This week, we revisit TransGlobe Energy’s Convertible Debenture, which matures March 2017, and is currently yielding about 7.5%. We took our first look at Transglobe in February 2013 and again in July 2013. Since that time, this well-managed Canadian-based, oil exploration and production company has made steady progress in its collection of revenues from Egypt and in fortify its strong balance sheet. Transglobe Energy continues to solidify its presence in Egypt through additional Production Sharing Agreements (PSA) with the Egyptian government, increasing its land position by 1.2 million acres in the last nine months. Just last week, the company reported a new oil discovery (42 feet of net pay) in its North West Gharib concession. With enough cash on hand to retire this debt, this executive team’s prudent management has stated that it is well positioned to finance its $100 million dollar exploration and development program through the use of working capital and the cash generated by operating activities, as well as continue with a quarterly dividend payment program that it re-introduced to its shareholders in the second quarter of 2014.
Although TransGlobe’s stock has contracted from higher prices over the last 3½ years, cash levels have continued to exceed its debt, and we think the 20 Canadian cent annualized dividend (representing a dividend yield of about 3%, which the Company intends to continue) may signal the end of a prolonged stock price consolidation period. This in turn would renew the hope for an increased return from this Loonie (CAD) denominated bond through the capital gains that its convertibility feature (as explained further in this review) allows for. Therefore, considering the reduced risk that we see in this relatively small and unrated 30 month issue, we think the over 7.5% yields in Canadian dollars that it currently offers merits an overweight position within our global high yield Fixed-Income2.com and Fixed-Income3.com portfolios.
An Update on the Issuer
Since our last review of Transglobe Energy in July 2013, there has been continued unrest in its primary operating region, Egypt. Yet, in spite of the geopolitical turmoil, the company collected a record amount from the Egyptian government for the large accounts receivable balance owed for past oil and gas purchases. TransGlobe’s exploration and development activities have been uninterrupted at desert facilities hundreds of miles from the violence in Cairo, and this consistently profitable producer continues to uncover and bring into production, new wells with substantial reserves.
TransGlobe has consistently carried a large accounts receivable balance from the Egyptian government. However, it seems that Cairo is attempting to encourage exploration through faster debt repayments. In 2013, TransGlobe collected 75% more ($72.7 Million) of this large account receivable balance than it collected in 2012. For 2014 YTD, they have already exceeded that amount, collecting $74.5 Million, and in July of this year the Egyptian government evidently reached an agreement with foreign oil firms to pay off all of its arrears by 2017 instead of its previous plan to pay only half of it by that time.
In November 2013 and July 2014, TransGlobe signed a total of five new Production Sharing Agreements (PSA) with the government of Egypt. (We discussed PSA’s in our previous TransGlobe review). These additional PSAs have increased TransGlobe’s land holdings in Egypt by 1.2 million acres, providing it with increased reserve and production growth potential. Also, TransGlobe is slated to spend $100 million in exploration and development in 2014 in an effort to add to its existing drilling portfolio.
In March 2014, a merger between Caracal Energy, a Canadian producer operating in Chad, and TransGlobe was on the table. However, by April 2014, the merger was terminated due to Caracal being acquired via a cash offer by Glencore Xstrata, a Swiss-based mining and commodities group. In accordance with the arrangement agreement between Caracal and TransGlobe, Caracal paid TransGlobe a break fee of US$9.25 million. Tranglobe subsequently declared and paid out a portion of this in a special $.10 share dividend to equity holders.
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 following the conclusion of TransGlobe’s fiscal year. TransGlobe’s reserves have been independently evaluated by a third-party engineering firm, DeGolyer and MacNaughton. As of December 31, 2013, TransGlobe had a total of 45.3 million barrels of Proved plus Probable reserves and 55.3 million barrels of Proved plus Probable plus Possible reserves.
We like companies with excellent ratios and strong balance sheets
TransGlobe has an exceptionally resilient interest coverage ratio. In 2013, finance costs totaled $8.021 million, while funds flow from operations were $139.0 million, resulting in a very healthy interest coverage ratio of greater than ten to one.
TransGlobe has experienced rapid growth over the last 10 years and future growth looks positive based on the company’s increasing exploration activity. Yet, the current price to earnings ratio of approximately 8:1 is lower than what would be expected of a company with such strong growth potential. Considering TransGlobe’s recent increase in land holdings and drilling activity, we feel this stock has ample room for appreciation.
