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Vaalco Energy Stock: Valued at Less Than 3x Free Cash Flow (NYSE:EGY)

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Investment thesis

Vaalco (NYSE: EGY) is a crude oil exploration and production company based in West Africa. This sentence in itself notes the main concerns that investors should be aware of – oil prices and business in West Africa.

If investors still feel they have the guts to keep reading, you’ll come across a relatively well-run company that’s hedged about a third of its output.

Meanwhile, its production forecast for the second quarter and beyond is growing rapidly. Indeed, Q2 production volumes will be approximately 24% higher than Q1 2022.

Therefore, by paying 3x my own free cash flow rough estimates for 2022, I already think prices are very negative.

Therefore, I consider this title a buy.

Vaalco short-term outlook

Vaalco is an energy exploration and production company focused on crude oil producing properties. Based in the West African offshore, Vaalco focuses on its Gabonese resources.

Part of the bullish thesis Vaalco faces is that the company is clearly looking at strong production volumes for the second quarter and beyond.

VAALCO Power Generation Outlook

Additional presentation Vaalco Q1 2022

As you can see above, the first quarter of 2022 recorded 8,051 BOPD, while the second quarter is guided towards 10,000 BOPD. This means that for the second quarter of 2022, Vaalco will produce around one million barrels of oil.

Clearly, increased production coupled with higher WTI prices is a very compelling dynamic for investors.

Vaalco coverage

Additional presentation Vaalco Q1 2022

The other important consideration for investors to consider is that Vaalco is approximately 33% hedged. This is clearly less than half of its production volume, which means that Vaalco is very well positioned to take advantage of high oil prices.

Next, we will discuss Vaalco’s capital allocation strategy.

Vaalco Energy Capital Allocation Strategy

Vaalco has no debt on its balance sheet. Therefore, given the strong price environment, one would have expected to see Vaalco significantly increase its return on capital to shareholders.

Additionally, Vaalco said on its earnings call,

[…] many of our capital expenditures and commitments decline through the third quarter of this year. The fourth quarter will have some, but not the level of spending that we have had in the first 3 quarters of this year.

We can see a company that is going to report very strong free cash flow. But management does not appear, at this stage, to be aggressively considering returning capital to shareholders.

Valuation of EGY shares – 3x free cash flow

Next, let’s discuss Vaalco’s valuation.

Vaalco margins 2022

Additional presentation Vaalco Q1 2022

For the second quarter of 2022, Vaalco is targeting around one million barrels of oil. This very roughly translates to some $55 million of free cash flow for the second quarter.

If we assume that WTI prices stay around $105, that could mean that Vaalco’s free cash flow over the next twelve months could be around $200 million.

Obviously, assuming oil prices stay around $105 is a huge assumption. Realistically, to get a margin of safety, we would have to base Vaalco’s free cash flow for the next twelve months probably closer to $150 million.

This more conservative assumption would put the stock price at around 3 times free cash flow. I think that’s a cheap multiple.

The essential

Needless to say, there are a few risks on the table. The first risk is that investors need to build confidence around investing in West Africa. This is arguably the biggest and most unavoidable risk factor here.

That being said, there is a price to pay for investing in West Africa to still make sense.

The other notable risk is that investors will need to gain significant exposure to oil prices. Oil prices are notoriously volatile. And when things blow up, as they will from time to time, the first companies to face a sell-off by investors will be the riskiest assets. I’ll put Vaalco very firmly in this basket.

On the other hand, I constructed my hypotheses with a significant safety margin. It’s not inconceivable that Vaalco could actually be priced closer to 2x free cash flow.

At some point, it starts to become the case that the multiple is not likely to compress significantly further. That’s not to say Vaalco can’t trade for 1x free cash flow. It can. But the likelihood of that happening appears to be relatively low, especially given its debt-free balance sheet.

All in all, there’s a lot to like about this investment. I rate this stock a buy.