TransGlobe Energy: unloved, unappreciated and dramatically undervalued.

TransGlobe Energy Corporation (TSX: TGL) (NASDAQ: TGA) (“TransGlobe”) is a Canadian oil exploration and production company with operating activities in Egypt and, to a much smaller degree, Yemen. The company had historically owned and developed a portfolio of producing wells in Canada and Yemen. In 2004, however, management announced a new strategy and the Company has since transformed into a predominantly Egypt focused operation. Egypt represents 95% of production today, while Yemen represents the residual 5%.                                                                                                  

Since this strategic pivot 10 years ago, management has established an admirable track record of long-term production growth with average daily production and total annual production each increasing by an annually compounded ~22%. 2P reserves have grown in-line with production, also compounding ~21% during this time. Over the same timeframe, revenues, EBITDA and net income grew by a compounded 33.8%, 33.6% and 25.8%, respectively. Infrequent share issuances to fund exploration activity somewhat dampened diluted EPS growth which, nonetheless, came in at 19.4% compounded.

Despite this history of operational and financial outperformance, TransGlobe’s shares have failed to keep up with its growing top- and bottom lines. Over these 10 years, the shares delivered an 11% compounded return (excluding dividends), with P/LTM E contracting noticeably from the 20x level in 2004 to 11.5x today. Similarly, EV / LTM EBITDA declined from 9-10x in 2004 to 2.3x today.

The long term 11% compounded share performance conceals much year-to-year volatility in share price – primarily attributed to two distinct events: (1) the 2008/2009 financial crisis and, (2) the 2011 “Arab Spring” revolutions. During the financial crisis, the shares dropped – peak to trough – ~70% over the span of one year. The selloff proved short-lived; by late 1Q 2010 the share price had quadrupled from crisis lows and more than doubled from pre-recession levels.

The Arab Spring, however, caused a more lasting impact on shareholder returns: since 12/31/2010 (the Egyptian uprising started in late Jan 2011), TGA’s shares have declined -52% against a +48% increase in the S&P 500 and a +43% increase in the Energy Select Sector SPDR ETF. The shares were pummeled even as management continued to deliver strong operational and financial results: production and reserves grew by 1.8x and 1.5x respectively since 12/2010 while revenues and EBITDA almost doubled.

So, what happened? Is the lagging share price the result of an arguably systematic event or is there something else at play here? After much research, I found a perfect storm of events (some idiosyncratic, some systematic) to have contributed to the recent underperformance. However, I strongly believe that many of these issues are transient, and that the shares should rerate materially over the coming months as many of the dark clouds pass and operational excellence shines through once again.

Positive #1: TransGlobe benefits from a strong balance sheet and historically disciplined capital deployment. As of 2Q 2014, the company had $108M of cash & equivalents against $88M of debt, a $20M net cash position. Importantly, management was able to deliver 20%+ compounded 10-yr production growth while maintaining relatively modest leverage over the years. Net debt peaked at $50M in 2008 (concessions acquired in 07/08 were part debt-funded) only to start reducing dramatically as production and earnings ramped up.

With the exception of the 07/08 concession acquisitions, the company has self-funded substantially all its exploration and development activity over the past 10 years (including other concession acquisitions and seismic investments) from operating cash flow. Despite this almost entirely cash flow financed expansion, management has delivered a 10yr average return on equity of 18.2%.

ROEs have dipped recently as a result of stalling production growth against a growing equity base, some of which is tied up in recently acquired 100% exploration blocks. The former will be addressed further down, and the latter could result in material near-term production and sales growth provided that management continues to remain disciplined and methodical in its capital deployment efforts.

Efforts to develop the newly acquired concessions are just ramping up: management recently budgeted a record $100M capital deployment plan for 2014, split roughly as follows:

• 94% Egypt, 6% Yemen
• 66% development, 34% exploration
• Of total $34M in exploration capex, $15M going towards seismic on new leasehold in the promising Eastern Desert region
• Gross well count: 48 in Egypt (of which 32 development and 16 exploration), 3 in Yemen (of which all development)

In other words, management plans to maintain development capex at $66M in 2014, a figure that is consistent with recent historical averages (2010: $63M, 2011: $63M, 2012: $46M, 2013: $67M).