At the end of Q2 2014, TransGlobe had cash on hand equal to $110 million, exceeding its long-term debt of $88.8 million, primarily from this bond issue. This large cash balance, along with the fact that TransGlobe finances all of its capital expenditures with cash generated from its operating activities, gives TransGlobe opportunities to continuously seek and invest in new long-term growth prospects.
We like companies that are profitable
Total revenue for the six months ending June 30, 2014 was $165,838 million as compared to $155,818 for the same period in 2013. The increase in total revenue for 2014 was due to the receipt of the reverse termination fee from Caracal Energy in the amount of $9.25 million. For the six months ended June 30, 2014, funds flow from operations was $75.7 million as compared to $68.9 million for the first six months of 2013. Although TransGlobe recently revised its 2014 production guidance down from a projected 18,000 – 20,000 Bopd (barrels per day) to 15,000 – 16,000 Bopd, it still projects funds flow from operations for 2014 would be approximately $126.5 million (assuming a Brent oil price of $100 per barrel), as compared to $139.1 million for 2013.
Strong Production Growth Prospects
In Q1, the company drilled nine wells, resulting in seven oil wells. In Q2, the company drilled eight wells, resulting in eight oil wells (100% success rate). The new PSA’s contain a lucrative location in the North West Gharib block. The company has identified more than 79 drilling locations at North West Gharib and commenced drilling in the first half of 2014. Production from this concession is expected in late 2014, with a more prominent ramp up in production expected in 2015. Based on currently identified opportunities, TransGlobe estimates a target production rate of 40,000 Bopd in the next four years, which would equal a 233% increase from 2012 production.
We found no credit ratings associated with this debt. However, with three year US Treasury yields at just under 1%, we feel the over 7.5% yield currently indicated in these Canadian bonds represents a welcome opportunity for much higher yields given the risks that we can identify. An unusual feature of this bond issue is the option to convert (prior to maturity) these debentures into common shares at the conversion price of $15.10 (Canadian dollars) per common share (current share price is about $7.00 Canadian dollars). Transglobe’s stock traded into the high teens near the end of 2011, and with the political situation in Egypt stabilizing, we think any significant increases in production could easily restore equity markets’ confidence in this company to boost its share price back to the more respectable levels of recent years.
The default risk is TransGlobe’s ability to perform. The company recently revised its 2014 production guidance due to prolonged pump issues at its West Gharib facility, decreasing production between 800-1000 Bopd. Half of the defective pumps have been replaced with the other half estimated to come online by year end. Even with decreased production, TransGlobe remains profitable, and its significant cash balances easily service all of its interest bearing debt. It is our opinion that the default risk for these relatively short-term bonds is extremely minimal
When compared to the increased return potential.
Perhaps the most difficult risk to quantify is the geopolitical risk. Egypt appears to be past the worst of the upheaval experienced since 2011, and appears to be moving towards stability in a region frequently characterized by conflict. The new Egyptian government has recently been instrumental in mediating a cease-fire agreement between Israel and the Hamas. They are taking steps to heal their ailing economy as evidenced by the recent reduction of fuel subsidies.
A new government taking such a politically sensitive step to improve their economy is encouraging and one would hope to see similar actions moving forward. TransGlobe continues to add economic value to the country through its PSAs, with new agreements having been signed in the last 12 months.
Given TransGlobe’s singular focus on oil, revenue and earnings would be adversely affected should oil prices significantly decline.
Since these bonds are denominated in Canadian dollars, bondholders would be subject to risks of the Canadian economy and the US/Canadian dollar exchange rate.
We think these bonds carry similar features and risks to other convertible debentures that we have previously reviewed, such as the 9% Lake Shore Gold, the 6.5% to 9% Temple Hotel, the 7.5% Canwell Building Materials, or the 5.6% Tricon notes that we have reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
While TransGlobe has experienced some challenges in its operations in the last 12 months, we feel the company is making strides towards excellent growth with its increased exploration and drilling activity, as evidenced by the recently won PSA’s and new discoveries in Egypt. It continues to have a very strong financials, maintains an excellent cash balance and a healthy interest coverage ratio. The financial markets appear to be wary of TransGlobe due to the geopolitical risks present in Egypt, but with Egypt’s need for cash from PSAs and its reliance on foreign oil companies for domestic oil production, we believe TransGlobe is strategically positioned to profit from these needs. Therefore, we think the lessening risk and over 7.5% yields of these short 30 month Canadian dollar convertibles should be elevated to an overweight position within the foreign currency fixed income portion of our global high yield FX-2.com and FX-3.com portfolios.
Yield to Maturity: ~7.55%
Disclosure: Durig Capital and certain clients may have positions in TransGlobe Energy 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.
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