Is This Oil and Gas Producer a Takeover Target?

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Although the company’s latest quarterly report showed a sharp slowdown in revenue growth and predicted an uncertain path forward, shares of Vaalco Energy (NYSE: EGY) could be due for short-term gains. In addition to the secular tailwind of a bull market for oil, the Houston-based oil-and-gas producer has several positive attributes.

For starters, the company has a strong return-on-assets ratio of 27 percent and well over $2 in cash per share. In fact, its total cash hoard of $136 million represents 29 percent of its total market value. Moreover, the company has no significant debt obligations and enjoys a higher operating margin than many of its competitors. As such, investors who wish to profit from the North American oil boom and pocket some short-term gains might gravitate towards this small-cap producer.

About Vaalco Energy

Vaalco Energy splits its efforts equally between the production and exploration of oil and natural gas. The company owns a wide range of small stakes in geographically-disparate properties. In addition to conventional fields in Texas and Alabama, Vaalco owns part of a shallow-water field in the Gulf of Mexico and a number of larger properties in two African countries. Although the company is exposed to some political risk in Gabon and Angola, this is mitigated by the more stable interests that it owns in several High Plains shale plays. Vaalco’s exploration activities are concentrated primarily in the North Sea and Africa. The company directly employs about 100 people and had an EBITDA of $160.3 million on gross revenues of $209.5 million in 2012.

Other Players and Main Competitors

Like all small energy producers, Vaalco operates in a crowded space that is dominated by larger players. In addition to like-sized competitors, the company must contend with two much-larger rivals: Hess Corporation (NYSE: HES) and Pioneer Natural Resources (NYSE: PXD). Both of these companies are heavily invested in oil and gas plays that directly compete with those owned, operated or coveted by Vaalco.

For comparison, Hess has a current market capitalization of nearly $23 billion and gross revenues of almost $38 billion. Meanwhile, Pioneer has a market cap of nearly $16 billion. Although high oil prices and a potential upswing in the price of natural gas during the coming months should provide Vaalco with the revenue that it needs to stay afloat, it must constantly mind these competitors, although right now, Vaalco’s operating margins are far above these competitors at 58%. Hess and Pioneer have operating margins of 10.8% and 15.6%, respectively. Ultimately, the company could well end up as a takeover target.

Efficient ROA, Lots of Cash, Little Debt

Vaalco’s holdings give it much-needed exposure to the fastest-growing segment of the market for global oil production and place it in a solid position for future growth. However, the company’s immediate financial condition is also promising. Its 27 percent ROA is truly impressive for a small-cap oil producer. Meanwhile, its cash hoard is sizable by any standards. Most exciting of all, the company has no long-term debt hanging over its balance sheet. Were it not for its disappointing revenue growth, Vaalco would be a solid buy. Nevertheless, short-term investors may still have reason to look at the company at these levels.

Possible Moves

Vaalco’s current financial position presents the company with three distinct options: it could initiate a regular dividend, begin a share buyback, or allow itself to be gobbled up by a larger rival.

Of these three choices, a regular dividend might be the most prudent course of action. Many of Vaalco’s peers pay modest quarterly dividends that provide annual yields of between .5 and 2 percent. If the company wished to deploy a 50 cent annual dividend on each of its 57 million outstanding shares, it would need to lay out approximately $28.5 million per year. This would represent roughly 13.6 percent of its current cash reserves and provide a yield of over 6 percent at an average share price of $8. Such a yield would immediately place Vaalco far ahead of its dividend-paying peers.

However, this might be difficult to sustain in the long run. Were the company to forgo a more modest dividend yield of 2 to 3 percent, it might choose to initiate a controlled share buyback. If it wished to dispatch roughly 10 percent of its outstanding shares over the course of several months, the company would need to spend at least $40 million. This represents a one-time outlay of about 25 percent of its existing cash reserves. Such a buyback could provide shareholders with a short-term return of 10 to 15 percent.

With a hefty cash hoard, no debt and soft revenue growth, Vaalco could easily become a tempting takeover target for a larger competitor like Hess or Pioneer Natural Resources. Although Hess could finance such a bid with its current cash reserves, it may not be prudent for the company to do so. After all, it currently struggles under a debt load of more than $8 billion.

Pioneer finds itself in a similar position: Its $4 billion debt load looks enormous compared to its cash reserves of $300 million. However, further revenue declines, earnings misses or unexpected production delays could weaken Vaalco’s position and make it more vulnerable to a takeover from either of these companies.

In sum, Vaalco’s cash hoard is a major asset for the company. Compared to its debt-ridden peers, the company’s liquidity gives it tremendous freedom of movement. Investors who wish to bet on a share buyback or dividend would do well to watch Vaalco at these levels. Those who wish to bet on a takeover attempt should wait until its share price falls by another $2 to $3.

mthiessen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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