On the other hand, exploration and other capex (excluding further concession acquisitions) is expected to reach $34M in 2014 as compared to $19M in 2013 and $5M in 2012. Exploration spend is likely to remain higher than historical averages in the near term as TransGlobe makes major investments to develop its prospective resources in the newly acquired acreage.

The combined $100M capital budget is clearly more aggressive than historical spend but should be easily absorbed by a combination of net cash and operating cash flows.

Positive #2: Management has a solid operational track record.

Source: Company presentation

The exhibit above speaks for itself. This is almost entirely blocking-and-tackling type growth: invest in seismic, acquire concessions, more seismic, explore, develop, and produce. Rinse and Repeat. As a result, since acquiring the first Egypt concession, West Gharib, in 2007, both production and reserves have tripled at TransGlobe. Exploration success is reflected in relatively muted historical exploration impairment expenses.

The most meaningful contributors to top line are now are the West Gharib (acquired 2007) and West Bakr (acquired 2011) concessions. The former contributed 11,100 bopd of 1Q 2014 sales (62% of consolidated total), while the latter contributed 5,757 bopd of 1Q 2014 sales (32% of consolidated). Both areas feature company-operated wells in which TransGlobe has a 100% working interest.

In the strategically important West Gharib, management has drilled 148 wells since 2007. Of the non-service wells, only 9% were dry & abandoned and the remaining 91% were producing. Same story in West Bakr where management drilled 23 wells since inception, 11% of which were D&A whereas the remaining 89% were producing. An overall 88% success rate since 2007. Lest you think management is slipping, 2014 YTD drilling results (as of preliminary 2Q operational results released on 07/08/2014) look no different: 19 wells drilled YTD, with 17 producing oil, one dry hole and one suspended for future sidetrack (i.e. 89% success rate YTD).

Positive #2: Second leg of growth around the corner after having recently secured promising concessions adjacent to its lucrative West Gharib acreage. In late 2013, TransGlobe announced the signing of four new production sharing concessions (“PSCs”) for an approximately 800,000 net acres, bringing the total number of PSCs in Egypt to eight. This is a notable development as (1) the company was able to offset $41M in signature bonuses against the outstanding receivables from the Egyptian government (a major issue to be discussed further down), and (2) management remains very optimistic about the prospects of the areas in question.

“TransGlobe is extremely excited about the potential to grow our base of operations materially over the next few years in Egypt. The Northwest Gharib concession, which surrounds all of our Eastern Desert production, is expected to be the cornerstone of that growth. The Southeast Gharib and Southwest Gharib concessions, which are situated directly south of our current operations, should provide lower risk exploration opportunities in the coming years. The South Ghazalat concession in the Western Desert abuts the recent condensate discovery and should provide some additional exploration opportunities as well. TransGlobe commends the Egyptian Ministry of Petroleum for making the ratification of these concessions a top priority of the new administration", stated Ross Clarkson, President and CEO.” Source: TransGlobe press release, dated: 11/08/2013 (http://www.trans-globe.com/news/release?id=1779357)

Drilling around the new Gharib concessions, specifically in North-West Gharib (“NWG”) (adjacent to the highly productive West Gharib concession which contributed 60%+ to 1Q ’14 sales) began on June 25, 2014. The first well (NWG 1), drilled in 2Q 2014, discovered oil consistent with management expectations. Shortly thereafter, the well was cased for completion as a future oil producer.

