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Collins: Drill Down on This Small-Cap Driller

This week, I had the opportunity to sit down with Tom Lapinski, the CEO of Torchlight Energy (TRCH). Torchlight's stock is one the components of the Mad Money portfolio of my firm, Portfolio Guru. It's an exciting story, with tons of growth potential.

Torchlight has four plays:

  • Central Oklahoma in the Hunton limestone formation
  • South Texas in the Austin Chalk and Buda formations, which are geologically adjacent to the Eagle Ford shale
  • Southwest Kansas in a joint venture with Ring Energy, which will be drilling shallow, vertical wells in an area that was exploited in the mid-20th century
  • Central Kansas, in association with the same partner, Husky Ventures, as in Oklahoma

One of the phrases that Lapinski and other Torchlight managers use is "drilling out of inventory." Torchlight is in plays that are relatively riskless, especially the ones in Kansas. The Torchlight guys like to talk about "hitting singles," and that is the key to the story: shallow, cheap wells that require very little expenditure and are quite repeatable. So that's the juice in the Torchlight story, a small company ($89 million market cap) that gives exposure to big plays and big-time partners.

When I talk about Torchlight with my clients, the conversation always turns to Gastar Exploration (GST - Get Report), which was the hottest stock at Portfolio Guru in 2013. Gastar stock rose 500% last year on the strength of early results from its Oklahoma joint venture with Husky, which is attacking the same Hunton formation that Torchlight is. Gastar's Preferred Series A and B shares will always be favorites for my Portfolio Guru model portfolio and my clients' income portfolios. But when it came time to decide on my 10 Mad Money names, especially given the high energy weighting, I had to choose Torchlight over Gastar as a common-stock play.

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I believe Torchlight's "risk-lite" strategy is more attractive now than Gastar's "go-it-alone" strategy. Last year, Gastar chose to go outside its Area of Mutual Interest with Husky and drill its own Hunton wells in Oklahoma. As Gastar's conference call Friday delineated, early results have been well below expectations, both in terms of production (barrels of oil equivalent per day, or boepd, of 100 to 300) and cost. Drilling and completion issues caused overruns and drove well costs to the $8 million range, a level at which payback times are greatly lengthened, especially given such tepid flow rates.

So, what is Torchlight worth?

Management doesn't offer official guidance on production volume, but on the basis of its aggressive drilling schedule, I believe Torchlight can pass the 2,000 barrels of oil equivalent per day (boepd) level by the end of 2014. So, as I did with Arabella Exploration in my column last week, I'll use the valuation afforded Miller Energy (MILL) when the market began to price in a 2,000 boepd rate for Miller.

That gave us a benchmark of an enterprise value of $226 million for a company that the market perceives can produce in the neighborhood of 2,000 boepd. Applying that comparable-company valuation to Torchlight and subtracting the company's $4 million of net debt, gives an implied equity value for Torchlight of $222 million, well in excess of the current market cap of about $90 million.

But drilling isn't free, and dilution can be an issue at companies that have raised private capital, as Torchlight has done repeatedly and as recently as February. So I'll assume that Torchlight adds about $30 million in debt to cover its drilling program for the rest of 2014. Subtract that $30 million to get to an implied equity value of $196 million, and the denominator is just as important as the numerator. Torchlight has only 17.73 million shares outstanding currently, but it does have 9.19 million warrants outstanding. So this gives a denominator of just under 27 million shares.

Then there's an estimated net cash benefit from the warrant conversion of $27 million, which we add to the $196 million to get a diluted equity value of $223 million. That, over the diluted share count of 27 million, gives a Portfolio Guru a fair value for Torchlight of $8.25 per share.

So, Torchlight is undervalued at its current price of just over $5 per share. It's a thinly traded stock that has little sell-side coverage or institutional ownership, but I have seen this movie before, and it has a happy ending. As Torchlight begins to report results from its newer plays, the market will take notice. That's when volume increases, sponsorship begins and Torchlight hits the radar screens of small-cap money managers who are looking for growth and value in the same company.

Editor's Note: This article was originally published at 9:30 a.m. EDT on Real Money on March 20.

At the time of publication, Jim Collins' firm owned TRCH and GST-A and GST-B. Please note that due to factors including low market capitalization and/or insufficient public float, we consider TRCH and GSTR to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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