Developed Markets Bond
North American Bond
Durig Capital Fixed Income Review
A successful International oil and gas explorer focused in Egypt and Yemen
This week we revisit TransGlobe Energy’s 6.0% Convertible Unsecured Subordinated Bond denominated in Canadian dollars and maturing in March of 2017, which is currently indicating a yield to maturity of over 10% as a result of the recent weakness in its bond price. Should this relatively new producer return to its rapid growth and significantly increase in value, the possibility exists of increasing this already very high yield through the capital gains its convertibility feature allows for, as explained further in this review. After reviewing the recent factors contributing to the weakness in this bond’s price, we see this as having outstanding potential for oversized return in a very desirable (Canadian) currency. This well managed oil producer has positioned itself to directly benefiting from higher oil prices and the highly successful new wells in oil producing regions of Egypt and Yemen, and it is why we are targeting an overweighted position for these short maturity TransGlobe Energy convertible notes in our Foreign and World Fixed Income holdings.
An update on the Issuer
When we first looked at TransGlobe Energy Corporation last February, one of the more impressive features we found in this relatively new producer appeared to be the ability of its team of managers to adapt its business model to a changing global economy. TransGlobe Energy’s current activities are the exploration, development and production of crude oil, all of which are concentrated in two main geographic areas, the Arab Republic of Egypt and the Republic of Yemen. It has interests in 9 international blocks comprising 5.5 million acres, and its resilient management team and financially prudent business model have resulted in steady increases in oil reserves, oil production, and cash flow.
TransGlobe Energy’s goal is to become a significant energy producer in the Middle East/North Africa region of the globe, and its growth strategy is built on three pillars:
Achieve/maintain a high percentage of operatorship -TransGlobe operates the majority of its properties in Egypt, providing control of the drilling pace and choice of locations.
Diversified portfolio – TransGlobe’s operations contain a multi-year inventory of drilling prospects that range from low-risk development wells to higher-risk, high-reward exploration locations, and include oil as well as natural gas opportunities.
Prudent Financial management – TransGlobe maintains a very healthy balance sheet enabling the Company to fully fund its capital program with funds flow from operations.
International oil companies operating in Egypt have yet to react to the renewed unrest in the North African country with any concrete steps, but several said on Tuesday they were watching developments closely. A spokesman for British Petroleum (BP) stated that they were just monitoring the situation at the moment and that there’s been no impact on its people or its operations. In February 2011, when Egypt’s then president Hosni Mubarak was ousted following 18 days of anti-government demonstrations, international oil companies evacuated staff and halted drilling. However, companies quickly returned staff and resumed operations after Mubarak stood down. We think is an important to remember that in many countries, including Egypt and Yemen, oil companies are governed by Production Sharing Agreements (PSAs.) PSAs are a different approach from North American practices, where oil and natural gas producers obtain working interest leases over mineral rights and then pay royalties and/or taxes to applicable governments and/or the freehold mineral rights holder. All of the Company’s international projects are governed by production sharing contracts between the host government and the contractor (or joint venture partners). The government and the contractors each take their share of production based on the terms and conditions of the respective contracts. While PSAs vary in detail, they all determine the proportion of oil or natural gas produced by a company that is payable to the government. This proportion represents the government’s fiscal take and is roughly comparable with taxes and royalties as are customary in North America. The Company’s share of all taxes and royalties is paid out of the government’s share of production. Egypt and Yemen are both achieving significant income streams from the production sharing agreements (PSA’a) that are in place, and once addicted to how little effort it takes for political parties to gather big revenues from a successful oil wildcatter finding and pulling more and more oil out of the desert sands, we believe that sudden or swift changes to the way this easy money flows are less likely.
