A company trading for less than 4X cash flow in just about any market sector would be considered a "value stock". A valuation at 3X cash flow would be considered a "deep value stock" and is typically only found for a distressed business with declining revenues. For example Dex Media (NASDAQ: DXM) trades at just 3.7X cash flow because a majority of their revenues are derived from declining phone book advertising sales. If a stock trading at 4X cash flow is called a "value stock" and a stock trading at 3X cash flow is called a "deep value stock", what should we call a stock trading at less than 1.5X cash flow? I would call it a Unicorn, because such low valuations are not supposed to exist. This article will not only prove the existence of 3 Unicorns, but show that this mythological low valuation category actually includes some well run growth stocks.
There are several reasons why Unicorns are found in the Canadian microcap energy sector. The energy sector remains depressed following the recent crash in oil prices. The Canadian energy microcaps have lagged near their lows while US energy sector peers have already rallied sharply. Canada has an abundance of energy stocks. Most US investors are unaware of these bargains which can be traded OTC in the US or directly in Canada with most popular brokerage firms. There is an excess supply of Canadian microcap energy stocks as compared to the demand from the small pool of investors that trade them. The sharp recent decline in the Canadian dollar has further depressed Canadian stock valuations for US investors.
All 3 Microcap Unicorns identified in this article have low stock prices and market capitalizations of under $100 million. Most large institutional investors are unwilling to own such stocks. This further reduces the pool of potential buyers. Many retail investors chase momentum and sell offs can be compounded when these issues decline. These factors have combined to create some abnormally low valuations.
The 3 Microcap Unicorns identified here have something else in common. Although all of them are listed in Canada, two operate in New Zealand and one in Colombia. Retail investors are less familiar with these markets which creates misperceptions about the risks of these oddball stocks.
Tag Oil (OTCQX: OTCQX:TAOIF) is a growing New Zealand exploration company. At a recent price of $1.24 the market capitalization is $77 million, but the enterprise value is only $50 million on account of their debt free balance sheet and healthy cash balance. Tag Oil sells light sweet oil produced from their Taranaki operations at a premium to Brent pricing. Natural gas is sold at about double US pricing.
Tag Oil is an extremely low cost producer with production costs of under $30 per barrel. Low production costs are due to a combination of favorable factors. A well at their Cheal field typically costs only about $3 million to drill and complete. These are shallow conventional wells without the need for expensive fracking. Some wells are free flowing and don't even require the added cost of artificial lift. A typical Cheal well initially produces about 300 BOE /d with moderate decline rates. Royalties are low and infrastructure is readily available.
Tag Oil had production of 1,991 BOE/d for fiscal Q3 ended 12/31/2014 which was up 8% sequentially from the prior quarter. They are on-track to end calendar 2015 with production of about 2,500 BOE/d. With December 2015 Brent oil futures trading about $66 they should exit 2015 with netbacks of about $36 per barrel and an annual cash flow run rate of about $33 million. That puts enterprise value / cash flow at 50/33 = 1.5X.
Why is Tag Oil selling so cheaply? The company is now largely focused on their shallow drilling program at Taranki, but had some unsuccessful failed "home-run" shots including the recent Waitangi Hill well on New Zealand's East Coast. TAOIF peaked above $10 back in 2012 due to excitement about East Coast prospects and strong natural gas production from the Sidewinder field. High initial production rates at Sidewinder proved to be unsustainable. Investors were burned chasing those dreams and have been slow to recognize the company's solid performance from their more mundane shallow drilling program at Cheal.
Petroamerica Oil Corp (OTCPK:PTAXF) is a Colombian exploration company. Their overly conservative 5,400 barrels per day guidance for the first half of 2015 does not include any production from new exploration wells. Most US traded oil companies do not understate their production guidance in this manner. Even with very moderate drilling success, they should exit 2015 with production of at least 6,000 barrels per day. December 2015 netbacks should be about $30 per barrel with the Brent Oil December 2015 futures now trading near $66 per barrel. That puts them on target to exit 2015 at an annual cash flow run rate of about $66 million.
Petroamerica has a market capitalization of $86 million, but enterprise value is only $46 million due to a very conservative balance sheet with more cash than debt. Enterprise Value / Cash Flow is therefore equal to 46 / 66 = 0.7X
Why is Petroamerica so cheap? Production has declined recently at their Las Maracas field. This is already reflected in the company's lowered guidance and is being offset by growing production at their Putumayo fields. It costs Petroamerica about $15 per barrel to truck oil to market which roughly equals production costs. Their Q3 2014 production at Putumayo was shut-in as community roadblocks cutoff some trucking routes altogether.
Colombia has taken several measures to reduce these risks and significantly lower costs in 2015. A new sales route from Putumayo to Ecuador has just opened up. This will cut transportation costs in half while also reducing the risks of any further interruptions. The Colombian military has been improving security in an effort to facilitate increased production. Ongoing peace talks with FARC could further reduce security risks and related costs.
Colombia is enacting new rules to share more oil revenues with rural communities. This will create incentives to avoid disruptions. Agricultural policy reforms are also underway and should reduce farmer protests and their resulting roadblocks. The Putumayo oil fields are quite prolific. Substantial production increases are expected as these transportation bottlenecks and security issues are resolved.
Tiny East West Petroleum (OTCPK:EWPMF) owns a share of the Cheal field operated by Tag Oil. They are currently producing 350 BOE/d in New Zealand and are on-track to exit 2015 with production of about 450 BOE/d. With December 2015 Brent futures trading about $66 per barrel, they will be generating netbacks of about $36 per barrel and an annual cash flow run rate of about $5.9 million. At a recent price of 10 cents / share, EWPMF has a market capitalization of $9 million. The company has a debt free balance sheet and the enterprise value is nil after netting out the cash. It's no wonder that East West Petroleum has been actively repurchasing their shares.
Although all of the company's current production is from New Zealand, they also have a valuable 15% interest in four large blocks in Western Romania. Drilling is expected to finally get underway there in late 2015 and the company's costs are fully carried by operating partner NIS Petrol.
Why is EWPMF trading so cheaply? Many investors purchased the stock a few years ago at more than 10X the current share price. The company had grand visions of becoming a global shale play. EWPMF had also hoped to participate with partner Tag Oil in New Zealand's East Coast drilling. Things have progressed more slowly than expected in Romania and some investors lost patience. Their Romanian partner (NIS Petrol ) is a Serbian company that is majority owned by Gazprom. NIS Petrol is not currently subject to sanctions, but this potential issue may have scared away some investors.
What catalysts might improve valuations for these 3 Unicorns? Acquisitions and mergers are one potential catalyst since these deals are typically valued at 4X to 5X cash flow. Reverse splits would actually be beneficial for EWPMF and PTAXF by helping to attract investors that are put off by the low share prices. Growth is an important catalyst. As these companies grow, they will start to attract more institutional interest resulting in multiple expansion.
As many readers are aware, Seeking Alpha is itself an important catalyst. US trading volume has increased substantially over the past year as popular Seeking Alpha articles have already started the discovery process for US investors. Hats off to my fellow Seeking Alpha authors for some excellent articles such as the widely read articles by Value Digger.
Disclosure: The author is long PTAXF, TAOIF, EWPMF.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: PTAXF, TAOIF and EWPMF are currently equity picks in the Panick Value Research Report.