Red Flags at Transmeridian Exploration

After following this company like a hawk for 7 months, doing hours of initial and follow-up research, Transmeridian Exploration (TMY) has disappointed yet again.

On December 31, 2007, CEO Lorrie Oliver's Trans Meridian holding company "agreed" to buy out Transmeridian Exploration for $3/share if financing is approved. However, this deal will not be completed and Transmeridian will fall in a spiral as hope for a takeover may be permanently ended.

When I first heard about the deal, I was excited that my diligence had paid off, and that because of the "convenient" buyout date, there would be no price reset for warrants. This has led many investors to believe that this "buyout" is merely a delay for real bidding, and there are still foreign investors bidding on the real buyout price of Transmeridian for themselves.

However, these investors have become too emotionally attached to the performance of this stock, as Transmeridian (probably) could have written the deal with the same pullout clauses with the "real" buyer. Not to mention that a fake buyout is illegal (don't forget that).

This leads one to the question why Lorrie Oliver would lead a buyout of a company that has not made money, and seems to have no chance of doing so in the next few quarters, and more likely years. Assuming that the CEO knows more about his company than the public, and most likely more than an outside suitor, and because no one aims to lose money, why would he take private a company if he "knows" it is going to fail?

For Oliver, this company likely represents all his wealth, and has become over enthusiastic about either its drilling potential or its buyout potential. Perhaps he thinks that the price is much lower than it should be, and he will buy the company now cheap, sit on it, and hope more suitors come bidding higher than he paid. Another reason may be to cover his ineptness as a leader. This stock isn't even getting bought out at above its year high, when prospects have actually gotten better. Perhaps he is trying to avoid a lawsuit from shareholders who have watched their company get dumped on once again, and hopes once again a foreign suitor will bail him out.

As I wrote in my first article, Transmeridian has 67mm barrels of proven reserves and 210mm of probable reserves when calculated out, giving it a value much higher than its current value. However, these calculations were made under the assumptions that the oil would be pumped at levels that would only occur if its pumping system technology were upgraded, which would happen if it were taken over by a large oil company. Transmeridian needs to pump 4000 barrels of oil a day in order to remain profitable, supposedly, which means that they need to make $160,000 a day. They have only passes the 4000 benchmark once, two quarters ago, by pumping 5100 barrels a day. In that quarter, they were still unprofitable. This demonstration of possible profitability was simply to show potential suitors that their fields could be pumped profitably, yet no one bit. They failed to duplicate that performance the next quarter, and things look bleak. Production remains between 3300-3700 bpd, net losing money.

For Oliver and his group to complete a successful takeover, they need to convince a bank to lend them money. Assuming that they can even increase their max capacity to 6000 BPD immediately, think if you would lend to them. Here are the facts, would you lend? You are a bank suffering your biggest write-off in history due to subprime problems and now you are calling in all the loans you can. You know Transmeridian has never been profitable and is run by poor management. No outside suitor has bought it at this price, questioning if the CEO maybe has too much emotional interest for this company he has run into the ground. They will not only need to borrow the $825 million to buy the company, but will need to borrow more to upgrade to make it profitable. We will be very generous and only assume they need $100 million of improvements. So you need to make over $160,000 a day to be profitable. Now let's pretend over the next 20 years (which would be the duration of the supposed loan), oil prices stay exactly the same at $100 adjusted for inflation in this, the best oil market we have ever seen (of course this will happen right?), and we charge them for transporting $20 per barrel of oil, which is now costing them $60 per barrel. That means that they make 124mm in earnings per year. Given that they have minimal growth, their P/E is low…let's say 7. This makes the company worth $868 million total. He is paying $825 million ($925 million including upgrades), not including interest. Not only can he not pay the high interest that will accompany this risky loan, he cannot pay back the loan itself. Don't forget that this is under the most optimal conditions that I could imagine. Under more realistic conditions where oil averages $80 pb (Goldman est), same higher transport fees, P/E 7, the company looks to be worth $562 million.

This company has once again disappointed investors by failing to sell out to a foreign company. I give Oliver's takeover bid a 10% chance of succeeding. The only nice outcome for this troubled company is if a foreign company swoops in and buys it up after the stock drops when Oliver cannot get financing. Considering that there were supposedly other seriously interested companies, this could happen. However, considering that most international oil companies are sitting on mounds of cash right now, an extra 75 million to buy this company, were they really interested, should not have been enough to have turned them away. Chances of this happening are 1:3, and Transmeridian would not be bought for more than $2.5. If this company is left on its own after Oliver's pullout, watch it fall to hover around $1 until more takeover rumors start.

Given these calculations, Tranmeridian is currently worth $1.69 a share (.1*3+.33*2.5+.57*1), a definite sell as it hovers around $2. However, this largely takes into account that there is a 1/3 chance of ending up being bought by a foreign company; if this is not true, then the fair value per share is $1.2 (.1*3+.9*1).

Disclosure: none