As exploration efforts ramp up, a second drilling rig will be moved to the southeast corner of NWG in late July / early August. According to management, both rigs are expected to remain there through 2015 with up to 18 wells expected to be drilled by year end 2014. In NWG alone, management has identified 79 drilling locations based on existing 3-D seismic which was acquired as part of the nearby West Gharib exploration efforts. Based on this current mapping, TransGlobe has internally estimated a prospective resource base of 71 million barrels on an un-risked deterministic basis for the NWG block. The 2014 drilling program is expected to target up to 58 million barrels of the total 71 million of prospective resource.

Further, the Company believes the same structural configuration that created the pools found in the West Gharib concession is likely present in the NWG, SW Gharib ("SWG") and SE Gharib ("SEG") blocks. The historical field size distribution data indicates that the average field size in the broader onshore Gulf of Suez (Eastern Desert) area is roughly 20 million barrels per field of recoverable resource. (TransGlobe Operations Update for Q2 2014, dated: 07/08/2013 http://www.trans-globe.com/news/release?id=1856855)

It is important to note that no reserves were booked in relation to the 2013 concession acquisitions as these are exploration blocks. After dropping in 2013, reserves should grow modestly in 2014 and significantly thereafter as fields are discovered and developed in the NWG and others. To get a sense for the materiality of this development, compare the 71M bbl unrisked figure in NWG and 20M bbl per field estimated recoverable figure to the year-end reserve figures in the exhibit below. 

Granted the recoverable resource figure is a management estimate based on internal calculations. It is also unrisked and, by definition, both undiscovered and unproven, so I leave it to you to adjust this figure as you deem fit. Take it with a large grain of salt. But the key takeaway stands: huge potential across multiple concessions in an area that management knows quite intimately.

The last concession acquisition, West Bakr PSC, contributed 7.5mmbls to reserves (i.e. 62% of the 174% reserve replacement ratio for the year). NWG (162,000 net acres), with no reserves booked, is 14x larger than West Bakr (11,600 net acres), which has an associated 7.5mmbls of reserves.

In addition to NWG, the ratification of the three other PSCs in late 2013 has increased TransGlobe’s land position in Egypt by 160% to a combined total of 1.3 million net acres.

Negative #1: The struggling Egyptian government has been delaying payments to oil producers. For what good are all the billed receivables if one cannot turn them into cash?

As is common knowledge today, Egypt experienced serious disruptions to business activity and daily life during and subsequent to the 2011 revolution. Many businesses were forced to shut down and life ground to a halt as violence escalated over a series of daily demonstrations that lasted 2-3 weeks.

The demonstrations were largely concentrated in and around major cities including Alexandria, Ismailia, Suez and the capital, Cairo. Unsurprisingly, TransGlobe experienced no disruptions to its field operations during this time as the operated concessions are many hundreds of kilometers away from Cairo and other major cities. West Gharib and West Bakr, which make up a majority of production today, are some 300 kilometers away from Cairo, separated by a vast empty desert. The same story unfolded during the massive civil protests of late June 2013 – no significant impact on TransGlobe’s day-to-day operations.

Ok, but what about the economy? It is also no secret that the Egyptian economy has continued to deteriorate post revolution. Mr. Hafez Ghanem, a senior fellow in the Global Economy and Development program at Brookings, described the situation as follows: “the fiscal deficit is about 12 percent of GDP, the public debt has ballooned to 80 percent of GDP, international reserves barely cover three months of imports and the Egyptian pound is under increasing pressure. As a result investment and growth are down, unemployment is up, prices of basic necessities are rising, and fuel shortages and electricity blackouts are common occurrence.”

Foreign oil companies in Egypt are required by law to sell their produced barrels to the Egyptian General Petroleum Corporation (“EGPC”), whom they invoice on the basis of global market prices. Due to the deteriorating fiscal situation and the resulting impact on its finances, EGPC has been very noticeably delaying payments to all such foreign oil companies. Where things stand at TransGlobe today:

A/R has ballooned from $70M in 2004 to $214M in 2013. Granted, sales and production growth have contributed to the increasing balance, but so has non-payment: months outstanding fluctuated between 7 and 11 months since the revolution (vs. as low as 2-3 months pre revolution). As of June 2014, the Egyptian government is said to owe ~$5.9B to foreign producers; i.e. TransGlobe represents 3.7% of the total outstanding.

