Talos Energy: Improved Cash Flow and Strategic Investments Point to Potential (NYSE:TALO)

investment thesis

Talos Energy (NYSE:TALO) is an emerging oil producer in the Gulf of Mexico that trades at a significant discount to its net asset value (or NAV). I was excited about it stock in 2022-2023 but his performance was disappointing:

I believe this was largely driven by the negative short-term consequences of management’s long-term growth strategy. Talos management has always been clear that they are looking for growth and scale, especially when the acquired assets offered development synergies (eg links to existing offshore infrastructure). In this sense, TALO’s acquisitions over the past two years can be seen as the successful implementation of the stated strategy.

Unfortunately, most of the acquisitions were equity deals, and the acquired targets were private equity-backed operators looking for exit liquidity. In the short term, these transactions created many structural sellers in an otherwise not very liquid stock and that naturally weighed on the stock price.

What has changed recently?

With each deal, Talos grew larger, which brings two benefits. First, as the number of shares increased, so did the liquidity. Second, future acquisitions should represent a smaller portion of enterprise value. This means they can be financed with less equity or even entirely through cash and debt.

A key development was that Talos was able to attract Mexican tycoon Carlos Slim as a strategic investor. Initially, TALO partially monetized its interest in the Zama field offshore Mexico by selling a stake to an entity affiliated with Slim. However, Slim’s family office directly added shares and now owns about 20% of Talos. So far, Slim seems to buy more when the stock is oversold and should be a stabilizing factor.

Perhaps most importantly, Talos Energy’s management finally seems a little frustrated with the stock price and is signaling that it is ready to take steps to bring it higher. TALO now has positive free cash flow (or FCF) and the company has already started buybacks, so management isn’t just engaging in “cheap talk.”

The reality for energy investors was that mainstream capital showed little appreciation for oil stocks simply because their multiples are low. However, companies that actually started aggressive buybacks did quite well. Talos seems to be learning that lesson and the string of stock deals was perhaps just the evil it needed to reach critical mass.

If asset value mattered, the TALO would be $18

Based on NAV, TALO should be worth close to $18, which is 50% more than the current $12:

This can also be seen as a conservative calculation, as it assigns value only to so-called “proved reserves”. Oil companies usually get credit for their 2P or “probable” reserves as well, and taking these into account would imply an even higher fair value for TALO.

Wall Street analysts have a price target in the same range:

Crucially, the valuation thesis is not about the price of oil. The PV-10 asset value measure assumes an oil price of $78, which is near the middle of WTI’s (CL1:COM) trading range over the past two years. So the argument is not that if oil prices go up, TALO will go up. If they do, that is indeed a very likely outcome, but that is not the point. Rather, if oil remains in its current range, TALO should rise as it generates FCF that is converted into buybacks.

Greater liquidity and fewer structural sellers

If you look at Talos Energy’s share count over time, you can easily spot the bigger buys:

Private equity funds that sold assets to Talos then sold their shares, creating sustained selling pressure. TALO itself was also backed by PE before going public and took some time to get through this residual ownership. However, EP interest in TALO is now at an all-time low:

Meanwhile, daily trading volumes have more than doubled as Carlos Slim continues to build his position with his most recent purchases in August, when the share price fell to $10:

As of November 2023, Carlos Slim had 13 million shares, which have now increased to 40 million. Mr Slim seems happy to provide exit liquidity to PE sellers in their teens and I don’t think his long term plan is to lose money.

Management is unhappy with the stock price

Management openly commented on the stock price on the Q2 earnings call:

We recognize that some people might think the discount rate here or the capital cost a little higher than the PV-10s, and that’s fine. But I think the main thrust of that comment was that there is so much value above and beyond PV-10 above and beyond proven reserves that even if you assume a higher discount rate, there are so many other ways you can reaches a much higher rate. a higher share price or a higher market cap than we currently have, that people should feel comfortable even with a higher discount rate, that the stock is actually quite undervalued compared to the fundamental value of our businessright, even at a slightly higher discount rate.

Management also seems to understand that the only proven method of getting the job done is through buyouts:

Now with this free cash flow, we were also able to continue paying down our debt. We paid down $100 million in debt and then opportunistically used a portion of the previous repurchase authorization to buy 3.8 million shares in the open market. And we increased that authorization by another $150 million that we talked about in the earnings release.

Q2 saw a fairly substantial $40 million buyback that retired 3.8 million shares:

FCF bowed

Management not only wants to see the stock price higher, but has the tools to do so. The company now sets aside $400 million in FCF for 2024:

That’s a 20% return on market capitalization and just over 10% of enterprise value. Analyst estimates for 2025 are even higher.

Additional considerations

It’s worth noting that TALO also sold its carbon capture business to TotalEnergies ( TTE ) for $148 million and used the proceeds to repay debt. I think it was a good decision. Despite generous government carbon sequestration credits, the business is capital intensive and better placed in the hands of a major than an independent.

TALO also got the most out of Zama. As a reminder, the company was forced by the Mexican government to merge its prolific discovery with the adjacent Pemex block and cede the operator role on the combined block to Pemex. Talos sold half of its Mexican interest to Carlos Slim, and having a strong local partner will likely help mitigate any future problems with Pemex. In addition, as mentioned, Mr. Slim had a long-term interest in TALO beyond the Mexican asset.

Take away

Talos Energy shareholders have had a rough ride over the past two years, but the company has had to do whatever it takes to gain scale. Now, with FCF also tipping Mr. Slim’s support, it looks like the moon and stars may finally be aligning.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.