I am an investor in Torchlight Energy (NASDAQ:TRCH). My fellow investors and I have had to live through 3 short attacks in less than a week and a half, all predicated on half-truths, heavy-handed at best assumptions, backward looking analysis and terrifying headlines with no fundamental argument to support them. I'm sure most of us are left feeling a bit beaten up and beginning to question the "bull case" for the company. Since I am exhausted from attempting to address all the things wrong with the short articles in the comment sections, I thought I may as well express my logic for being long the stock and where I think it can trade over the next six months. Maybe I can jump on this headline bandwagon and the rest of you can attack me in the comments section. So, before that starts, let's get some easy stuff out of the way, I am long the stock and I do not work for nor am I compensated by the company.
I will admit at the beginning that there are certain assumptions that I have made to reach my price target, but investing is supposed to be forward looking and any price target should highlight the variables and risks to their thesis. In this case, the primary variables are twofold: 1) Can the company access the necessary capital to execute the very aggressive capex program that they have for the year, and 2) Can the performance of past wells be used to project the performance of future wells, with some handicapping of course. So in reality, the only difference between my thesis, which gets to $7 by year end and the short author (who claims this is going into bankruptcy) is whether or not the company raises capital, even on really bad terms. I even use the short author's previous article and his valuation metrics to arrive at the $7 price target for year end.
Let's start with a quick history lesson on the company so that you can see how far the company has come in a short period of time.
Who is management and why do shorts hate them so much?
Torchlight was founded by two individuals: Tom Lapinski, a geophysicist who retired from BP Amoco after 30+ years, who admittedly has never before run a public company as shorts love to point out, and John Brda, whose background reads as a consultant/banker/fund manager whose partner sued him 10 years ago after they dissolved a previous consulting company -- the shorts have expounded upon this to mean awful and terrible things, but the actual complaint reads like sour grapes at the end of a bad marriage, either way, not a required SEC disclosure, but relevant all the same. So you have an oil guy and a capital markets guy, those skill sets seem to offset each other fairly well.
A little over a year ago the company added its COO, Willard McAndrew, who has 43 years of experience in the oil sector as an operator, having worked with everyone from majors to his own public endeavor Xtreme Oil and Gas, which unfortunately was one of many junior E&P companies that didn't get off the ground -- reading old filings, it looked like they had too much debt and too little production at a time when an error in the field caused them to lose an important well, and from there things spiraled down. Torch doesn't seem much like Xtreme to me, other than that they are both junior E&P companies and having watched several of the company presentation videos, Will seems like a competent and knowledgeable industry person. With 30-odd wells online within the next month or so I hope the company doesn't experience something traumatic that takes one offline, but given the diversification, it would survive to fight another day and continue to service their debt if that were to happen.
How/when did they come public?
The company came public through the dreaded reverse merger (RTO) process by which a private company merges into a publicly traded shell. This process has been vilified over the past few years as tons of Chinese companies stampeded to market using the same methodology and most have failed for any number of reasons, none of which you would've wanted to be on the long end of. In reality, the RTO methodology is one that has been used for decades to allow small companies to create a public entity for much less than it would cost for an IPO. In any case, whether the company went public through an RTO, SPAC or an IPO process; at this point the company has been public and fully reporting for 4 years and has up-listed from OTCBB to NASDAQ in December of last year. If there was anything wrong with the shell or any RTO related issues, it should've shaken out by now.
What acreage do they have?
From the time the company came public, up until mid-2013 the company had 1,080 acres in the Eagle Ford in which they have a 75% working interest. Over the last year that acreage package has grown to include three other plays. From a drilling standpoint the focus is now on Oklahoma, where they have 25,000 acres in an AMI that can grow them to 300,000 acres and working interest listed at 15%-30% and two Kansas plays, one called Smokey Hills, which has 18,000 acres with 50% working interest and another where they announced a partnership with Ring Energy (NYSEMKT:REI) where they have a 50% working interest in 17,000 acres. This gives them a drilling inventory of 870 gross wells to the primary zone; this is probably 9-10 years of drilling inventory based on this year's drilling plan. Management has said they have an inventory of more than 1,000 locations in several interviews I have watched, so my guess is the acreage is growing across one or more of the plays.
How about reserve value?