Currently, 100% of TransGlobe’s production is crude oil, which is benchmarked against Brent prices (a type of spot sales contract that has been priced with a known loading date.) The Company’s reserves are reviewed annually – as is customary in the oil and natural gas industry – following the conclusion of the fiscal year, which is also the calendar year. All of TransGlobe’s reserves have been independently evaluated by a third-party engineering firm, DeGolyer and MacNaughton, headquartered in Dallas, Texas. As at December 31, 2012, TransGlobe had a total of 48.7 million barrels of Proved plus Probable reserves and 62.4 million barrels of Proved plus Probable plus Possible reserves, representing a production replacement for the year over 170%.
We like companies that are profitable
First quarter production sales averaged 17,909 Bopd, up from the average of 12,132 Bopd in 2011 and 17,496 Bopd in 2012. Estimates for 2013 daily productions level was previously projected to be up to 21,000 to 24,000 Bopd. However, last week TransGlobe announced that a portion of the 2013 planned production ramp up would be delayed to 2014 due to delays outside of the company’s control. The revised Production Guidance of 19,000 to 20,000 Bopd clearly disappointed the market and both the stock and the convertible have been punished. TransGlobe’s production averaged 19,222 Bopd in April; 17,872 Bopd in May; and 18,000 Bopd in June to date.
Is spite of the market’s disgust with this change in production guidance, we view the minimal but steady increase in production over last year’s average as a continuation in lowering the risk to its debt holders. Furthermore, we see these higher 9.5% yields that have resulted from an imbalance in the markets have presented us with a great buying opportunity. Net earnings for the first quarter of 2013 were $24,878 million vs. $10,975 million in the same period of 2012.
Even though TransGlobe was ranked #30 in Forbes magazine in 2012 for fast growing companies, it bears noting that this outstanding growth was achieved while keeping its cash flow and balance sheet in a very strong position, making $1.20/ share for the year in earnings.
Strong Production Growth Prospects
The company announced December 11, 2012, a 2013 Capital Budget of $129 million with $53 million (41%) allocated to Exploration. On June 11, 2013 the Company finalized an amendment to its banking facility, which re-established the borrowing base at $100 million (current drawings are $18.5 million), and on June 20, the company revised the Exploration budget to $80 million. Transglobe YTD has drilled 24 wells, resulting in 20 oil wells and 4 dry holes (an 83% success rate.)
Based on currently identified opportunities and upside predictions, TransGlobe is targeting a production rate of 40,000 bopd within five years, which equates to a 233% increase from 2012. TransGlobe uses hedging arrangements as part of its risk management strategy to manage commodity price fluctuations and stabilize cash flows for future exploration and development programs.
Interest Coverage Ratios
Finance costs for 2012 was $13.9 million, while funds flow from operations was about $153.5 million, indicating a healthy interest coverage ratio that’s greater than ten to one.
We like companies with lower debt to cash ratio
TransGlobe Energy ended Q1 of 2013 with $112.2 million in cash and cash equivalents and debt of $167 million, primarily attributed to the 6% convertible debentures that were issued in March of 2012. This gives them a very modest debt to cash ratio of less that 1.5 to 1.
TransGlobe has had aggressive profit and production growth over the last 10 years and is forecast many more years of the same kind of growth. Yet, with earnings at $1.20/share and its stock trading around $6.01, the approximately 5:1 price to earnings (PE) ratio is significantly lower than what we would normally expected for a company evidencing such steady increases and strong growth potential. Hence, we think this company’s stock has plenty of potential for appreciation, even if it only achieves about half of its projected growth.
We like companies that have good balance sheets
TransGlobal’s debt of $167 million appears to represent about 33.3% of the nearly $500 million enterprise valuation currently given it by the equity markets. While this has increased substantially since our first review, it remains well within our strict criteria for sound balance sheets. Overall, this company continues to remind us of our look into Netflix (NFLX) bonds. Although rated as junk bonds, we saw the company as having a well managed and an incredibly strong balance sheet. As the stock declined and in spite of the criticism of many others that continued to refer to it as “junk,” we revisited and recommended the bonds to our clients more than once. Since then, the bonds were called at a hefty premium (110) and a very large gain for our clients.
