electricity use, cannot be underestimated .

The upcoming winter season, with its increased demand for natural gas, offers the potential for Vermilion to rebound from a weaker 2023 performance. With a possible return of at least CAD$300 million in 2024 and a target of CAD$1.4 billion in free cash flow, Vermilion's low valuation at around 4x next year's free cash flow makes it an appealing prospect for long-term investors.

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