(Note: This article was in the newsletter on July 14, 2022)
TransGlobe Energy Corporation (NASDAQ:TGA) announced a merger with VAALCO Energy, Inc. (EGY) in an all-stock transaction, with the surviving company to be VAALCO and the surviving officers to be VAALCO officers that run the combined company. TransGlobe Energy just announced a new contract with Egypt that would be far more profitable. Therefore, this announcement is coming before shareholders can adequately ascertain the benefits of the new contract.
What was even more interesting was the slide of VAALCO common on the announcement of the news. That slide should doom the transaction. But time will tell if that actually happens. The deal appears to be a very good one for VAALCO shareholders, as they would acquire a company that has not been properly priced by the market in some time. The market certainly has not taken into account the profitability of the new contract that TransGlobe Energy has with Egypt.
Probably one of the more conservative figures I have ever seen for cash flow guidance for the current fiscal year is shown above. The fiscal year 2021 cash flow was earned under a completely different (less favorable) contract with the Egyptian government. It frankly needs to be restated in the terms of the new contract.
The whole purpose of the new contract was to enable the company to grow reserves and production that had been uneconomical under the old contract. Clearly that would materially change the comparison above. The current fiscal year would be materially different. Management stated that cost recovery and margins would improve in the future. If that is the case, then the actual earnings in the previous year are largely irrelevant unless they are adjusted to current business agreements.
But the other thing is that most insiders agree that this is still a buyers’ market. There really should be no hurry to sell the company until optimism about future commodity selling prices prevails.
There are a lot of things that the market is uncertain about. The effect of the Ukraine war upon future selling prices and commodity supplies would be the main stumbling block. Waiting for things to become clearer would be far more beneficial to shareholders.
VAALCO itself is a conservatively run company that maintains a net cash position. That kind of conservatism tends to indicate that a conservative acquisition offer was consummated. The general lack of benefits other than geographic diversification and participation in a larger company tends to reinforce that the offer was conservative. If that is the case, then VAALCO shareholders stand to benefit from this merger much more than TransGlobe Energy shareholders.
Africa has long been a money-losing proposition for a fair number of oil and gas exploration companies. VAALCO does have some production and does have a strong financial position. The company is also making money. But it also has an offshore business that is far riskier than is the case for the secondary recovery that TransGlobe engages in.
Furthermore, the offshore business tends to include very financially large projects. VAALCO is actually extremely small to engage in the offshore business. The company probably needs to have several mergers to gain the proper size for offshore upstream. TransGlobe does provide considerable cash flow certainty to the combination through its secondary recovery business.
Personally, I prefer doing business in Egypt to many other places in Africa because the Egyptian government is stable and the support for the industry has been evident for a long time. There is nothing necessarily wrong with doing business in Gabon and Equatorial Guinea. But I think in terms of infrastructure and government effectiveness, the Canadian business and the Egyptian business of TransGlobe Energy would be superior.
Probably the most important consideration is that the stock price slide of VAALCO common stock left TransGlobe Energy with little to at times no premium as a result of the merger. The stock price reaction to the merger announcement is shown above.
Therefore, TransGlobe Energy shareholders receive no credit for the improved contract with the Egyptian government. Instead, the shareholders of TransGlobe would have to share the benefits of the new Egyptian contract with all the shareholders in the newly merged company.
On the other hand, should the offshore business of VAALCO prove to be unexpectedly successful, then TransGlobe Energy shareholders would share in the success of the combined company. The tradeoff here is the reduction in participation of the more reliable secondary recovery business for participation in a less predictable offshore business.
The market lately has had a strange reaction to all stock mergers. That is especially the case here where the merger of VAALCO with an undervalued company would likely prove accretive. One would think that would have sent the common stock price of VAALCO ahead. Now that reaction could still happen in the future.
Many times, these kinds of mergers have a success based upon the votes of a lot of traders that can make a small profit and move on. So, this merger is likely to succeed. It remains a disappointment to TransGlobe shareholders that were looking to benefit from the long-awaited new contract in Egypt.
This merger appears to benefit the shareholders of VAALCO at the expense of TransGlobe Energy shareholders. The initial stock price reaction left a very small premium to the trading price of TransGlobe common before the announcement.
There is really no synergy announcement with the merger. Instead, the benefits are the much more intangible matching of the onshore TransGlobe business with the offshore VAALCO business. I personally do not like the riskiness of the offshore business, nor do I like the location. For that reason alone, I think TransGlobe management could do far better than this.
TransGlobe Energy has a relatively new contract with the government of Egypt. Before engaging in any merger discussions, management should have a few years of results from that new contract so that shareholders can properly gauge the value of the company. At that point there would likely be adequate support for a transaction like this. Right now, there is a fair amount of uncertainty.
Right now, I plan to read the materials about the merger once they get here. There is an excellent chance that I may sell my shares at some point and just move on. Small companies often carry risks of less-than-optimal outcomes, as is the current case. This is also the reason that investors tend to ignore smaller companies.
The result could well work out for shareholders of the combined company in the long term. But I think that the shareholders of TransGlobe Energy deserved better than this. The time to sell is when there is a sellers’ market. That does not appear to be the case right now. As the industry cycle progresses, there is every chance that management would receive a far better offer for the company.