Surge Vitality: Climbing Out Of The Debt Gap (OTCMKTS:ZPTAF)


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(Note: The original article was written in the Marketplace newsletter on April 17th and has been updated with current information as necessary.)

Like so many other junior producers, Surge Energy (OTCPK:ZPTAF) had a conservative financial record to enter the OPEC price war, followed by the destruction of demand caused by the coronavirus. But fiscal 2020 and the recovery in fiscal 2021 have been far more challenging than anyone ever imagined. Luckily for shareholders, fiscal 2022 so far promises a second chance to set things right.

Management actually began the task of “fixing the balance sheet” in fiscal 2021. The first major acquisition at CA$160 million used mostly stock, while assuming debt represented a little less than 10% of the transaction value. This started a typical pattern I’ve been seeing across the industry for quite some time. Management continued to make acquisitions to immediately reduce this debt ratio, resulting in value-added transactions overall. Rising commodity prices are currently making all deals look good.

But going into the fiscal fourth quarter, it was really difficult for the market to see the progress it was making. Now, higher prices to sell production will put this advancement in the spotlight. Debt reduction will be one of the top priorities going forward. The key here is when the company has changed enough and when its debt is low enough for the stock to get out of the market doghouse. This process usually requires patience. Sometimes it takes more patience than many would have when there are “one decision” stocks that are considered safe with superior returns. However, the end of the “one choice cycle” can change that thinking very quickly.

Many have argued that lower leverage is all many of these companies need right now. However, the market has long desired conservative leverage ratios at significantly lower prices than today. There is plenty of evidence that management will execute a plan that meets the needs of the market. So the stock price starts to react.

Surge Energy (Canada) common stock price history and key valuation dates (Search Alpha website, May 30, 2022)

The big increase in the share price is due to a reverse split in August 2021. Shareholders received 1 share for every 8.5 they owned. Any time a company issues a lot of stock, it takes time for the market to digest the extra liquidity. Therefore, the delay in participating in the industry recovery is not unexpected.

This stock really hasn’t gone anywhere for quite a while. A reverse split can result in many investors deciding to exit at either breakeven or a small profit. As such, it’s not uncommon for the stock to “stand still” or even lag after such an event.

But now that commodity prices are extremely strong, the stock price is just beginning to react.

(Canadian Dollars unless otherwise expected)

Surge Energy Fourth Quarter and Fiscal Year Changes in Shares Outstanding

Surge Energy Fourth Quarterly and Fiscal Year Changes in Shares Outstanding (Surge Energy Fourth Quarter 2021 Annual Financial Statements)

I deliberately kept this as most of the “action” took place in FY2021. The number of potential buyers increases with the reported profit increases. So how long this remains a buyer’s market will be a big question going forward. There are still many CEOs commenting on cheap valuations. This tells me that this recovery still has a long way to go even if oil prices fall, which is very likely.

The two acquisitions mentioned in the annual report were largely settled with equity and some borrowed capital. The debt assumed was clearly low enough to allow for some improvement in some key debt ratios.

The currently strong commodity prices have put an end to a need for more of these transactions. On the other hand, management will make more value-added trades that become available because such trades reduce leverage. Management has also reintroduced a dividend. Management’s attempt to portray a return to normalcy is a pretty thorough endeavor. Note that management now feels financially comfortable enough to redeem the convertible debentures for cash. That’s a big change from 2020.

The company recorded an acquisition gain corresponding to the shares issued above. Both of these things show quite a heavy financial burden. Therefore, while leverage ratios appear to be okay at the moment, investors would need to continue monitoring the situation to make any significant progress on leverage in the near future.

(Canadian Dollars unless otherwise noted)

Surge Energy 2022 Guidance and Sensitivity to Change in Pricing Benchmarks

Surge Energy 2022 Guidance and Sensitivity to Change in Pricing Benchmarks (Surge Energy Q1 2022 Company Presentation)

Surge Energy has a very profitable production mix. Additionally, many Canadian manufacturers, including this one, benefit from the ability to sell products using benchmarks related to US benchmarks. But the issues lie in the weaker Canadian dollars.

The current environment guarantees a blockbuster first quarter that no one saw coming. As hedges expire, the cash flow picture could improve. The company needs time to pay off the debt burden. Even with the fantastic debt ratios shown above, lenders and the bond market want conservative debt numbers at significantly lower selling prices. Nobody wants to repeat a near-crisis that happened in fiscal 2020 with many operators previously thought to be conservative. But for now, it looks like management is getting time to hit more conservative debt targets.

This stance appears to be reflected in the recent rally in the share price. This was delayed due to all the shares issued as well as the finances behind this share issue. It now looks as if the current environment will allow for a balance sheet correction that is rare in an economic cycle.

The stock price action is likely to mirror the better-known Occidental Petroleum (OXY) as deleveraging will result in a lower risk assessment by the market (and hence higher stock prices).

The only problem with the ability to delever is that many investors expect a leveraged investment to get that opportunity in the future. But it really doesn’t work that way. A company’s ability to deleverage is rarely matched in the market cycle. Many times I have followed companies to a dismal end because they could not or did not want to deleverage the balance sheet. Most of these companies reorganized and that wiped out the shareholders.

Increase in reserve values ​​for energy oil at various price points

Surge Energy Oil Reserve Values ​​at Different Price Points (Surge Energy Q1 2022 Results Conference Call Slides)

– The key to any company realizing the values ​​in the reserves report must be the cost structure that enables the ability to profitably produce those reserves. In this case, finding and development costs appear to support reserve values ​​at much lower selling prices. That’s a big advantage for the company when the next inevitable downturn hits.

The other consideration is that Surge Energy (like so many junior producers) was busy transitioning from a lease-acquisition-and-test strategy to an operating model when the challenges of fiscal 2020 surfaced. The Company’s acquisitions and combined production may allow the Company to further reduce costs solely due to higher combined production volumes.

The future

This company’s stock is likely to soar as debt reductions become visible in the market. As many have noted, current high commodity prices are allowing many companies that have been financially strained to announce that their financial woes are over. The credit market often does not entirely agree with this.

The lending banks will likely require that the line of credit be repaid with at least some of that cash flow. Management pointed out in the annual report that in the current environment there is a fair chance of a reduction in the credit line. Many lenders that should never have entered this industry were badly burned in both 2015 and 2019-2020. Those lenders are gone. What’s left are the lenders, who know the industry cycle and therefore calculate collateral based on far more conservative selling price assumptions.

It appears that Surge Energy will have the cash flow to meet such demand if the company either has to repay the line of credit in full or significantly reduce debt. However, the fact that management mentioned this (debt reduction) in the annual report poses a risk that some competitors do not have. I think that risk will subside (if it hasn’t already) as lenders realize that high commodity prices are going to be with us for a while.

The last two rallies were quickly aborted as too many inexperienced lenders and investors poured money into the industry. For now, the forward curve and past losses seem to be keeping that money out of the industry.

I like the chances that this management manages to improve the balance sheet. But until these efforts are well underway in the eyes of the market, this is a very risky investment. Debt ratios have improved significantly. What is needed now is a change in attitude in the debt market. That will probably take some time. The debt market has a long memory of the financial crisis, even if the crisis was an event like 2020 that is unlikely to be repeated.

Light oil production is a big plus. That and the low cost give this company a huge advantage over many others that have to pay down debt. But this topic is really not for the average investor right now.