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Talisman Energy (NYSE:TLM) is primarily an oil/gas exploration and production company with some natural gas midstream operations in Canada. Their operations can be neatly segmented into 3 sections: North America (primarily Canadian natural gas), North Sea (mostly oil) and Southeast Asia (mostly oil with some nat. gas). They also have non-operating interests in African energy plays. Their liquids-to-gas ratio is 46:54.

Intrinsic Value: $22 - $24 per share

Accumulation Range: $17 or better

Valuation

Like many growing resource companies, TLM's capital expenditure is uneven, swinging from heavy outlays one year to big free cash flow [FCF] another year. Evening it out over the last 7 years, I get an average annual FCF of ~ CA$700M (US$660 @ $0.92 FX rate). Assuming 7.5% growth for the 1st 5 years, 0% thereafter, discounted at the risk-free T-bill rate, DCF comes out to ~$12 per share. I'm using the DCF to get a gauge of the company's operating history. At some point, the company has to be able to convert its assets into cash for the owners. While this value is under the current share price, Talisman has only existed for 11 years or so and is still in its growth phase. It would be misleading to evaluate Talisman at the same cash flow standards we might use for a Chevron. The DCF does show the company's ability to generate free cash to shareholders and bolsters confidence in this possible investment.

Using Joel Greenblatt's versions of earnings yield [EY] and return on invested capital [ROIC], we get an EY of 15%. Inverting the EY gives us a modified PE (EV to EBIT) of 6.7 which looks good to me. The traditional PE is around 9. ROIC is a healthy 17%. I included the non-cash depreciation and amortization charges as part of tangible capital which lowers the return. Greenblatt assumes D&A roughly equals maintenance capex, which is not the case for Talisman due to their growth trajectory. Anyway, the 17% ROIC beats any reasonable estimate of WACC so Talisman has a record of creating value for shareholders.

Using the same method I used to value Devon Energy (NYSE:DVN) (valuing proven reserves in a price range of $50-$70 oil, $5 - $7 natural gas, $15 - $30 NGLs, 7.5% WACC), I get a range of $21.70 - $25 pre-tax. In Talisman's case, the growth prospects are a big part of the story and I'm comfortable calling it a wash between the tax rate and their prospect pipeline. I've tightened the range to $22-$24 to take into account the issues I have with their affinity for operational setbacks.

I consider this a pretty conservative estimate as this is proven reserves only - probable reserves are not included nor the midstream operations. For some perspective, the company had 1.67 BBOE in proven reserves at YE 2006. The company boasts 2.7 BBOE in proved+probable reserves, 1 BBOE of possible reserves, 4.5 BBOE of contingent resources in North America and 2.2 BBOE of risked prospective resources elsewhere. Of course, there's no guarantee the company will be able to realize the value of these assets at an attractive return but it gives some indication of future potential.

The Skinny

Finding exciting investments in the oil space is getting more frustrating. As a result of the supply/demand dynamics that I've detailed elsewhere, all companies are facing major challenges industry-wide, increasing the risk that these companies won't be able to maintain/increase margins and create shareholder value. Almost all of the growth visibility is mired in nasty oil sands, politically hostile territories, deep beneath the ocean or in the hands of national oil companies who put politics ahead of profits. Throw in an escalating cost environment and the outlook for oil companies is highly uncertain, even as the outlook for the commodity couldn't be stronger.

In this context, I can't say that Talisman Energy is my 1st or even my 4th choice for an oil investment. I'd prefer a company that did a better job of hitting numbers (3 downside misses on earnings in the last 4 quarters) and not so prone to operational delays and setbacks. Over the last few quarters, they've announced delays in gas sales to West Java, consistent misses on operating costs, late production on the Tweedsmuir field and lowered guidance on cash flow as well as overall production.

But even my 1st choice faces major challenges and it looks like Talisman is available on the cheap. As far as I can tell, analysts don't like the geographic dispersion of their assets and there's been talk of splitting the company into 3 parts based on geography so the market can understand it better.

On the plus side, they have some high-potential oil prospects in Vietnam and Alaska. Management also believes their North Sea assets have more resources than the market is giving them credit for. CEO Buckee has always questioned the viability of the oil sands, partly because of the tremendous water and energy requirements. We are already seeing natural gas exports decrease from Canada as they utilize more of it to exploit the oil sands so Talisman should be in a good position to benefit from their deep gas plays up in the Outer Foothills.

The company has a good track record of growing reserves and their conservative approach may keep this trend going forward. I'm not sure if incoming CEO John Manzoni will maintain the company's current strategy or shake things up a bit. We'll soon find out as he comes onboard Sept 1.

Looking at their capital structure, the company is in the process of divesting non-core assets. They're in the midst of a share buyback program and plan on using sales proceeds to pay down some of the credit facility debt and for buybacks. Buckee denied any interest in levering up to increase dividends or share buybacks, which I think is a positive. The company pays a small dividend (1% yield on 8% payout ratio) but has increased it near 20% annually over the last few years.

Despite my misgivings, I can't deny the fact that Talisman has delivered solid results over its history, dating back even before the big run-up in oil prices. The ROIC, margins and cash flow are strong. The balance sheet looks okay. They have ample interest coverage and enough cash flow to fund their growth. At the right price, our investment should do fine over the long-term.

The biggest risk to our investment would probably be operating cost inflation. One of their main growth drivers in the North Sea, the Auk field, is a high-cost play. They are also having a difficult time procuring equipment, rigs, etc in Southeast Asia & the North Sea as offshore oilfield services are in high demand. And the company has backed off some of their assets in Canada due to high costs over the last 2 years. As the industry en masse moves toward more challenging plays, it remains to be seen if companies can exploit these resources and generate returns that keep pace with the rise in the commodity price or if cost inflation will outstrip price realizations. If it's the latter, our investment will suffer.

Finally, I worry about their Vietnam assets. The government is playing nice right now as they need foreign investment capital. As the economy develops, I would not be surprised if the government seeks to renegotiate terms under false pretenses, similar to what is happening in Kazakhstan with the Eni-operated field.

Certainty Rating: B

This certainty rating is as much a rating on the company's operational abilities as it is on the confidence of my assessment. B- isn't bad; it's like scoring an 80 on an exam. Not something I'd personally be thrilled about but enough to get by.

Bottom line is we're getting a good price and if the energy situation plays out like I see it (and at this point, there is ZERO visibility to suggest anything but a tighter energy market moving forward) AND Talisman is able to keep their costs and setbacks from spiraling out of control, we'll be fine.

Disclosure: The author has open Jan '08 $17.5 put options on TLM.

Source: The Long Case for Talisman Energy