CA - Vermilion Q3 Earnings: Strong Free Cash Flow Projection For 2024

2023-11-06 14:41:01 ET

Summary

• Vermilion Energy Inc. has hedged 40% of European natural gas production.
• Anticipated robust 2024 free cash flow of CAD$750 million.
• Projected price-to-free cash flow ratio of less than 5x.

Investment Thesis

Vermilion Energy Inc. ( VET ) is named after a reddish-orange color. Akin to well-oxygenated blood color. Ironic, if you think about it because this ''bloody'' stock has cut many investors in 2023. And whilst I'm firmly aware of its trial and tribulations, I also believe that this is categorically not the time to throw in the towel on this stock.

Vermilion has hedged close to 40% of its European natural gas production. Allowing the company to declare that its free cash flow in 2024 could reach as much as CAD$750 ($550 million), leaving this stock priced at less than 5x next year's free cash flows.

Quick Recap,

I've been bullish on Vermilion for a considerable amount of time, see below .

As such, I believe that I'm sufficiently well-informed to know many of the trials and tribulations as well as Vermilion's upside potential.

To be clear, 2023 didn't play out as I had expected for Vermilion. However, 2024 is now just around the corner and there's a lot to be bullish about with Vermilion.

The Energy Transition, Slow But Taking Hold

The ongoing energy transition, while indicative of a global shift towards sustainable practices, undeniably demands a significant investment of time and capital.

The magnitude of the transition is unmistakable, with the momentum gradually picking up as societies worldwide grapple with the challenges of decarbonization.

Notably, a clear trend has very slowly started to emerge, highlighting an inclination towards the electrification of everything. From the adoption of EVs to the transformation of data centers and the surge in demand for a diverse array of consumer electronic devices, the common denominator remains the need for a dependable supply of base-load electricity.

As this trend gains traction, it underscores a critical juncture in the global energy landscape, where the requirement for sustainable, resilient, and efficient power generation stands as a defining factor in the progression toward a cleaner future energy supply.

Natural Gas Is a Destination Fuel

Beyond the visible presence of solar panels and wind turbines, the intricacies of the ongoing energy transition reveal a complex reality.

While the proliferation of renewable energy sources signifies a crucial step towards sustainability, the persistent challenge lies in the absence of robust energy storage solutions capable of effectively managing the intermittent nature of renewable energy generation, that gets added to the grid.

Consequently, the current energy landscape remains heavily reliant on the provision of baseload energy, primarily derived from nuclear (I've talked about this elsewhere on Seeking Alpha) and natural gas sources (discussed here).

Given the limitations in energy storage technology, these conventional sources serve as indispensable pillars, ensuring a continuous and stable supply of power to meet the demands of modern society. Despite the advancements in renewable energy technology, the pressing need for a reliable base load remains a foundational aspect of the energy transition, underscoring the intricate interplay between infrastructure, the electrical grid, and the need for an uninterrupted energy supply.

Given this framework, let's turn our focus to Vermillion's prospects.

Vermillion's Capital Returns Strategy

The point that I've attempted to make is to describe that natural gas is not as cyclical as oil. There's an underlying secular trend that positions natural gas as taking its share of the energy market from oil.

Vermillion declares that it will exit 2023 by returning 30% of its free cash flow back to shareholders. But starting Q1 2024, when Vermillion believes its net debt to EBITDA will fall to 1x leverage, it will update investors on its new and increased capital return strategy.

For more than 12 months Vermilion has been alluding to significant capital returns that will come to shareholders as soon as its balance sheet's net leverage falls below 1x net debt to EBITDA.

Windfall Taxes to Stop in 2024

On Vermilion's earnings press release , they note:

To date, there has been no extension of the windfall tax by the EU into 2024, which is in line with the EU's statement that the measure was exceptional and strictly temporary.

What's more, Vermilion has hedged about 40% of its 2024 European natural gas production. This implies that Vermilion has a reasonably good handle on what its free cash flow profile will be like in 2024.

Vermillion states that their capex will probably reach CAD$630 million in 2024. And at the current strip pricing, Vermilion believes that its free cash flow could reach about CAD$750 ($550 million) in 2024.

This means that this close to 40% hedged natural gas stock is priced at less than 5x next year's free cash flow.

If Vermilion seeks to return close to 50% of its free cash flow back to shareholders, this would mean that its share repurchases, plus dividends combined could approximate a 14% total yield.

The Bottom Line

In summary, despite the challenges faced by Vermilion in 2023, the current valuation of the stock presents a compelling investment opportunity.

With close to 40% of its European natural gas production hedged, the company anticipates robust free cash flow of approximately CAD$750 million in 2024, leading to a price-to-free cash flow ratio of less than 5x.

The bullish outlook for Vermilion is supported by its strategic capital returns strategy, with plans to increase shareholder returns once its net debt to EBITDA falls below 1x leverage.

Moreover, the expected cessation of windfall taxes in 2024 will bolster the company's financial position.

With a well-managed hedge portfolio and a projected increase in free cash flow, Vermilion's commitment to returning a significant portion of its earnings to shareholders signals a potential total yield of around 14%.

Considering these factors, the current valuation suggests that Vermilion Energy Inc. is an attractive investment opportunity for investors looking to capitalize on the potential upside of the energy sector, with natural gas as its destination fuel.

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