Shorts have shown an EV/Proven reserve value that indicates that the company is hugely overvalued relative to comps. According to the company presentation, at the end of 2013, the company reported a PV-10 value of $47.4m, $21.5 from Oklahoma and $25.9m from Texas, meaning that 35,000 acres, or 57% of their total acreage contributed no reserves to the 2013 report, because they were not in production at the time. The $47.4m of PV-10 was determined with 10 producing wells coming from less than half of the total acreage position.
Based on the 2013 reserve base, I would be in complete agreement with the short author, the company is overvalued based on those reserves. But I don't own the stock because of 2013 production, I own the stock because of what I believe the 2014 production can be. And it should be pointed out that even one quarter later than this year end information, barrel per day production had already doubled as they ended Q1 with a run-rate of 250bpd.
Here is Torchlight's presentation that highlights the company's current opportunities and progress to date. Take a look at pages 9 and 10 for the year-end 2013 reserve values.
What has happened since the last reserve report?
What a difference 6 months can make. They ended the year with 10 producing wells and a run rate of 115bpd, since then production more than doubled in the first quarter to 250bpd and management has projected and reiterated guidance for the current quarter (that ends in less than two weeks) of 500bpd, meaning that it should double in sequential quarters. During a recent update management said that it had drilled 30 additional wells to date and that more than half of those were either online or would be in the immediate future.
Management has spoken to the fact that they have begun to develop the 17,000 acre play in which they are partnered with Ring and the management of Ring stated in a press release from this week that it planned to provide an operational update on Kansas soon. So 6 months after the last reserve report 30+ wells have been drilled and production has grown more than 4x the year end run-rate, and the company has begun to drill in one of the two plays that it did not previously receive any reserve value for.
Here is a link to Torchlight's presentation at the Marcum conference, which provides an update on the wells drilled to date and wells currently being drilled. Let's summarize that for a second: the number of wells tripled, production quadrupled and another acreage play has come online. Let that sink in for a minute while you weigh that against the "shouting fire in a crowded theater" calls from the shorts.
Any thinking person would admit that the reserve base is probably much higher now than it was at year end. As I stated in the comment sections before, I hope that management decides to do a mid-year reserve update and if they do, I hope that the short sellers update their notes with some level of objectivity; I don't mind if they still want to look back, just look back at Q2.
Where can things go from here?
Management provided guidance at the beginning of this year that it intended to drill 90 wells during the year and that it would spend $35mm to do so and that they expected production to ramp by a doubling in each sequential quarter over the balance of the year -- so far so good, Q4 ended at 115, Q1 ended at 250 (OK, on pace) Q2 guidance was just reiterated for 500bpd. I have no reason to think they won't hit it. Management recently reiterated its prior guidance for 1000bpd in Q3 and 2000bpd in Q4 (see the link to the Marcum conference above). 2000bpd at year-end is the aggregate contribution from the 30 wells currently being drilled and the 60 wells to be drilled by the end of the year; also important to mention that the working interest in the next 60 wells will be higher than in the first 30 wells.
That means that production over a calendar year would have grown more than 17 times the previous year's exit rate. 17 times -- and the stock is now lower than it was at the end of the year, those two things may not make sense, other than the fact that with the company uplisting to NASDAQ in December shares were pretty rich relative to existing production. But now you have to ask yourself: Where can shares be if they are only fairly valued to a year-end target rate of 2000bpd? Probably higher than $4?
What has to happen to hit 2000bpd?
This is where things become a bit more interesting and where oddly, the tenacious short author and myself would likely agree most. The company has a $35m capex plan to drill 90 wells, they stated that they have drilled 30 so far and have spent $9-10m, how do you fund the $25m to get the additional 60 wells? You raise capital; herein lies the single biggest risk to the investment thesis. I would argue that it is not necessarily a binary risk because there is no collapse if they don't raise money, but if they do raise the money they can get to the 2000bpd. Now I'm sure if they do announce a raise the short author will publish something about how he doesn't expect well performance to be on trend or something of the like; doesn't matter, the issue at hand is can they raise the money and if so what is the structure and how will existing shareholders be diluted?
At this fork in the road investors have to join one of two camps, like flipping the pages in a choose your own adventure novel, if you believe they can raise the necessary money follow path A toward 2000bpd of production 6 months from now; if not, follow path B and continue to read Light of Day's Seeking Alpha articles. Let's take a quick walk down each path, starting with the scariest, path B. If you do not believe the company can raise new capital on any terms, either debt or equity, then by all means build your short positions.
