Description

Long Vermilion Energy (VET CN, and also -less liquidly- VET in the NYSE). We believe VET CN is a compelling story that should outperform E&P peers over the next few months. Note this call is "relative to peers" and not necessarily an absolute call - We have no particular view on oil prices, and if oil prices sink, VET is likely to follow.

Description

VET is a high-quality E&P that should've outperformed peers in this bear energy tape, but for some bizarre reason hasn't. The company flies a little under the radar screen given it's popular with Canadian income investors, and also because unlike most peer mid-cap Canadian E&Ps, it's not a pure-play on Canadian resource.

VET has grown since been founded by CEO Lorenzo Donadeo 20 years ago into a "mini-global E&P" (55-57kboepd in 2015), with a collection of niche assets around the world that give it exposure to premium-priced markets, differentiating it from peers: 80% of the company's cash flow will come from European gas and Brent crude, which trade at a premium to WTI crude.

• 40% of VET's production is in Canada (Alberta), evenly split between gas and oil
• 30% of production is European gas: including the Netherlands, Germany, and the upcoming Corrib project in Ireland
• 30% of production is Brent crude: in places like France, Germany, Australia (latter gets premium pricing to Brent)

Premium pricing and low opex needs imply industry-leading netbacks and margins (62% 15E EBITDA margin, versus CNQ's 42%, COP's 31% or APC's 49%). Notably, VET's production decline rate is in the mid-to-high teens, much lower than most peers. This means less capital intensity to sustain production, and leads to higher ROIC (9% estimated for 2016, well ahead of most peers)

VET has largely assembled this collection of assets by picking away at divestitures out of larger oil&gas companies where the asset was non-core or too small to move the needle for the seller (companies like TOT, MRO, GSZ FP, etc.). The lack of serious competition in tiny energy regions like Germany, France or Ireland, means that VET doesn't have to overpay (unlike so many US onshore plays).

Thesis

A high-quality E&P with a sound balance sheet (1.5x net debt/EBITDA) and a very attractive dividend yield (4.7%) should've outperformed peers since the decline in crude prices last Fall, but the stock has lagged most peers in spite of spotless execution in the last couple of quarters. VET's trading multiple has de-rated relative to comps: a historical 50-60% EV/EBITDA premium vs COP has shrunk to only 25%; a 30-35% premium to CNQ is now only 15%.

We believe VET is likely to re-rate higher as its Corrib project in Ireland comes online this Summer. This is a gas development offshore Ireland where Royal Dutch/Shell operates and VET holds a 18.5% working interest. The project has been a nightmare to develop with strong opposition from environmentalists, but is finally coming to life. During development, Corrib has cost VET an annual $100mm capex outlay, but upon production start-up, it will swing to a $200mm cash inflow each year. This is a major swing, that also anchors production growth in the low-teens for VET in 2016. The surge in free cash flow will bring VET closer to covering its dividend (roughly 3.5% FCF yield vs 4.7% divvy yield).

As Corrib comes online, we believe VET should return to its historical premium versus peers, trading into the mid-C$60s all else being equal. In the meantime, barring a collapse in oil prices, the C$0.215 monthly dividend should provide strong support. VET is as committed to sustaining its dividend as any company we've seen out there, and has the balance sheet to ride out low commodity prices for many years before considering a divvy cut.

Beyond Corrib, VET is run my smart capital allocators that have built this company from the ground up. Lorenzo Donadeo holds 3% of shares outstanding, and other directors and executives hold an additional 5%. Get to know the management team and you will realize these guys work to create value, not to grow bigger or to satisfy their ego. A true rarity in the E&P space.

Risks

VET's Canadian production is focused in Alberta, where the NDP party recently won the provincial election on a platform that appears hostile to the energy industry. There are fears of a potential hike in royalties and generally a harsher environment for oil&gas companies that operate in Alberta. This is a real risk, but one that can easily be hedged by shorting any Canadian oil sands producer. Note that Alberta represents 40% of VET's production but around 20% of cash flow.

We believe the company's entry into the US by way of a small $10mm acquisition in the Powder River Basin last year may have also raised some fears that VET could overpay to gain entry into the up-and-coming shale plays in the US. We believe this is highly unlikely - the company seems committed to focusing on under-the-radar opportunities closer to existing markets, such as Germany and France.

Catalyst

• Corrib start up, guided for mid-year 2015.
• Accretive deal-making, particularly in Europe.