The payments issue is not going unaddressed by the industry; many of the foreign oil companies have been loudly threatening to dramatically curtail production if the matter remains unresolved (http://on.wsj.com/1fvl9xc). Egypt can ill afford this as a majority of production is used to meet local demand. Nor does the government (in the form of EGPC) have the capacity or ability to replace any such production losses. As a result, the new, army-backed, Egyptian government has been scrambling to address this mess.

As recently as 06/26/2014, the country’s oil minister revealed plans to pay back some of the growing debt to foreign oil companies in a bid to revive confidence and boost production in its flagging hydrocarbon sector. The plan is to settle $1.5B of outstanding receivables in the next few months.

In its recent 2Q 2014 operations update, TransGlobe management commented as follows:

“In an effort to reduce its budget deficit the Egyptian government recently implemented higher gasoline, diesel and natural gas prices by reducing the subsidies carried by the government. These price increases are expected to have a material impact on Egypt's current budget deficit and are also expected to enable the Egyptian government to make more timely payments for its purchases of oil and gas from international oil companies.

In an effort to expand the Company's exploration opportunities in Egypt, TransGlobe submitted a bid on a single exploration block on July 3, 2014 in the EGPC bid round. It is expected that the blocks will be awarded to successful bidders during this year.

The Company has collected $74.5 million from EGPC to date in 2014, and is targeting total collections for the year of $250 million.”

This $250M of expected 2014 collections figure is slightly below 2013 collections ($275M) and remains well below the $300M+ in annual sales. As such, A/R now represents 25% of assets and 33% of equity. Despite the ongoing delays, however, operating cash flow has been sufficient to cover the $66M annual development capex budget and the recently instituted 2.6% dividend.

Recent events reveal that the government is aware that it stands to lose more from production shut-ins than from reduced subsidies: last week Egyptian officials announced a decision to slash subsidies on fuel and natural gas, thereby increasing fuel prices more than 70%. By making a conscious choice to accept the possibility of civil unrest, the government is making a strong statement about the importance of the economic reform. This is a critical milestone to say the least.

In response to these development, a Royal Dutch Shell spokesman said: ““The current subsidy burden affects EGPC’s financials and profitability significantly, impacting on its ability to pay its receivables to international oil companies (IOCs). Energy subsidies also burden the government, which in turn forces the government to impose a ceiling on gas prices, dampening the investment incentive for IOCs and affecting the long term supply of gas.”

Other relevant industry comments from a recent Businessweek article:

1)      Egyptian General Petroleum Corp., the state energy company, “is doing the best it can” to pay off the debt, said Chris Green, CEO at Circle Oil. “The key thing is reducing subsidy.”

2)      Sea Dragon Energy Inc. (SDX) plans to acquire additional assets in the country, said CEO Paul Welch. “The time is great now to get involved in Egypt.” Incidentally, Sea Dragon is chaired by Said Arrata who previously built Centurion Energy into an Egypt-focused E&P company with 32,000 bopd production. More on this below.

3)      “We would like to spend more” in Egypt, said Randy Neely, chief financial officer at Transglobe Energy Corp. (TGL) But until there are further payments for fuel supplies, “we will be probably spending more outside of Egypt.”

The payments issue is a well-publicized matter that you should research in further detail. You should especially look at the press releases and run some numbers on Dana Gas, Kuwait Energy Company and Sea Dragon Energy Inc., three of the closest TransGlobe comps. In addition, read the disclosure from Apache and BG regarding developments around Egypt. I have done a lot of this work already, but this report is now getting too long.

The key points to keep in mind are: (a) despite ongoing payment issues since 2014, TransGlobe has been able to manage its cash flows relatively well, and (b) the Egyptian government cannot afford a showdown with the IOCs and is therefore demonstrating serious efforts to resolve the mess.

