TransGlobe Energy - speculative undervalued small cap oil company..

[cannadian]

Note: I started studying investing in August of 2011, and prior to that knew little-to-nothing about investing/finance - so you should be very skeptical when reading this, but I've been studying like crazy since then and here's my take on this small-mid cap oil company I found that I think looks super undervalued/good. So let me know what you guys think of the article and of the company! I love being critiqued so if you notice some flaws don't hesitate to let me know - keep in mind it's the first one I've done though haha.

TransGlobe Energy - based in Calgary, Alberta but its primary operations are in Egypt.

Its market cap is around $600 million right now - but I think that's way undervalued due to the political instability Egypt is facing at the moment.

It's of course a high-risk investment, but it looks to me like a it has a favourable risk-reward ratio so I decided to take it last month, investing a smallish amount of money that I can afford to lose at around $7.50 a share.

Here's a shortish article I wrote up on the company that doesn't quite cover everything but I hope will show why I'm excited about this company/stock.


TransGlobe Energy Analysis

First we’ll look at some basic fundamentals:

Category: TGL vs Industry Average

Price/Earnings: 10x vs 19.4x
Price/Book: 1.8x vs 3.1x
Price/Cash Flow: 7.5x vs 13.3x
Gross Margin: 49.62% vs 9.44%
Operating Margin: 73.53% vs 27.31%
Profit Margin: 24.19% vs 5.62%
Return on Assets: 13.84% vs 6.46%
Return on Equity: 20.07% vs 11.21%
Return on Investment: 15.17% vs 9.4x

It’s also worth noting that as of Q3 2011, TGL has over $100 million in cash and cash equivalents. TGL’s total assets are worth $465 million, and shareholder equity is at $310 million which is up from $30 million in 2003. TGL has a very small debt load, a very competent and intelligent management, and great future prospects: they’ve continued to grow at an exceptional pace.

They are currently not producing any oil in Yemen due to attacks on the pipeline, but in the future if stability returns to the region they have the potential to increase their oil production by at least 3000 bopd without any additional investment. Furthermore, the company is currently producing more than 10,000 bopd in Egypt (their main operation) – and they just received government approval to acquire a $60 million property in West Bakr which will likely double their production within the next 18 months.

Okay, okay, so it’s a great company with solid fundamentals and growth prospects – but what’s the downside? What’s the market cap?

Well, currently the market cap for TGL is under $600 million: at the rate they’re growing their shareholder equity should overtake this market cap within 18 months, and based on any discounted cash flow models the company is worth well over $2 billion – and could be worth more than $5-$6 billion if they can keep growing at this astounding rate.

So why is the stock so cheap right now? Why did the share price tank from nearly $19 in late 2010 to below $8 in late 2011?

The reason is two-fold. First, a global economic slowdown caused by the European Sovereign Debt Crisis could push oil prices down, and keep them down for an extended period of time. Second, after the ousting of the dictator Mubarak, there has been growing political instability in Egypt. People are again taking to the streets, and some rogue elements are even attacking oil pipelines that export oil to neighboring Israel, and there is a lot of uncertainty as to whether the Egyptian army will give up power or not, and if they do – will the new government be as in favor of foreign investment as the current one? Could they nationalize the oil industry?

Well, to tackle the first point the company has already shown that it can survive a global slowdown and poor oil prices: the company not only survived during the financial collapse of 2008, it thrived: by the beginning of 2008 to the end of 2010 the company’s share price increased nearly 400%. Furthermore, I’m somewhat bullish on oil prices: I think the US will continue its economic recovery, and I think that the growing tensions in the Middle East, particularly with Iran and the Strait of Hormuz, where 35% of the global seaborne oil is shipped through, could continue to sustain the current oil prices – or push oil even higher.

To tackle the second point: Egypt nationalizing the oil industry or rogue elements attacking pipelines are very real concerns. I emailed the CEO of TGL, Ross Clarkson, who said he doesn’t think the oil industry in Egypt will be nationalized anytime soon: he thinks that their economy is hurting badly and that they’re starving for all the foreign investment they can get. Furthermore, the oil pipelines that have been attacked by rogue elements are only the pipelines exporting oil to hated neighbour Israel, which is to the north east of Egypt – TransGlobe’s oil production takes place in the far north west and south west regions of Egypt – nowhere near the attacks, nowhere near Israel.

I do not want to play down the risks involved, as they are very real and very substantial. The question is: are the risks severe enough to justify a $600 million market cap for a $2 billion+ company, and a company which will exceed $600 million in equity within 2 years?

