TransGlobe Energy: Turnaround Gem Hiding In Plain Sight

Summary

• TransGlobe's business has seen great improvement in terms of free cash flow as well as production.
• Cash is being used to pay off debt, pay out dividends, and invest in future growth.
• Despite the turnaround since the crashing oil prices of 2014, the shares are trading at an extremely low valuation.

TransGlobe Energy Corporation (TGA) has successfully turned its business around, yet the shares are priced as if the business is suffering. The fundamentals have seen a tremendous improvement over the past few years with strong cash flows, but its share price has yet to follow this trend. By now the difference between fundamentals and share price is so wide, that investors can expect significant upside.

Company overview

TransGlobe Energy is an oil and gas exploration and production company whose main activities are in Egypt. But towards the end of 2016, it expanded to Canada when management acquired assets of Bellatrix, a company headed for bankruptcy. A total of $59.5 mln was paid for the transaction.

During the fiscal year 2018, 88% of the total revenue was derived from operations in Egypt, while the other 12% was generated in Canada.

Background

Just like any energy-related company, the crashing oil prices in 2014 had a severe adverse effect on TransGlobe Energy’s financial results. Revenue plummeted along with the oil prices.

Source: Seekingalpha.com

In 2015, a year after the start of the price decline of oil, TransGlobe's revenue was only 33% of the year before. This was both due to a 51% decrease in realized oil prices as well as a 26% reduction in sales volumes compared to 2014.

While the revenue was declining, the cost structure was adjusted to lessen the impact on the bottom line.

After the company had survived the declining oil prices, it had to position itself for growth again. The focus was directed towards increasing production volumes. The effect of this was first seen in 2017 when production volumes grew on an annual basis for the first time since 2013.

During 2015 and 2016, the company had difficulty selling all produced barrels. Sales volumes were 85.5% and 92.2% of produced barrels respectively. After that, sales started to pick up again due to a deal with Mercuria, which resulted in 108.7% of the produced oil volumes being sold in 2017 while production already increased by 28%.

With it, revenue started to increase again as well. On an annual basis, revenue grew by 135% during 2017, resulting from a 28% increase in production, a 51% increase in sales volume and an increase in oil prices.

Impairments

As TransGlobe initially saw business turning around in 2017 with higher production volumes as well as revenue, the major progress went unnoticed by most. Even though its financial results had rebounded and cash flow started to look solid again, the net income was still deep in the red, leading a lot of people to believe that TransGlobe was still severely struggling with the lower oil prices. However, what most people failed to see was that the negative bottom line was a direct result of some significant impairments.

Source: Seekingalpha.com

Without these impairments, the company would have been breakeven during 2017. But instead, it reported a loss of $78.7 mln for the year, a massive one compared to the market cap of $105 mln at the end of that year.

The impairments had different sources. TransGlobe used to be active in Yemen as well. But as unrest in that country grew, the company decided to pull out of that country, resulting in a $51.5 mln write-down in 2014. This did not have a big impact on the business since Yemen only accounted for about 2% of the sales volume during 2013 and 2014. Most of the other impairments in 2014 were the direct result of lower oil prices as was the case in 2015. The impairments recorded in 2016 and 2017 were mostly due to adverse exploration results. After 2017, no more major impairments are readily expected. Even though this is the case, impairments will always be a part of TransGlobe's financials as it is an exploration, development, and production company.

If we take a better look at the financials, $22.2 mln in free cash flow was generated during 2017, while $29.1 mln worth of free cash flow was generated during 2018. That year was also the first time that a positive bottom line was reported since 2014 due to the combination of higher volumes, higher prices, and lower impairments worth $14.5 mln.

Short-lived surge

After showing strong signs that the company had recovered during 2017 and even more so in 2018, the stock finally surged on the back of higher oil prices. An increase of around 288% was welcome but unfortunately short-lived.

Source: Tradingview.com Brent Crude Oil in orange (left axis)

Oil prices started to decline again and with that, the TransGlobe share price collapsed to the lowest point since 2017.

Financial performance over the past twelve months has not been as strong as during 2018, seemingly leading investors to think that the company is in deep trouble, which is far from the truth. The fundamentals and future potential look far stronger now than back in 2017.

Past twelve months

Due to all the progress seen in the past years, TransGlobe is able to generate a significant amount of free cash flow, although this might not be that obvious at the moment. The trailing twelve months free cash flow currently stands at $-11.8 mln, a yield of -14.2%. At first glance, such a free cash flow yield looks horrendous and could indicate that a company is in trouble, scaring investors away. However, the negative free cash flow is merely temporary.

In Egypt, a lot of the oil is sold in shipments that are very infrequent. As a result, financial results are quite volatile. This has been the case these past twelve months as well. Less has been sold than produced in all of the past four quarters, leading to lower revenue and higher inventories.