Negative #2: Production growth declines and operational setbacks

After a multi-year run of consistent growth, production seems to have stalled quite noticeably. Guidance for 2014 was recently reduced from 20,000-21,000 bopd to 18,000 bopd. Even this reduced figure (i.e. essentially flat from 2013) is beginning to appear somewhat optimistic; the first two quarters of 2014 were quite disastrous. There is some weakness from West Bakr, where production is 900 bopd below 2014 plan due to mixed drilling results in early 2014. However, West Gharib is the main disappointer: 1Q 14 production is down -14.4% YoY while 2Q 14 production is down a whopping -22.2%.

The reasons for the declines in West Gharib are: (1) progressive cavity pump (“PCP”) failures, (2) lower than expected drilling results, and (3) increased water cuts associated with natural declines.

The failure of the new PCPs explains a large part of the deviation of production from 2014 plan and 2013 historical averages. TransGlobe explained the PCP issue in its 1Q 2014 filing as follows: “In 2013, the Company received several consignments of PCPs from a new manufacturer who was the successful bidder in the 2013 tender process. The new pumps were used to replace existing PCPs and for new wells starting in late 2013 / early 2014. Unfortunately approximately 60% of the new pumps failed prematurely from as early as a few weeks up to three months, which is significantly less than the historical run times of 1 to 2 years for PCPs in West Gharib. The poor PCP performance has adversely impacted 2014 production due to increased down time associated with the more frequent pump changes, slower response time for pump changes due to increased demands on service rig availability and a shortage of properly sized replacement pumps which has impacted well optimization plans. Approximately 40% of the West Gharib production was produced using PCPs with the balance produced using sucker rod pumps. The PCPs are often used for higher volume producers, which further impacts production when shut-in for pump changes. The Company is working with the pump manufacturer to determine if the problem is an elastomer design issue, a manufacturing issue for this batch of pumps, or some combination of both.

The Company received a new consignment of pumps from this supplier which may or may not have similar problems depending upon the root cause of the failures. Concurrently the Company placed a special order for additional pumps with another supplier/manufacturer which are expected to arrive in Egypt early in the third quarter. The Company is currently tendering a 2 year supply agreement for PCPs. This contract is expected to be awarded by early June, at which time the Company can procure a proper supply of new pumps. It is estimated that the PCP failures impacted 2014 average Q1 production by approximately 1,000 Bopd and will continue to impact future production until the faulty pumps are replaced with more reliable pumps. Given the current outlook for the supply chain delivery time, we do not expect the pump situation to be fully resolved and all wells properly optimized until Q4-2014.”

The Company provided additional color in its recent 2Q 2014 operational update: “The manufacturer of the failed PCPs has conducted a detailed review of the failed pumps and the manufacturing process for the pumps. Subsequent to the review, the manufacturer has modified its processes and advised the Company that they will provide replacements at no cost to the Company for the forty pumps which were supplied during the past year. The new pumps are being manufactured, with the first batch of 20 pumps expected to be delivered in July and the remaining 20 pumps to be delivered by August/September. In addition, the Company placed a special order for nine replacement pumps from the Company's previous pump supplier. These have been manufactured and are expected to arrive in Egypt in July. With the delivery of the replacement pumps, it is expected that the majority of the defective pumps will be replaced by the end of the third quarter which should reduce production down time and facilitate well optimization.”

The installation of the new pumps is expected to restore some 800-1,000 bopd of resulting shut-in and curtailed production. This will begin to show in 3Q 2014 results, but more so in the fourth quarter. Once the pump matter is resolved and an additional 1,000 bopd of production is reinstated, Egyptian production will still average 17,000 bopd (i.e. another 1,000 bopd below early/mid 2013 averages). This difference is primarily due to disappointing well results and natural declines.

