A successful International oil and gas explorer focused in Egypt and Yemen
Denominated in Canadian Dollars, TransGlobe Energy’s 6.0% Convertible Unsecured Subordinated Bond matures in March of 2017, and is currently indicating a yield to maturity of about 7%. Should this relatively new producer continue its rapid growth and significantly increase in value, the possibility exists of increasing this already high yield through the capital gains its convertibility feature allows for, as explained further in this review. Consequently, we see this as a rare and unusual opportunity for high yields in a very desirable (Canadian) currency from a well managed oil producer directly benefiting from higher oil prices and highly successful new wells in oil producing regions of Egypt and Yemen, and it is why we are adding these 49 month TransGlobe Energy convertible notes to our Foreign and World Fixed Income bonds.
A Look at the Issuer
Headquartered in Calgary, Canada, TransGlobe Energy Corporation (TGA) was incorporated on August 6, 1968 and was organized under variations of the name “Dusty Mac” as a mineral exploration and extraction venture. In 1992, it entered into the oil and gas exploration and development field in the United States and later in Yemen, Canada and Egypt, ceasing operations as a mining company. The company’s U.S. oil and gas properties were sold in 2000 to fund opportunities in Yemen and its Canadian oil and gas assets and operations were divested in early 2008 to assist with the funding of opportunities in Egypt and Yemen. Having changed its name to TransGlobe Energy Corporation on April 2, 1996, the company has been listed on the Toronto Stock exchange (as TGL) since November 7, 1997 and on the NASDAQ since January 18, 2008. Prior to listing on the NASDAQ, the Company had its U.S. listing on the AMEX since 2003.
TransGlobe Energy’s current activities, which include the exploration, development and production of crude oil, are concentrated in two main geographic areas, the Arab Republic of Egypt (“Egypt”) and the Republic of Yemen (“Yemen”). It has interests in 9 international blocks comprising 5.5 million acres, and its impressive management team and financially prudent business model have resulted in strong 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.
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.
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.
We like companies that are profitable
Revenues last year were up chiefly as a result of increased sales, which averaged 17,124 barrels a day for the third quarter and 16,942 barrels a day for the first nine months of 2012. These figures represent a 28% and 39% increase over Q3 and the nine months ended 2011 respectively. Profit margins are stated at 29.17% and operating margins are 59.33%.
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 over a dollar a share 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. The $53 million Exploration budget includes 23 exploration wells and seismic, which is primarily focused on Egypt (96%). In the Western desert, 10 of the exploration wells are planned to test 10 of the 38 prospects summarized in the independent resource report. The total working interest Mean Prospective Resource (prior to the application of geologic success) to be evaluated by the 2013 ten well exploration program, is approximately 75 million barrels.
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. 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
Interest expenses for the nine months ending Q3 2012 appear to be $11.5 million, while operating income (EBITDA) was about $118.6 million, indicating a healthy interest coverage ratio that’s greater than ten to one.
We like companies with lower debt to cash ratio
The long term debt of TransGlobe Energy at the end of 3Q 2012 was $134.9 million, primarily attributed to the 6% convertible debentures that were issued in March of 2012. Cash and cash equivalent at the end of Q3 was about $45.7 million, giving them a modest debt to cash ratio of about 3 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 its earnings at about $1.10/share and it stock trading around $8.75, the approximately 8:1 price to earnings (PE) ratio is less than what is might be expected for a company evidencing such consistently robust growth. 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
TransGlobe’s debt of $134.9 million appears to represent about 18% of the near $735.6 million enterprise valuation currently given it by the equity markets. This is one of the least leveraged balance sheets of any company that we have thus far been able to identify. Overall, it reminds us of our first review of Netflix (NFLX) bonds. Although rated as junk bonds, we saw the company as having a well managed and 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 strengthened considerably and now command a hefty premium.
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 paltry 0.88% yields of longer five year U.S. Treasuries, we think the 6% difference in yield (in what many pundits say is a very desirable currency) alone represents a savvy opportunity for higher rewards given the level of risks that we can identify.
However, one of the more unusual features to 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 17½% annual appreciation from it current price of $7.86, it’s notably lower that the nearly 18½% annual increase in production that the company is projecting it might achieve. Adding in the capital gains potential significantly sweetens the opportunity here for higher returns.
The default risk is TransGlobe’s 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 forecasted 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. This is an unfamiliar path that has no precedent set for it. 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. Perhaps what needs to be remembered, however, is that both Egypt and Yemen are achieving significant income streams from the production sharing agreements (PSA’a) that are in place. 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, sudden or swift changes to the way this easy money flows are less likely. Being 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, which 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 (CHV), French based Total (TOT), or British Petroleum (BP). 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.
Even though it 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. It has a sound cash position, good cash flow, excellent interest rate coverage, and given its strong growth potential going forward, we think these TransGlobe convertible debentures offer great diversification, a high yield in Canadian currency relative to the risks that we can identify, as well as 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: ~6.98%
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. If you intend to use our research efforts to make an investment decision, we kindly ask that you respect our fiduciary business model and allow us the opportunity to assist in your equity acquisition. We sincerely appreciate your courtesy and understanding.
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