Vaalco: Potential Deep Value Pick

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About: VAALCO Energy, Inc. (EGY)
by: Hunter Reinhart
Summary

VAALCO sells for only 1.15 P/E and 0.83 P/B.

Proved to be profitable over the last two years while also paying off all of their debt last year.

The company is planning on drilling four or five more wells in the second half of 2019 setting themselves up for more potential growth in the African market.

We are long VAALCO and with a 52-week high of $3.38, the stock has plenty of room to run.

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Editor's note: Seeking Alpha is proud to welcome Hunter Reinhart as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Essential. Click here to find out more »

VAALCO (EGY) has seen great progress over the last two years finally breaking into profitability, yet the stock price is near all-time lows. VAALCO plans on drilling four hopefully five new wells in the second half of 2019. The new wells will be funded by cash on hand and cash flow from operations. With more potential wells, growing reserves and no debt weighing them down, EGY should continue to flourish in the African region.

From their 2018 Annual Report, "The appraisal well bores will help further define opportunities to potentially add significant reserves and production in future drilling campaigns beyond 2019." Management will continue to push growth for years after 2019. Their claim of future growth is plausible and likely as most of the new drills will be from existing platforms minimizing the additional costs. There will also be no trouble taking out additional loans in the future if needed for larger investments since they have no debt.

These new wells will increase output leading to higher reserves and revenue. They will be drilled off of existing platforms minimizing additional costs. Two main points on VAALCO's future strategy is to maximize cash flow and income generation with maintaining a strong balance sheet through financial discipline, displaying that they will not take out unnecessary loans falling back into debt. Keeping a strong balance sheet combined with the forecasted growth in production will lead to growing sustainable earnings and positive cash flow.

Buying Opportunity:

After falling over 40% in the last year, is there value in buying EGY at the current price? According to Benjamin Graham's value investing strategy, in order to find value in common stocks they must be selling at a low multiple in relation to earnings, for example, 15 is the maximum P/E ratio Graham would recommend buying. He also restricts the P/B ratio to 1.5. The only exception to a stock not satisfying both criteria is if the P/E multiplied by the P/B is less than 22.5.

Ticker P/E P/B Diluted EPS TTM
EGY 1.15 0.87 1.63

VAALCO satisfies all of Graham's pricing ratios with ease as the company is selling for almost even with earnings and for a discount in relation to Book Value. VAALCO's current price compared to both earnings and book value presents an obvious buying opportunity here especially with the strong balance sheet with anticipated growth in the next year and beyond.

Their earnings rely on oil prices; Crude and Brent are now hovering around $58 and $64 respectfully. Below is a chart representing VAALCO's margin and free cash flow per barrel depending on prices from their latest June company update.

Margins and Free Cash Flow

Source: VAALCO June Company Update

Good Financial Strength And Capital Structure:

VAALCO is in a great financial position as they just paid off the rest of their outstanding debt last year. The four possibly five new wells will also be funded from cash on hand per their 2018 annual report. Cash flow has been positive over the last two years while paying off debt and with no large stock redistributions proving that VAALCO is not simply burning cash to turn a profit. Being in a position to grow without going into debt will fuel their potential without having to worry about interest rates and debt building up.

Production and Income

Source: VAALCO June Company Update

With forecasted profits and increased production, their balance sheet should only continue to improve without having to issue any debt or stock offerings. Higher incomes and no debt has enhanced their liquidity and the company will continue this trend by funding everything with cash on hand and from operations.

VAALCO Debt vs. Working Capital

Source: VAALCO June Company Update

Long-Term Potential Growth:

Per the 2018 annual report, VAALCO will be continuing to grow in Africa, drilling two potentially three new development wells and two appraisal well bores in 2019 funded from cash on hand and from operations. Without having to issue more debt or stock shows great potential growth and earnings for VAALCO. The company also extended its license in the Etame/Gabon area until 2028 with another 10-year option. VAALCO will keep a large footprint on the Western African region with few threats from nearby competition with the ability to keep their license for up to 20 years.

From their 2018 annual report, “Our goal is to achieve transformational growth both organically and through potential acquisitions or mergers as we believe we have a clearly differentiated African expertise and plan to maintain our geographic focus in Africa.” They explain this in further detail in their 2025 Vision Plan with the goal to grow by 5x by 2025.

2025 Vision Plan: Per their June Company Update, VAALCO is targeting for five times growth by 2025 along with top quartile total shareholder value. They have broken up their 2025 Vision Plan up into four main focuses: 2019/20 Etame (Gabon) License Work Program, Future Etame License Work Programs, expansion to Equatorial Guinea, and New Ventures and M&A. All of these projects will be aimed at output growth including a crude sweetening project in Etame.

With this vision plan, EGY will continue to drill new wells over the next 5-6 years increasing production, reserves and ultimately earnings. Their financial positioning presents them with no issues in continuing this growth from their cash, future cash from operations and retained earnings.

VAALCO will have no issues expanding in their already licensed regions, however, it may be hard to continue to acquire more desirable oil and natural gas acreage as larger companies will have more money and personnel to outbid VAALCO's offer for the land.

Investment Risks:

With every investment, comes potential risks. VAALCO being a micro-cap stock with a market cap just under $100 million typically run into higher volatility and EGY has a beta of 1.37 signaling higher volatility. Due to being a much smaller company, a large risk is that VAALCO may not be able handle huge swings in commodity prices, poor market conditions and unsuccessful wells as well as their larger competitors. Larger companies will also have an advantage on acquisitions as they can pay more for desirable oil and natural gas assets, which may hinder the 2025 Vision Plan that has M&A as a key growth aspect.

Also, being an oil and exploration company, VAALCO may suffer due to lower oil prices and the future conversion towards greener energy ultimately hurting demand. The company does have some hedges in case the prices begin to fall even further to limit the potential risk of another collapse in oil prices. There also may be more regulations in the oil and natural gas industry that could potentially affect margins and outputs which would hurt earnings.

Another risk is that 100% of their 2018 sales was to one distributor, Glencore Energy UK Ltd. For 2019, they signed a new contract with Mercuria Energy Trading SA. This does pose a risk as VAALCO will need to sign another contract for 2020, however, there is minimal reason to think there will be issues finding another distributor.

VAALCO does not offer a dividend which is not a surprise since they began profiting only two years ago. Oil companies also tend to have decent dividends so hopefully once VAALCO profits more consistently over the next few years, they will begin to issue a dividend.

Buying VAALCO now near its 52-week low would also be a contrarian buy which runs the risk of momentum pushing the stock even further.

Overall Verdict: Buy And Hold

VAALCO shows great promise as a deep value pick. With a future vision plan set for 5x growth by 2025, the company should see great growth in earnings similar to the past few years. After a rough year, the stock is very cheap priced at 1.15 P/E and 0.87 P/B, no debt, great 5-year average EPS growth rate of 16.92% with further plans for growth as noted in the annual report. I am long on VAALCO and I entered a position at $1.68 per share.

We also believe price targets are very arbitrary and hold little value, however, the industry P/E is 23.01 so any correction towards this multiplier would ensure large gains from our investment.

* All stats are taken from VAALCO Reports and investing.com.

* This short report is my opinion and all investors should complete their own thorough research before investing in any equity.

Disclosure: I am/we are long EGY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.