Shortly after an article I wrote was published suggesting Torchlight (TRCH) is at risk of going to $0, three articles were published by supposedly unrelated parties all addressing my article but not addressing the fundamental risks associated with an investment in Torchlight. The response was problematic and does not address the following risks, many of which were not addressed in my prior article nor in the responses to my article. Here are some key risks, many of which have not been addressed previously, which could lead to Torchlight trading to $0, and could challenge Torchlight's ability to raise additional capital, which the company has disclosed that it needs. It is worth paying particular attention to issues related to violation of fiduciary duty, as trust is an essential component of an investment. And to issues related to asset ownership and quality, as Torchlight owns less of the good wells in its area and more of the bad wells, which explain poor performance to date and may make it difficult to raise additional capital.
1. Management having been proven in a court of law (and in an appeals court) of violating fiduciary duty
2. Management's involvement in a failed company immediately prior to Torchlight
3. Torchlight's use of an auditor with an unusually small number of disclosed public company clients
4. Excessive G&A -- $6.7MM in 2013, $5.8MM in Q1. Where is this money going?
5. Likely minimal cash left in the bank account, given $5mm capex in q2, only $2.4mm cash as of end of March and high levels of G&A
6. Poor track record of sole research analyst covering the stock (and also doing investment banking work for the company!)
7. Risk to the bull thesis from inconsistent results in the Hunton
Below are details addressing each of these items:
1. Management prior violation of fiduciary duty:
The suit alleged breach of fiduciary duty, theft/embezzlement of corporate opportunity, conversion, money had and received, tortious interference with business expectancies, accounting, and constructive trust. Respondent further sought a temporary restraining order and permanent injunction against Appellants to prevent them from transferring 500,000 shares of stock in LMG. On November 22, 2004, the parties entered into a consent order in which Appellants agreed not to "sell, assign, transfer, disburse, use as collateral, or in any manner encumber or convey any Shares of Limelight Media Group stock acquired by either Defendant ․ while the above-styled cause of action is pending before this court." All shares of LMG were to be placed in the custody of either counsel for Respondent or counsel for Appellants to be held in trust while the case was pending. On May 2, 2005, Respondent filed a motion to show cause as to contempt of court for Appellants' failure to comply with the November 22, 2004 consent order. This motion was granted on May 27, 2005 with any determination of damages to be determined at the time the cause was tried. The cause was heard over several days. On October 18, 2005, the trial court entered a judgment in favor of Respondent. The court concluded that Brda had breached his fiduciary duty and duty of loyalty to Respondent.
2. Management prior CEO and Chairman of XTOG (n/k/a HUGE), which traded down 99% immediately prior to joining Torchlight.
3. Torchlight's audit firm only has 4 disclosed public company clients
This is unusual for an audit firm being used by a public company. Here is a link to the filing regarding the auditor discussing the auditor's clients, which is the most recent publicly available document available on the firm. The firm does not disclose a client list outside of this document.
4. High G&A compared to current cash position and negative operating cash flow:
Page 5 of the recent 10-q, for the first quarter of 2014, shows that the company was operating cash flow negative (contrary to the false claim in Joe Giamichael's research report that the company is cash flow positive, which was emailed to the investor contact list but not published online, so it cannot be linked) :
|Net cash used in operating activities||(444,017||)|
Negative operating cash flow is relevant because Torchlight is one of the only publicly traded oil and gas companies with this financial metric. Due to the capital intensity of the business, many oil and gas companies are free cash flow negative, but almost all are operating cash flow positive, even "early stage" companies like Torchlight. This is particularly important as Torchlight goes to market to raise more money - why should investors trust Torchlight with more money if the money Torchlight has already spent has been wasted?
Page f-3 of the recent 10-K:
This shows G&A from 2013 and 2012. Note G&A up 3x despite continued losses from operations. Keep in mind, this is before accounting for capex; including capex, Torchlight lost more than $10 million in 2013, and had lost almost that much already in 2014 just in the first quarter!
General and administrative
$6.7 million in G&A in a year is exceptionally high for a company Torchlight's size in the oil and gas industry. Other companies producing 10x as much as Torchlight produced in 2013 spent a similar amount in G&A, and those companies were criticized for overspending on G&A, such as US Energy (USEG).
