Vital Energy: Optimizing The Acquisitions (NYSE:VTLE)

Vital Energy (NYSE:VTLE) management set about converting the company from a reserves-based strategy that involved asset sales to keep the debt down to a Mr. Market approved (and debt market approved) cash flow strategy. The success of this strategy should imply a revaluation of the stock price now that the debt issue and the debt ratio issue are far less important than it once were.

The company made six acquisitions in the previous fiscal year. The last article and several before it detailed these acquisitions. As a result, company production is roughly double where it was when fiscal year 2023 began before any acquisitions were made. Additionally, the company legacy acreage that was gassy is now a very small part of production. This company has become an oil producer that now has to optimize the operations of all those acquisitions. While management appears to be off to a good start, it will take some time for regular operations to be reported without a lot of acquisition related optimization costs.

The advantage of these acquisitions is that the percentage of oil produced is greater and therefore the acquired acreage is cash flow positive as operated at the time of acquisition. The strong buy rating remains due to the significant financial progress of these acquisitions, both on the debt coverage and the coming income improvements. Management has a long history of acquiring this type of acreage from these small operators and lowering the breakeven point to increase the value of the acreage more and increase the future cash flow.

Income Statement

The company actually reported lower income than before the acquisitions.

Notice that sales increased $149,832,000 from the previous fiscal year quarter, or very roughly less than 50%. Of that increase, $79,328,000 was offset by the increase in depreciation. Another $55,547,000 of that increase went to increase lease operating expenses. Those two items pretty much wiped out the sales increase. That meant that operating income did not increase nearly enough to account for the increase in debt.

However, noncash charges do allow cash flow to increase despite the weak commodity prices. Therefore, the debt ratio improved considerably, as is shown later in the article. The debt ratio progress was forecast by management as a condition of the acquisitions.

That left the loss on derivatives, which is another noncash expense, to send the income to a loss. Further increasing that loss was a one-time loss on extinguishment of debt of roughly $26 million.

That depreciation expense increase is likely because Vital Energy has lower operating costs. Therefore, a higher cost acquisition is not worth as much, nor does it have as long a life as it might with the original operator. Hence, the older production depreciates over less time and likely less production. As new wells come online with lower lease operating costs and depreciation, that situation will likely change over time.

These reasons are why the initial year or so of reports is not worth much to valuing the future income of the company. Instead, investors need to give management time to optimize operations. Also, time needs to be given to replace higher cost production with lower cost production.

The good news is that management probably paid what the leases were worth with the income they were producing under the selling operator. Any improvements made by Vital should increase the value of these assets and increase the income produced by the assets. All of this should lead to a higher stock price.

Improvements

Management detailed some major cost improvements that will lower production costs substantially. Now, as management gains experience with the acreage, the production costs are likely to decline more.

This new design and costs means that depreciation for this production will be lowered. It may also lower lease operating costs, as new, more efficient production often costs less. Sometimes, a better design can increase oil recovery rates, which may affect the production mix of the leases.

Note that management paid for the leases by using the current profitability. Therefore, any improvement is likely to increase the return on capital invested going forward and probably long-term per share results as well. Many of these acquisitions were accretive on the purchase price assumptions. Those assumptions are going to become increasingly favorable with the progress shown above.

The last consideration is that the current production will not automatically turn into efficient production. But it will become less important over time. Since unconventional production often fades an average of 30% a year, it is easy to see it will not take that long for new, more efficient wells to dominate the income statement of the acquired properties.

Specific Leases – Delaware

The breakeven shown above for Vital is based upon company estimates made by management. Actual breakeven points will likely be determined by the experience (and ongoing optimization) as management drills more wells.

What is left out of the presentation is how much of that 45% uplift is factored into management estimates, and how much is above or below management expectations. The breakeven point that management shows is not bad. However, Reeves County can do better on at least some acreage. Now, whether that can happen here is an open question.

The breakeven shown should enable free cash flow to climb quite a bit during the current fiscal year. That climb could continue as more older wells become a less significant part of production.

Western Glasscock

This acreage breaks even at a slightly higher oil price. The situation is still much better than was the case with the Eastern part of the County. As this company grows larger, management can compete for better acreage. As management noted in the last article, they intend to do just that. But in the meantime, the acreage acquired is building cash flow with reasonable paybacks in the current environment. Technology advancements and experience achieved may make the current breakeven points obsolete quickly. But there is no guarantee that will happen.

Investors need to keep in mind that the results shown above are likely to be a starting point. Management is likely to improve those results over the coming fiscal year.

Debt

The main reason for all those acquisitions was to get rid of the relatively high debt ratio “once and for all”. That is largely the case. But the debt market will want more improvement and will likely reward that improvement with still lower debt costs.

Management has reduced the interest paid. The latest income statement lists a loss of roughly $26 million on redemption of debt. That loss will be earned back from the interest savings shown above in a little over 2 years. That is about what it takes to make refinancing a good idea.

The company has no debt due for a while. If in that time, management improves the debt ratio situation more as receive a debt upgrade, then it may be worth refinancing again.

The debt situation and lack of free cash flow kept the stock price low. Now that appears to be far less of an issue than it was in the past. If management can demonstrate the cash flow potential of these new properties, then this stock should revalue upwards over time without the high debt ratio as an issue.

Intrinsic Value

Back when Sailingstone sent a letter to the board that really began this whole process, Sailingstone felt that the stock was worth north of $200 (taking into account the reverse split that came later) if the company was run correctly. The whole idea of reducing the debt and making (hopefully) accretive acquisitions was to get probably more than that value. Before the last six acquisitions, the company was running about $20 per share earnings and a price-earnings ratio of 2 because of a lack of free cash flow and a high debt ratio.

Now, with these acquisitions bringing the debt level down to a place where it needs to still make progress, but the current level gains some acceptability combined with climbing free cash flow, a conservative (very conservative guess) would be adjusted earnings of $30 per share once things get properly assimilated and optimized times a price-earnings ratio of 8 for a total of $240.

I would expect that management will likely use more acquisitions to quickly get the debt level down, more probably by including stock as part of the acquisition (by either selling stock concurrently with the acquisition or making stock consideration part of the deal).

That price earnings ratio could expand as this process continues. Two other companies, EQT (EQT) and Crescent Point (CPG) got the debt ratio way down and to some extent are benefitting more from the earnings growth even without much of a quarterly record of the companies as they are now. The “final” valuation could well depend on where the industry is in the business cycle as a downturn could really lower expectations and cyclical downturns happen all the time.

Risks

This company significantly increased its size through six acquisitions in the past fiscal year. Fast growth or relatively large acquisitions (especially into several new areas) can have daunting logistics and other challenges. This management does have the experience to deal with the situation. But there is no guarantee of success.

Any acquisition (let alone 6 in one year) can fail for any number of unplanned reasons. It will be up to this management to make all the pieces work cohesively and optimally.

Right now, the company is lowering the breakeven point of several acquired properties. This process probably needs the cooperation of inherently volatile and low visibility commodity prices until there is enough new production that will significantly lower the corporate breakeven point to an acceptable level.

The loss of key personnel could be very damaging to company prospects with everything that is on management’s plate at the current time.