[londoncalling]

Nice work. It looks like you have done your homework on this one. I haven't cross referenced your numbers or done my own due diligence on this stock. However, numbers don't lie. I think you have summed up the reasons for the current price and it all comes down to geo political risk. Unstable governments and uncertainty = huge risk = huge reward or huge loss. There is lots of potential outcomes to unfold in the next while re: US,Europe, Middle East, Egypt, and the rest of the emerging world. There is definitely a potential for a 10 bagger on this stock if things go well. If I had some gambling money I would pull the trigger on this stock as well. What the CEO told you may be true for the time being but if there is an escalation in the middle east then who knows what the possible outcomes could be. Oil may skyrocket but Transglobe may not be able to get any product out.

Once again nice work on the Due dilligence and the summation. Keep it up!

[Ethan]

Nice work. Did you do this as part of a university class or for personal enjoyment?

I would add a few things. First, since they are operating in Egypt they get to price their oil at Brent pricing which is fetching about $10 more per barrel than the WTI that Canadian oil is priced at.

While they are generating solid profits and trade at a low multiple to unadjusted earnings, they are not generating positive cash flow. Their cash flows from operations has been less than the cash required by investing activities for the past several years, resulting in the issuance of both debt and equity. In my opinion, this is OK if the company is acquiring significant undeveloped assets. This does not appear to be the case, TGL only has $17 million in exploration and evaluation assets after they took a significant write down on some dry wells In their Nuqra location.

The undiscounted value of their proved and probable reserves is 672 million, Which is roughly equivalent to their market cap. It should be noted the engineering report assumed Brent prices in the mid 80's over the next four years which seems low to me, however if any discount rate is applied at all their proved and probables are less than the market cap.

Q3 net back was $31, that seems low to me for a producer of light oil priced in Brent. Upon further investigation, this is due to $46/bbl in royalties and $16/bbl in current taxes which is much higher than they would pay in Canada.

As you said it is a speculative play, due to their operations in Egypt more than anything. Could be a great investment, but it is simply too risky for me with not enough upside.

[cannadian]

Nice work. It looks like you have done your homework on this one. I haven't cross referenced your numbers or done my own due diligence on this stock. However, numbers don't lie. I think you have summed up the reasons for the current price and it all comes down to geo political risk. Unstable governments and uncertainty = huge risk = huge reward or huge loss. There is lots of potential outcomes to unfold in the next while re: US,Europe, Middle East, Egypt, and the rest of the emerging world. There is definitely a potential for a 10 bagger on this stock if things go well. If I had some gambling money I would pull the trigger on this stock as well. What the CEO told you may be true for the time being but if there is an escalation in the middle east then who knows what the possible outcomes could be. Oil may skyrocket but Transglobe may not be able to get any product out.

Once again nice work on the Due dilligence and the summation. Keep it up!

Thanks for the comment!

It definitely is one of those very high risk, very high reward stocks it seems.

I'm hoping that if oil prices stay high that they divert some of their cash flow to investments in other countries/regions just to diversify for safety...

Nice work. Did you do this as part of a university class or for personal enjoyment?

I would add a few things. First, since they are operating in Egypt they get to price their oil at Brent pricing which is fetching about $10 more per barrel than the WTI that Canadian oil is priced at.

While they are generating solid profits and trade at a low multiple to unadjusted earnings, they are not generating positive cash flow. Their cash flows from operations has been less than the cash required by investing activities for the past several years, resulting in the issuance of both debt and equity. In my opinion, this is OK if the company is acquiring significant undeveloped assets. This does not appear to be the case, TGL only has $17 million in exploration and evaluation assets after they took a significant write down on some dry wells In their Nuqra location.

The undiscounted value of their proved and probable reserves is 672 million, Which is roughly equivalent to their market cap. It should be noted the engineering report assumed Brent prices in the mid 80's over the next four years which seems low to me, however if any discount rate is applied at all their proved and probables are less than the market cap.

Q3 net back was $31, that seems low to me for a producer of light oil priced in Brent. Upon further investigation, this is due to $46/bbl in royalties and $16/bbl in current taxes which is much higher than they would pay in Canada.

As you said it is a speculative play, due to their operations in Egypt more than anything. Could be a great investment, but it is simply too risky for me with not enough upside.

Hey thanks for your comment, I always appreciate constructive critiques.
I'm taking a year off to work/save/learn/invest before going to university so this was just for fun/learning.

In 2006 TGL had ~60 million shares outstanding, now according to google finance they have 73 million outstanding - is that really a large dilution over 5+ years when the company's equity went from $100 million to over $300 million in that time?

Does the value of their reserves include the West Bakr acquisition that just happened? And I wasn't looking so much at their net asset value as much as at their growth rate and discounted cash flow (though to be honest I have a lot to learn about that, I just did some very basic ones).

Also, oil prices were very low for part of Q3 so keep in mind that now that brent oil is consistently above 100 they'll be bringing in a lot more cash..

