When it comes to dividend yield, Ithaca Energy (LSE:ITH) has most of the FTSE 350 beaten. The oil & gas producer’s been on a downward trajectory since going public in 2022. However, the shares are now trading at an unusually cheap valuation.
In fact, on a trailing 12-month basis, the company’s sitting at a price-to-earnings ratio of just 7.3. By comparison, the industry average is closer to 11.5. So from a relative valuation perspective, the stock could rise by as much as 57% if it moves back in line with its peers.
Needless to say, a high dividend yield and tremendous growth potential sounds wonderful. So wonderful it seems too good to be true. What’s going on here?
Why is Ithaca’s yield so high?
Following the completion of its massive £750m acquisition of Eni’s UK oil and gas fields, Ithaca has transformed itself into a substantial producer of fossil fuels. Total production hit a high of 120,000 barrels of oil equivalents per day (boepd) in the latest quarter. And this figure’s expected to rise even higher next year to 150,000.
That’s almost three times 2023’s production level. And even with weaker oil prices, the leap in production volume’s sending Ithaca’s operating cash flow generation into overdrive. As such, management intends to return $500m worth of dividends to shareholders this year, $300m of which has already been announced. And this ginormous output’s expected to be repeated in 2025.
In other words, the dividend yield, even at 17.7%, actually looks affordable for this business. But if that’s the case, why are shares priced so cheaply? And why aren’t more investors jumping on board this opportunity?
The elephant in the room
Sadly, this explosive income and growth opportunity hasn’t gone unnoticed. Yet it seems most institutional investors are steering clear. Why? Because the attitudes of regulators regarding the North Sea fossil fuel industry are becoming increasingly hostile.
Earlier this year, the Supreme Court found that authorities must consider both operational and end-use emissions when deciding on granting development permissions to oil & gas enterprises. While that’s great news for the environment, it’s quite problematic for Ithaca. Two of its major projects are in the North Sea – Rosebank (of which it owns 20%) and Cambo (100% owned).
Rosebank’s development’s already fairly advanced, so the project is less of a concern. But the fate of Cambo’s far more uncertain. Shell actually bailed on this region last year. And analysts from Stifel have estimated only a 25% chance that Cambo will actually get a greenlight for development, with Rosebank sitting at 50%. In other words, these projects are surrounded by political and legal risks.
What does this mean for Ithaca? Well, if these projects fail, analysts’ projections for free cash flow generation suggest a steady decline to $300m by 2029 and then zero by 2033. Given that free cash flow is ultimately what funds shareholder payouts, the stock’s dividend yield may only be sticking around for a couple of years before potentially disappearing.
So while a buying opportunity might exist here, it comes with some substantial risks that investors have to consider carefully.
This post was originally published on Motley Fool