It seems that the market is extrapolating the PCP- and drilling- related production declines into the future and, as such, discounting this into the valuation. The pump issue, though raising valid questions about the procurement process, will most likely be resolved by year-end. In my opinion, the weak drilling results are much more concerning. However, we should not be quick to write off management especially in light of their historical track record. Keep a close watch on drilling results in Q3 and Q4.

In 2013, the $67M in development capex translated into at 7% increase in Egypt production (from 16,656 bopd to 17,874 bopd). Management expects to spend the same amount in 2014 though this time showing no growth in return. Going forward, one must determine whether this $67M development spend is sufficient to drive growth, as it had been in the past, or whether it is only enough to sustain current production, as appears to be the case in 1Q and 2Q 2014.

Negative #3: Recent exploration delays in South Alamein and the resulting questions about management. In 2012, TransGlobe secured a 100% working interest in the South Alamein PSC by acquiring two entities that owned 50% working interests each. The company paid ~$29M for the two entities. Management has expressed confidence in their ability to dramatically increase production and reserves at South Alamein because a discovery (Boraq) already exists on the lands. However, plans to begin exploratory drilling in the area continue to face significant delays. Namely, a military shooting range had been recently set up over the Boraq Discovery, preventing access indefinitely.

Management has been working closely with government and military officials to relocate the range. In the meantime, EGPC (the NOC that manages the concession bidding and award process) has suspended the clock on the South Alamein production sharing contract. This gives the TransGlobe a 20+ month exploration window from the date access is granted by the army.

One should watch this development very closely as, if anything, it serves as a litmus test for the strength of relationship between management and military/government officials on the ground. I cannot find any evidence that these drills had been taking place prior to the acquisition. However, one cannot help but question whether there was material oversight on the part of management. Were there gaps in the due diligence process or was this truly a recent surprise development?

Also, how confident can one be that this management team, despite the successful West Bakr acquisition, has secured good prospects at a bargain price? After all, this concession is hundreds of kilometers away from the lucrative Bakr / Gharib acreage in which they have the most experience. Management points to a test well (Boraq #2) that, in the primarily Cretaceous zone tested at a rate of 1,323 bopd of 34 API oil with no water. They believe that, when combined with secondary tested zones with the Cretaceous, the well should be capable of 1,700+ IP. Only time will tell; how long is anyone’s guess. In the meantime, we have $29M (5% of market cap) worth of shareholder’s equity trapped in a non-productive asset on which no associated reserves have been booked. Ouch.

Negative #4: Risk: Management aware of undervaluation due to Egypt exposure - efforts to diversify the business may result in imprudent acquisitions and/or a company sale at a bargain price. Management has, at numerous points in the past, expressed the view that the company remains underappreciated by the market. The recent 2.6% dividend initiation was one attempt taken to highlight value and return capital to investors. TransGlobe had also expressed an interest in diversifying its production base without elaborating much about how this will be achieved – company sale, acquisition, organic growth outside Egypt, etc.

You should research the recent failed Caracal merger in a lot of detail. The highlights: a director of TransGlobe (Gary Guidry), resigned from the board in March 2014. Concurrently, Caracal Energy, an Africa focused E&P company (run by none other than Gary), announced a deal to merge with TransGlobe in a bid to create one of the largest independent Africa focused producers. As a conflicted director, Gary recused himself from evaluating the transaction. At the proposed exchange ratio, the deal valued TransGlobe stock at USD $8.69, an 11% premium to the previous day close (03/14/2014) and 26% higher than the most recent closing (07/11/2014).

The deal was called off after Caracal itself received a buyout offer from Glencore. But suffice it to note that an industry-insider director saw sufficient value in TransGlobe to attempt to acquire it at $8.69 per share. This valuation, though representing a premium to today’s prices, gives no credit to the asset value (attractive concessions) and prospective growth profile of the Company.

Although the deal has been dropped and TransGlobe received a $9.25M termination fee, there is no assurance that management will not give the company away at a bargain price as it had almost done with Caracal. The only consolation was that the combined operation would have given TransGlobe shareholders exposure to very promising and attractive oil assets in Chad. 