One thing that I'm not really understanding is that you say they are not generating positive cash flow? How could the shareholder equity go from $100 million to well over $300 million in 5 years if they're not generating positive cash flow?

I am new to investing, but shareholder equity = assets - liabilities right?

So if the shareholder equity trippled, then the assets - liabilities trippled, therefore the assets increased at a much greater rate than the liabilities increased - therefore they must've generated a good return on their investments, no?

Sorry if this is completely wrong, I'm just a bit confused because to me it looks like they are generating a positive cash flow - it's just that most of the cash they generate is re-invested..

Eagerly waiting your response - you sound like you know quite a bit not only about investing, but also about the oil industry, have you known about TransGlobe Energy for a while??

[kcowan]

I think the valuation relates to the uncertainty of their dependence on Egypt. Where do their pipelines ship the oil? I would agree that it is a speculative play based on the political resolution in Egypt. The bad drilling results in West Gharib, Egypt has also contributed to the the price volatility.

[cannadian]

I think the valuation relates to the uncertainty of their dependence on Egypt. Where do their pipelines ship the oil? I would agree that it is a speculative play based on the political resolution in Egypt. The bad drilling results in West Gharib, Egypt has also contributed to the the price volatility.

I agree, and I'm not 100% sure but I believe they said they ship it to the Mediterranean Sea, and then I'm guessing it goes off to Europe or something.

That's a 22% increase in the number of shares outstanding. I consider that large, and indicative that the companies cashflows cannot sustain their operations. Again, this wouldn't be a problem if they were building up significant evaluation/exploration assets, but that doesn't appear to be the case.

Well you know way more about the industry than me so I’ll have to take your word on the 22% being a lot. I just think that since the company’s market cap went from $300 million to ~$1.4 billion in the same amount of time (now it’s down to ~$700 mill due to political risk – despite their production about to double within 18 months if they aren’t nationalized) that it’s not that big of a deal, is that false thinking?

I mean, I wouldn’t mind a 22% dilution of my shares over a period where my shares increased in value over 450% you know?

And look at how low the company’s debt is, the vast majority of their investing is funded through cash flow from operations, and they’re extremely disciplined about that. Look at what they’ve been able to create over 10 years, starting with shareholder equity of like $35 million, without piling on any significant debt, and they just invested ~$63 million on great acquisitions – solely with cash.

You can find TGLs reserve reports here:

http://www.trans-globe.com/operation...rves/index.php

Oil companies get these done annually, the most recent one for TGL is December 31, 2010. Therefore it won't include any acquisitions after December 31, 2010. The price estimates are made several years into the future, as it will take several years to extract all of the oil on their current properties. I find the reports to forecast the price of oil conservatively.

Ahh thanks, they just acquired a massive property though so that’ll most likely be quite a bit different in the near future.

Look at their cashflow statement. Their cashflow from operations is typically exceeded by their cashflow from investing activities. This is a problem given they do not have significant undeveloped land, or significant reserves (relative to the size of the company). TGL takes all of the cash they generate from operations, plus proceeds from the issuance of debt and equity, to maintain their current drilling program.

That’s just not true man, they’re definitely investing quite a bit, but they’re getting a great return on it and they keep the debt low and cash reserves high for some safety.

Are you factoring in West Bakr/probable future acquisitions with the tons of working capital they have at the moment when you say they don’t have significant reserves?

They definitely don’t just spend everything they take in to maintain their program – they’ve grown substantially and continue to do so: without piling on tons of debt/issuing tons of shares they’re going to have no problems doubling their production in 18 months, West Bakr is already producing like 4500 Bopd).

True, but the balance sheet is often not correct. Assets in particular are subject to significant estimates that are difficult for auditors to prove as impaired. Balance sheets are often not correct due to holding large amounts of PPE at amortized cost, when their fair value could be signficantly different.

True, and I know that with me being new and all to the game there are probably many accounting tricks I’m falling for, but with $470 million in assets, and over $100 million of it being in cash, how much could they really be distorting the picture? Plus they had, as of last year, 30.4 million barrels of reserves. Wouldn’t that be able to fund their operations/expansion for a good while? What is the typical amount a company would/could distort the balance sheet anyway?

FFO - funds from from operations
Netback - sales price of oil less drilling costs/royalties/taxes etc. per bbl
Decline rate - the rate at which oil production from an existing well decreases
P3 reserves - proven + probable + possible oil reserves. This can be found in reserve reports prepared by independent engineering firms and estimate the companies share of oil on their lands.



Thanks, I'm a CA with experience in the oil/gas industry. I hadn't heard of TransGlobe until your post.

Hopefully all those quote tags show up right.

But hey I just want to thank you for your posts man, I’m finding them extremely thought provoking and informative and I hope my questions and questioning aren’t coming off as rude or anything; I’m just new to the game and so I want to dissect everything I can and get as good a picture on this possible.