5. Likely minimal cash left in the bank account, given $5mm capex in q2 and only $2.4mm cash as of end of March and given high levels of G&A. From the 10-Q page 17 (emphasis added):
"Our current assets are insufficient to meet our current obligations or to satisfy our cash needs over the next twelve months and as such we will require additional debt or equity financing. Subsequent to December 31, 2013, we received net proceeds of approximately $5.57 million from the offering of units of equity consisting of our common stock and warrants, but these proceeds will not be sufficient to fund all of our proposed drilling operations and operating needs during 2014. We will seek additional financing to meet our drilling plans and needs. We face obstacles in continuing to attract new financing due to our history and current record of net losses and working capital deficits. Therefore, despite our efforts we can provide no assurance that we will be able to obtain the financing required to meet our stated objectives or even to continue as a going concern."
6. Dismissal of analyst track record and inherent conflict of interest
The one investment banking research analyst who covers Torchlight only covers one other company currently. Immediately prior to his current job, he worked as an analyst at Global Hunter and covered Chinese RTOs. This is relevant because Torchlight is an RTO. Virtually every RTO turned out to be a fraud. A number of the risks at Torchlight are similar to the risks at RTOs - managements with previous breaches of fiduciary duty, going concern issues disclosed by auditors / in SEC filings, managements with track records of managing companies that traded down 99%+, etc. The connection between these fraudulent RTOs and Torchlight is germane, both because of the investment banker / sole research analyst connection, as well as because of the above risk factors.
Additionally, the analyst also does investment banking for Torchlight, helping Torchlight raise money while collecting millions of dollars in commissions from equity and debt raises for Torchlight. This raises the question of where exactly the "chinese wall" resides, or in other words, how an analyst being paid millions of dollars in investment banking fees could possibly publish unbiased research, and how they could comply with the securities industry requirements mandating a separation of those two inherently conflicting activities.
Citron Research, a well known research firm providing contrarian research on numerous public companies, highlighted Joe Giamichael as far back as 2009. It pointed out that Joe managed to cover companies across a breadth of industries, and that many of them had already gone to zero, including Home Solutions. Here is a link to the Citron article from 2009. If investors had paid attention, they could have avoided staggering losses on Joe's picks in 2011 and 2012, as virtually his entire coverage list went to 0. This is worth consideration - the only connection between the different companies Joe Giamichael has covered is that they are RTOs. Torchlight is an RTO, and Joe Giamichael is the only investment banking research analyst covering the stock.
7. Inconsistent results should be factored into valuations
The Hunton is the main area cited in the investment "research" on Torchlight and in the bullish response to my article. It is notoriously spotty and inconsistent, which is why vertical development of the Sooner Trend had slowed to a halt. And it is why, despite drilling dozens of wells in the play, public and private operators are getting inconsisent horizontal results. Torchlight has played up individual high producing wells while not highlighting the numerous disappointing wells. This is particularly relevant for Torchlight, which has had low working interest ownership in the better wells and has had high working interest ownership in the worse wells. This can be seen in Torchlight's most recent operations update. Torchlight owns only 1% of the best well drilled in the Hunton, but over 4% of a well that produced 1/4 as much oil - the "Kodiak" and the "Gamebird" wells. This is consistent with previous high and low production rate wells participated in by Torchlight, which may partially explain the negative operating cash flow despite tens of millions of dollars spent on capex!
Assigning a high per acre value ignores the inconsistency in well results and in well ownership. And the inconsistent results and disproportionate participation in lower performing wells may explain where some of Torchlights losses are coming from and why the company is still operating cash flow negative despite deploying tens of millions of dollars in capex and G&A. It may also explain why the company needed to disclose in its SEC filings that it needs to raise additional capital to continue as a going concern, despite having raised expensive convertible debt and equity with warrants in the past 18 months. The Hunton should be heavily risked even in a bullish case for Torchlight, and it does not appear to be. Considering the conflicts of interest discussed above and what appears to be a coordinated stock promotion campaign (3 articles and 1 press release all within a few hours of each other!) perhaps that should not be surprising.
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Disclosure: The author is short TRCH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.