Sources: Quarterly and annual reports

Only 88.6% of the total oil boe produced has been sold during the last quarter. The three quarters before that had 94-95% of oil produced sold. This has caused a negative effect of $7.1 mln on the free cash flow over the past twelve months. Excluding that effect, and a $13.9 mln build in accounts receivable, TransGlobe's cashflow would have been $9.3 mln, or a yield of 11.2% at the current share price.

The free cash flow is actually expected to grow much further due to the rising production volume. In the graph above you can see that production has been on the rise since Q2 2018. About 2,164 boe/d have been added to the production, or 15.7%. Growing production volume has been the result of management stepping up growth efforts again. Since 2016, CAPEX has been steadily increasing each year from $7.2 mln to $40.3 mln over the last twelve months, a huge expense as it is almost half of its current market cap of $83 mln.

The CAPEX budget for 2019 is less than the $40.3 mln that was spent in the past twelve months.

The Company’s 2019budgeted capital program of $34.1 million (before capitalized G&A) includes $24.1 million for Egypt and $10.0 million (C$13.0 million) for Canada. The 2019 plan was prepared to maximize free cash flow to direct at future value growth opportunities, debt repayments and dividends. At this time the Company expects to come in approximately on budget for the year.

This would suggest that CAPEX is likely to decline $6.2 mln for the full fiscal year compared to the trailing twelve months, which will possibly trickle down to a significant increase in free cash flow, leading to an even higher yield for the full fiscal year than the earlier mentioned 11.2%.

TransGlobe’s high amount of free cash flow is what makes this stock so attractive as it is what enables management to invest significant amounts into further expansion without getting into a dangerous situation.

Increasing production volumes

Production has been outperforming guidance given at the start of the year, after which management recently increased it to 15,500 to 16,000 boe/d. This is despite the fact that production has averaged 16,269 boe/d thus far this year with 15,943 boe/day in Q3.

Soon, production volumes will be driven up even further due to the SGZ-6X discovery well in the Western Dessert. SGZ-6X was successfully tested earlier in the fall of 2018 at a rate of 3,840 bbls of light oil per day. Production of SGX-6X will commence in Q4 of 2019 at an initial bopd rate of about 1,000. So it looks like the updated guidance for the full year could be outperformed as well.

Besides the SGZ-6X well, the company has plenty of land to explore and develop both in Egypt and Canada. Further acquisitions are also a possibility as management has stated that it is actively looking for merger and acquisition opportunities.

Solid cash position

Besides reinvesting its massive cash flow in further growth, TransGlobe manages to allocate a large portion of cash to pay down debt. The total debt stood at $84.8 mln after Q1 2017 but has since then been lowered to $41.7 mln, which is part of the reason that the cash position has been shrinking despite generating solid free cash flow.

Source: Seekingalpha.com

The cash position is expected to rebound nonetheless due to the earlier discussed temporary negative free cash flow.

The turnaround of the business has also enabled TransGlobe to initiate dividend payments to shareholders. A dividend of $0.035/share is distributed to shareholders twice a year, originally initiated in the second half of 2018, resulting in a dividend yield of 6.1%. So management is keeping its shareholders interests in mind.

Valuation

The P/S, EV/EBITDA, and EV/EBIT are trading at multi-year lows.

Source: morningstar.com

TransGlobe’s shares are trading at an extremely low valuation. Its P/S is even lower than during the times it was burning cash and generating a negative bottom line. Because of the fact that this business has seen amazing progress, is able to generate solid free cash flow, and is working hard on future growth opportunities, I believe that the shares should easily be able to trade at higher at a higher valuation than during the years it was struggling. At the very least, this would imply an upside of 65% of the current price of $1.14, or a target of $1.88. Don’t forget that this merely brings the share price to the minimum valuation that TransGlobe has had in the recent past. The fundamentals show that it is in a way better position than it was at that point in 2017. Therefore, a much higher valuation should not be surprising.

EBIT and EBITDA were both negative during 2015, 2016, 2017, which is why the data is lacking there. But other than that, the same thing goes here as well. Since those years, both EBITDA and EBIT have rebounded strongly which, again, is not reflected in TransGlobe’s share price.

Conclusion

TransGlobe has seen tremendous improvement these past years. It managed to generate a solid free cash flow yield while initiating a solid dividend yield of currently 6.1%, paying off a huge portion of debt as well as significantly raising CAPEX to drive growth even further.

Despite all of this, TransGlobe still trades at an extremely low valuation as if its business is in deep trouble. The only logical explanation for this is that the stock is dragged down along with the entire sector, resulting in a great investment opportunity for contrarian investors. My initial price target is $1.88, but I expect much more upside.

Keep in mind that this is a micro-cap stock with low liquidity. Be aware of the risks associated with this before making an investment.

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Analyst’s Disclosure: I am/we are long TGA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.