P.S. Are there any oil companies out there you’d recommend me to check out?

Your DD is thorough and impressive, however, there is no way to evaluate geopolitical risk. It is not impossible for holdings in Yemen and Egypt to be seized and nationalized, therefore I believe you have to zero value these assets. Not that I'm saying it's not a good punt, just that geopolitical risk is an independent variable that can't be properly assessed. This kind of stock you go with your gut and hope for the best. Not trying to put you off it. Hell, I just bought some Seadragon. Just know that your analysis may mean nothing when the harsh winds of political change gust. Good luck!

Thanks man, yah I’m definitely taking a calculated gamble with regards to the political risk, but I feel strongly that if that variable pulls through then the company’s healthy balance sheet/great management will be able to pull through and the stock price will eventually reflect that (in 1-5 year’s time that could be 300-1000%) if it’s not nationalized, of course (and that’s a big if, don’t get me wrong).

[Ethan]

Hey thanks for your comment, I always appreciate constructive critiques.
I'm taking a year off to work/save/learn/invest before going to university so this was just for fun/learning.

In 2006 TGL had ~60 million shares outstanding, now according to google finance they have 73 million outstanding - is that really a large dilution over 5+ years when the company's equity went from $100 million to over $300 million in that time?

That's a 22% increase in the number of shares outstanding. I consider that large, and indicative that the companies cashflows cannot sustain their operations. Again, this wouldn't be a problem if they were building up significant evaluation/exploration assets, but that doesn't appear to be the case.

Does the value of their reserves include the West Bakr acquisition that just happened? And I wasn't looking so much at their net asset value as much as at their growth rate and discounted cash flow (though to be honest I have a lot to learn about that, I just did some very basic ones).

Also, oil prices were very low for part of Q3 so keep in mind that now that brent oil is consistently above 100 they'll be bringing in a lot more cash..

You can find TGLs reserve reports here:

http://www.trans-globe.com/operation...rves/index.php

Oil companies get these done annually, the most recent one for TGL is December 31, 2010. Therefore it won't include any acquisitions after December 31, 2010. The price estimates are made several years into the future, as it will take several years to extract all of the oil on their current properties. I find the reports to forecast the price of oil conservatively.

One thing that I'm not really understanding is that you say they are not generating positive cash flow? How could the shareholder equity go from $100 million to well over $300 million in 5 years if they're not generating positive cash flow?

Look at their cashflow statement. Their cashflow from operations is typically exceeded by their cashflow from investing activities. This is a problem given they do not have significant undeveloped land, or significant reserves (relative to the size of the company). TGL takes all of the cash they generate from operations, plus proceeds from the issuance of debt and equity, to maintain their current drilling program.

I am new to investing, but shareholder equity = assets - liabilities right?

True, but the balance sheet is often not correct. Assets in particular are subject to significant estimates that are difficult for auditors to prove as impaired. Balance sheets are often not correct due to holding large amounts of PPE at amortized cost, when their fair value could be signficantly different.

So if the shareholder equity trippled, then the assets - liabilities trippled, therefore the assets increased at a much greater rate than the liabilities increased - therefore they must've generated a good return on their investments, no?

Sorry if this is completely wrong, I'm just a bit confused because to me it looks like they are generating a positive cash flow - it's just that most of the cash they generate is re-invested..

More than 100% of the cash they generate is reinvested into expanding operations (as they are also issuing debt and equity). Oil exploration companies need to expend significant resources to get their drilling programs going. While these assets are amortized over several years, significant costs are required to be incurred up front. That is why oil companies can show large profits but have negative cashflow from operations and investments (with the shortfall being covered by financing activities). While net income is important, these are some metrics I would follow more closely for an oil company:

FFO - funds from from operations
Netback - sales price of oil less drilling costs/royalties/taxes etc. per bbl
Decline rate - the rate at which oil production from an existing well decreases
P3 reserves - proven + probable + possible oil reserves. This can be found in reserve reports prepared by independent engineering firms and estimate the companies share of oil on their lands.

Eagerly waiting your response - you sound like you know quite a bit not only about investing, but also about the oil industry, have you known about TransGlobe Energy for a while??

Thanks, I'm a CA with experience in the oil/gas industry. I hadn't heard of TransGlobe until your post.

[underemployedactor]

Your DD is thorough and impressive, however, there is no way to evaluate geopolitical risk. It is not impossible for holdings in Yemen and Egypt to be seized and nationalized, therefore I believe you have to zero value these assets. Not that I'm saying it's not a good punt, just that geopolitical risk is an independent variable that can't be properly assessed. This kind of stock you go with your gut and hope for the best. Not trying to put you off it. Hell, I just bought some Seadragon. Just know that your analysis may mean nothing when the harsh winds of political change gust. Good luck!