We like higher yields
It appears that there are no credit ratings currently assigned to this debt, making it vastly different than that of our government’s sovereign debt. Yet, when set in comparison to the low 1.47% yields of longer five year U.S. Treasuries, we think the 8% difference in yield (in what many pundits say is a very desirable currency) represents a savvy opportunity for higher rewards given the level of risks that we can identify.
One of the more unusual features to also consider here is the bondholders option at any time (prior to maturity) to convert these debentures into common shares of the company at the conversion price of $15.10 per common share. While this strike price represents a stout 28% annual appreciation from it current price of $6.01, we think any significantly increases in production could just as easily restore the equity markets confidence in this company and boost its share price back to the more respectable levels it recently traded at. Regardless of its stock price, we believe the better than 9½% yields currently achievable through the maturity of the bond represent a very high return relative to the risks that we can identify.
The default risk is TransGlobal ability to perform. As we have found rating agency do not rate this convertible debt, we turn to the company’s underlying financial fundamentals. Considering its historical, recent and foretasted levels of performance, its sound cash position, excellent balance sheet and the excellent cash flow that easily services their interest bearing debt, it is our opinion that the financial default risk for this relatively short term bond is minimal relative to its more favorable return potential.
The hardest risk for us to identify is the geopolitical risk. With that said, the new government in Egypt appears to remain friendly and an ally to both US and to Israel, as well as with the Arab Spring and Iran. However, this is an unfamiliar path that has no precedent set for it, as the recent civil unrest there attests to. With TransGlobe’s current oversized appetite for exploration and production growth in Egypt, the possibilities of geopolitical risks deepening there is the by far the sole greatest risk that we can identify. Egypt faces a drop in its hydrocarbon production, stemming from a slowdown in oil and gas exploration due to unrest over the past couple of years. Considering that TransGlobe Energy is a smaller Canadian oil exploration and production company focused on financially benefiting both Egypt and itself through its ongoing operations there, we see it as adding key economic value to the society that it’s associated with regardless of which political party is currently in power, and it fits with our strategy to reduce overall risk through broad diversification.
TransGlobe may face increasing competition from any number of substantially larger and better financed companies, such as Exxon Mobil (XOM), Chevron (CVX), French based Total (TOT), or British Petroleum. All of these behemoths have massive resources and a global umbrella of resources services around the world. However, we think many of these major oil producers would find it more attractive to acquire companies like TransGlobe Energy and its proven reserves and PSA’a than rely solely on their own internal resources.
Although Transglobe has a keen track recorded of being able to change direction while still achieving significant increases in production, because of the particular and singular nature of its business, its revenues and earnings would be adversely affected should there be significant declines in the price of oil.
Being denominated in Canadian Dollars, this note also exposes bondholders to the Canadian economy and the exchange rate of the loonie.
This convertible bond not only carries a 6% coupon yield, paid semi-annually, but it also has similar risks to other convertible bonds that we have reviewed. These are the Tricon Capital convertible bonds, which have appreciated about 15% in the 3 months since our review, and the Neo Materials bonds, which were bought by the industry leader MolyCorp (MCP) shortly after our review early last year.
Summary and Conclusion
TransGlobe Energy clearly made changes in its core business over the last twenty years, and we find its ability to grow its cash flow from production, while also expanding its reserves and keeping a low leveraged balance sheet, to be quite refreshing. All things considered, it is our opinion that this company has established itself as a niche player in the supply of oil and gas. Although it clearly disappointed the markets recently with a reduction of its prior aggressive growth estimates, it continues to have a solid cash position, good cash flow, excellent interest rate coverage, and a strong growth potential going forward. We think these TransGlobe convertible debentures offer great diversification, an incredibly high yield in Canadian currency relative to the risks that we can identify, and a possibility for significant capital gains due to its convertibility feature. Therefore, we are adding these higher yielding, 2017 maturity, TransGlobe Canadian dollar notes to our portfolio of Foreign and World Fixed Income bonds.
Yield to Maturity: ~10.1%
Disclosure: Durig Capital and certain clients may have positions in TransGlobe bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.
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