I would suggest also praying for the credit markets to seize up or oil prices to tumble to $50 or both, although either or both scenarios result in a world in which you would not want to be long TRCH or any other oil company, junior to super major, so short everything, be long bullets and beans and hope for the world to fall apart, it worked once for Paulson, but there are probably better, less risky ways to play doomsday. So path A, what is the worst, most dilutive and painful way for the company to raise money and how much do they need to fund the remaining $20m-$25m? Let's go with the most expensive form of capital, equity capital and let's say they need to generate 80% of the needed capex from new money. They have to be able to generate something from 500bpd that can be reinvested.
So there is a $16m-ish funding gap and we are assuming a hugely dilutive equity issuance, let's say money is raised at a discount of 15%, as is customary in the pipe world; that would mean selling $16m worth of stock at $3.50, resulting in 4.5m new shares coming to market. Let's be clear that I think I am being overly pessimistic in my pricing and I highly doubt that they would have to do that, but we are looking at my worst-case scenario. While this would hurt, it would mean that fully diluted shares would be 36-37m at this point (there are about 32.7mm of fully diluted shares now -- 20.2m common shares, 9.2m warrants exercisable in the $1.75 - $6.00 range and approximately $10m in convertible debt; all of these numbers are in the public docs) not counting the fact that to actually get to that number you would have to exercise all of the warrants that would give the company another $25m in cash, but nobody exercises warrants when companies actually need money.
What can the stock be worth if they complete a raise?
So now, under this aggressive scenario, the company is funded to drill the remaining 60 wells. There are 37m shares outstanding, rounding up and not including warrant revenues. I will use the short author's valuation comparables to extrapolate the potential value of TRCH. I am not smart enough to predict the reserve value or quantity, other than directionally (a lot more than they had at the end of 2013) so I will rely on the two valuation metrics the author used that I am capable of calculating. I have included an excerpt from the short author's article just so we are all on the same page; these are his word's below.
Summary of peer valuation comps:
- Average $/boepd of the 5 comps is $131,000. Torchlight $/boepd is $480,000, or 3.7x higher than the comps.
- Average $/BOE of 1P reserve of the 5 comps is $27. Torchlight $/BOE of 1P reserve is $80, or 3x higher than the comps.
- Average EV/EBITDA of the 5 comps is 7.4x. Torchlight EV/EBITDA is 33.3, or 4.5x peer valuation.
Since I have excluded $/BOE because I can't pretend to know how reservoir engineers will calculate things, let's focus on $/boepd and EV/EBITDA. I think you will be pleasantly surprised at how close both calculations come out after we walk through the math, I know I was.
EV Targets by valuation methodology:
- $/boepd: The author shows that comparables are trading at $131,000/boepd. If TRCH reaches 2000bpd by year end that would translate to $131,000 x 2000 = $262,000,000.00 as an enterprise value, not bad, well more than a double from here, I'll take it, we will get to what that means in share price afterwards.
- EV/EBITDA: The author shows that comparables trade at 7.4x EBITDA, a reasonable value relative to most any sector and it represents a fair cash on cash return. If TRCH is to reach 2000bpd, what does that generate in EBITDA? 2000bpd x $90/barrel x 350 operating days/year would give you revenues of $63,000,000, using an average EBITDA margin for an oil company of 60% (although I would argue that their assets and operating model with this revenue base would yield a higher margin, but let's stay cautious) that would give you EBITDA of 37,800,000, which when multiplied by 7 (see I'm even willing to reduce the multiple to lower than the comp set) gives you a predicted EV of 264,600,000.
Results: So using the author's own comp sets and valuation methodologies we have arrived at enterprise value targets that are within 1% of each other, $262m vs. 264m -- not bad, math can be fun.
What does that mean in regard to share price?
Please bear in mind that we are using the author's same comparables logic and the only assumption that we are making that is different from his, which somehow leads to a $0 target, is that the company CAN raise money, even on awful terms and still survive and flourish, but what can this return to our portfolio? Taking the midpoint of our EV calculation is $263m and using the fully diluted share base of 37m shares outstanding (which includes the conversion of the debt in place that is convertible and currently callable -- that doesn't sound like a bankruptcy if they don't have debt). This would give you an EV and by extension the market capitalization (since there will be no debt and we will not credit them for having any cash at all) of $263/37mm shares out = $7.10/share.
Why is the short author targeting $0 while I am at $7?