Finally, this management team has little experience with corporate acquisitions, and an attempt to diversify by acquisition would be a serious cause for concern. This is mitigated by a history of prudent concession acquisitions, some of which included developed and producing acreage.

For example, TransGlobe acquired the West Bakr concession from the Egyptian Petroleum Development Co of Japan in March 2011. The $60M all-cash deal gave TransGlobe operatorship of three fields with 28 producing wells and 11,600 acres in two development leases (all funded with working capital). Importantly, the implied purchase multiples were extremely favorable:

• EV/production: $13,793/boe
• EV/1P reserves: $ 8.11/boe
• EV/2P reserves: $ 6.82/boe

Refer to the comparable company analysis below to better appreciate how much of a bargain this deal was. The assets were purchased in early 2011, at the peak of the revolution – likely the result of distressed selling which TransGlobe capitalized on. Mind you, these are not underperforming fields: management was able to increase production from 4,000 bopd at date of acquisition to 5,757 bopd today.

Valuation: comps, precedents, and a crude DCF

I compiled the following list of comparable companies for which I show a snapshot of trading multiples (from CapIQ), as well as reserve and production valuation metrics (my calculations):

The closest comp on the basis of concentration of geographic exposure is Dana Gas, a primarily Egypt and Kurdish Iraq focused producer. They have similar payment issues in Egypt. In Kurdistan, however, they face much bigger problems. Though Dana Gas states that it is owed $447M from the Kurdistan Regional Government, the KRG in turn claims that it does not owe Dana Gas any money. The matter, which highlights the risk of operating in disputed Kurdish Iraq, has been filed for arbitration in London. Dana Gas has not received any regular payments from the KRG since July 2013.

TransGlobe’s historical valuations have trended as follows: note that each annual figure represents an average valuation over the course of that year and NOT a snapshot of the valuation at year-end.

Finally, I have found two relevant comparable precedent transactions of note:

1)      Centurion Energy International Inc. which was acquired by Dana Gas in November 2006. Centurion was a Toronto and London listed oil and gas E&P company with principal operations in the Egyptian Nile Delta. This was the only other publicly listed pure-play Egyptian producer; it is as comparable as comparables come. Centurion was sold to Dana Gas for $1.02Bn in 4Q 2006 (EV/EBITDA: 8.8x, EV/Sales: 6.9x, P/LTM E: 30.7x, P/BV: 4.5x, EV/Production - $44,074/boe). Compare these multiples to the current TransGlobe valuation per the above tables.

2)      Apache’s Egypt assets, 33% of which were acquired by Sinopec for $3.1B in Aug 2013. Based on the in-place reserves and production figures of Apache Egypt at the time, the deal implied the following valuation: EV/Production - $ 58,125/boe (based on 160,000 boepd 2012 production), EV/1P Reserves - $34.1/boe. Again, compare this to the multiples in the valuation tables above.

I also prepared a DCF based on some very simple calculations with the following draconian assumptions:

1. Free Cash Flow: FCF remains stable – no growth from 2014 onwards. Compare this to 22% historical compounded growth.
2. Capital expenditures: keep flat at historical levels – i.e. $65M of development capex per year. This level of historical capex translated into 5% production growth in 2013 and 11% in 2012 (adjusted for the producing wells acquired as part of the West Bakr concession) yet the DCF assumes 0% growth.
3. Terminal multiple: assume an 8.0x multiple on FCF, a reasonable multiple for a no-growth company (adjust accordingly if you disagree).
4. Discount rate: 15% which reflects the considerable uncertainty regarding upcoming well performance and business environment in Egypt.

Using these assumptions, which I consider to be overly conservative, I arrive at a $7.10 per share value for TransGlobe. Call this your valuation bookend. If you assume a nominal 3% growth over the 6 year projection period, and without adjusting the terminal multiple at all, the valuation becomes $8.80 per share. This is not to say that a mere 3% is desirable or expected, but that a substantially lower than historic growth (despite capex consistent with historical levels) alone reveals the dramatic undervaluation of the equity. Conclusion: at best, the market is valuing TransGlobe as a business in perpetual decline. At today’s prices, and based on a relatively high 15% hurdle rate, you are paying a no-growth price on existing production only, and getting the undeveloped concessions and growth upside for free.

My own analysis relied on a combination of private market value (value to a trade buyer) and asset value from which I estimate a fair value range of $10-$14 per share. This Company, at least in its current form, does not belong on an exchange. It should not be publicly traded. The exposure to Egypt and undiversified nature of operations will likely result in a discounted valuation for a prolonged period of time. The main value catalysts are: (1) an acquisition at fair value, (2) resumption of material production growth, (3) more aggressive capital return activity – larger dividends or buybacks. Good news is that #2 should begin to materialize early in 2015.

Parting words

Ok, if this is such a great deal, why is this opportunity available to me? What is my edge?

The unfollowed and neglected trifecta: (1) this is a small capitalization company (<$500M cap) with (2) limited liquidity, and (3) single-geography exposure in a country most investors prefer to avoid. The headlines alone are enough to keep investors from even thinking to do research on this name. A small E&P company in where? Egypt? Pass. One need look no further than the comments section of Seeking Alpha contributions to confirm this. Investors perceive this asset, simply by virtue of its Egypt exposure, to be toxic – and therein lies the opportunity.

This name is also underowned institutionally and by the ever-growing universe of index funds. The principal reason for this is size and liquidity. Specifically, over the past 2.5 years, TransGlobe has seen 30-35M shares trade in any given year. Compare this to 75M shares outstanding. This implies a share turnover ratio of 45% most recently, as compared to 120%-200% for the broader US market over the past 2-3 years. During this time, some 75,000 to 100,000 TransGlobe shares trade daily (market value of $525,000 and $700,000).

With less than $700,000 of shares trading per day, it would take an activist investor well over 300 days to build a 10% stake in the company (leaving aside the fact that shareholders adopted a rights plan). This assumes that the investor represents 25% of the daily shares traded. Additionally, this company is clearly just too small for most institutional investors. If the PM of a $2Bn fund wants a 2% position in the company (i.e. $40M investment), he/she would end up owning almost 8% of TransGlobe and spend three full quarters building the position. There are disclosure and other requirements of large ownership that make this an unappealing scenario to most fund managers. This restricts the universe of institutional buyers to those managers running $200M and less.

This is a classic equity yield curve type investment with no immediate catalysts to satisfy instant-gratification investors. A resolution of payment issues, shift in sentiment towards Egypt and resumption of growth would cause a dramatic re-rating of this stock. A near-term catalyst involves signs of progress around the resolution of the PCP matter, which should appear in 3Q14 and 4Q14 results. However, the rerating will likely be driven by medium term production growth and successful development activity. But how long until that happens? Development results are not expected to be material until at least 1H 2015 - around the time when we expect to see renewed signs of production growth. If you are looking for a quick-flip, there are plenty of speculative assets that you can trade. On the other hand, if you are looking for an attractively priced investment that may very well double over the next two years, then TransGlobe may very well be for you.

Disclaimer: author is long TGA.

This is a classic equity yield curve type investment with no immediate catalysts to satisfy instant-gratification investors. A resolution of payment issues, shift in sentiment towards Egypt and resumption of growth would cause a dramatic re-rating of this stock. A near-term catalyst involves signs of progress around the resolution of the PCP matter, which should appear in 3Q14 and 4Q14 results. However, the rerating will likely be driven by medium term production growth and successful development activity. But how long until that happens? Development results are not expected to be material until at least 1H 2015 - around the time when we expect to see renewed signs of production growth. If you are looking for a quick-flip, there are plenty of speculative assets that you can trade. On the other hand, if you are looking for an attractively priced investment that may very well double over the next two years, then TransGlobe may very well be for you.