The short author cites mounting losses, while later admitting to them being 80% or more non-cash, and a daunting debt load, when in reality the debt is the result of a convertible note raise that was done in 2013, where that debt is now freely callable and well in the money, meaning that management can get rid of every dollar of that debt through a call. Generally, it takes debt or actual mounting cash losses, combined with an inability to raise additional capital to result in a bankruptcy. Here the debt can go away with a single press release, so raising capital is the primary issue at hand and while $0 seems highly unlikely, regardless of the ability to raise new money or not, again the primary difference in opinion between their target and mine (outside of using the correct facts) is... capital.
Where is there upside to the $7 target?
So the stock is $4 and your target is $7, that's good upside, but typically if you invest in micro-cap you want something juicier. How can you get to a target above $7?
I think that I have haircut nearly every angle to the story short of assuming they raise the money, drill no wells and just light the cash on fire. Let's say there is a credit option that is less dilutive, let's say the equity option is prettier than what I suggested, what if we look out further than 6 months. There are many ways I can walk someone through the story that can easily lead to a $15 or $20 target, simply by drilling the properties they already own and accessing a reserve based lending line (an option that should be there by the end of this year).
I also have plenty of theories on how and when this becomes a take-out target, to whom it would likely be sold to and at what price. But we will save that for another day. Today I just wanted to combat the nonsense and show how with just raising capital, even on terrible market terms, the stock can nearly double from here. And the $0 target as a result of bankruptcy, while is a genuine risk for any and every company, is in no way a realistic concern at this point or any point in the near future.
What else gives me comfort in being long versus short, where are the catalysts?
Time is on my side. Investors are never patient, short or long and there are several events expected in the very near future and any one of which could completely negate the previous author's short thesis.
- Q2 is coming. In only a few short weeks, we will know if management hit their target, given the recent reiteration I'm guessing: Yes.
- Updated reserves should be coming. They need to raise money and they have drilled a ton since the end of the year, they should update their reserve reports for the mid-year and that should show a big increase in the reserve base.
- Capital - I believe they can fill the capex gap -- even raising terribly expensive capital on ugly terms, I can still get to a target that creates great upside for me from here over just the next 6 months.
- Lastly, Management is in the boat with us -- Tom Lapinski may not have prior public company experience and John Brda's ex-partner may not like him very much, but they are voting their personal dollars with shareholders as both announced open market purchases of shares within the last week according to the form 4 filings (see links below). Keep in mind that these are not trades, so a short will discredit this move by bashing the total dollar value of the trades, but I assume these guys aren't Elon Musk and both know full well that they will likely never be able to resell those shares short of retiring or selling the company outright, as they would have to wait for an approved window to sell and I personally highly doubt that they would do so, at least not before the company is trading in double digits. So they have either thrown good money after bad in order to create some false promotion of the company, or they are siding with shareholders and believe that the long-term value of the company is significantly greater than today's market price. The links to Forms 4 filed with the SEC showing recent management buying could be seen here, here and here.
Who am I and should you believe anything I say?
Seeking Alpha has created a great platform for a free exchange of ideas and the ability to remain anonymous, so that if one's ideas are dead wrong they only suffer the embarrassment economically rather than socially. I do not work in finance and I am not paid in any way by the company. I am happy to privately share my identity if needed, but I am a small business owner and a part-time investor who has a curious mind. I first came across TRCH in the $2s and wrote an article about the Hunton play in Oklahoma, where I was trying to find the best player.
Long story short, Gastar Exploration (NYSEMKT:GST) has proved to be the fastest boat there, but I thought I was already late to it at the time -- egg on my face. I have stayed with TRCH and increased my position at prices well above where the stock is now because I have seen the story improve and I feel that they are only a capital raise away from being a double-digit stock.
I write these comments out of frustration from reading terrible short articles designed to scare retail investors. I am not recommending people run out and empty their 401(k) to buy shares of TRCH, I am merely writing this because I am long, above $4, I consider myself a fairly knowledgeable shareholder and I am wildly frustrated with the irresponsible bashing. The most frustrating part is that it's working -- this person and their terrifying headlines with no actual content has succeeded in knocking down the price of shares, that means they are winning the hearts and minds of fellow investors and I had hoped you were smarter than that and at least understood what you owned and why you own it. If not, please sell, let this person cover or take a victory lap or whatever makes them feel better and let's shake out all the weak hands.
My bet on this stock is that 6 months from now we are celebrating new highs in the production runs and in the stock and the shorts will have covered their positions and receded to the sidelines. Time will tell.
Disclosure: The author is long 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.
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