Talos Energy: Still Trading At Significant Discount To NAV

Summary

• Talos Energy was trading at significant discount to NAV even before oil spiked above $100; the discount is much bigger now.
• The cash flow guidance is promising despite the negative impact of the hedges.
• The gradual exit of the PE funds which had taken the company public still applies some selling pressure, but this is temporary.
• Talos Energy is a strong buy even just based on its core Gulf of Mexico assets; the Zama asset in Mexico and the carbon capture business add further optionality.

Oil Rig Sunset

TroyVSmith/iStock via Getty Images

Investment thesis

Talos Energy Inc. (NYSE:TALO) is a relatively new public independent exploration and production company focused primarily on the U.S. Gulf of Mexico (or GoM). The company also has interests in offshore Mexico and is developing a future business centered on carbon capture and sequestration (or CCS) through collaborations along the GoM coast. However, for now the company only reports proved reserves for its core assets in the U.S.:

Talos Energy Form 10-K

Most of the company's reported proved reserves are developed, which takes off uncertainty about the impact of future capex on their value. Even after adjusting for the negative impact of hedges, asset retirement obligations and others, crude oil (CL1:COM) needs to be less than $60 for Talos' net asset value (or NAV) from the US GoM properties to align with the enterprise value (or EV) implied by the share price.

Oil has been much higher than $60 for a while now, and even if we see some retraction from the $100 level if the current geopolitical tensions subside, the valuation case for Talos remains very strong just based on its core U.S. properties. The cash flow guidance is also very strong despite the negative impact of the company's hedges while the interests in offshore Mexico and the future carbon capture business only add optionality.

Discount to NAV

Talos laid out its NAV for the core U.S. GoM properties at $65 oil, as well as the NAV sensitivity to changing oil prices, in a recent investor presentation:

Talos Energy investor presentation

Talos Energy investor presentation

Adjusting the PV-10 measure for asset retirement obligations, net debt (secured notes maturing in 2026 plus bank credit facility due in 2024), hedging liabilities and G&A cost, the company estimated at $65 oil its NAV is about $2.3 billion, which implies a $29 share per their calculation. Despite being up a lot so far in 2022, Talos was trading in the $17s as of the time of writing this article and oil is already above $100 as opposed to just $65.

The company also provided an update of the PV-10 sensitivity as part its 2021 Q4 earnings presentation:

Talos Energy earnings presentation

Using a simple regression which usually works well in such cases and recalculating the hedge liability (e.g., the hedging losses are much higher at $100 oil than at $65), I updated the NAV analysis at a high level. I assumed $55 average hedging price and came up with the following contingency table (dollar figures in millions):

Author's Calculations

The table speaks for itself, but it appears that Talos going up at least 2x from here is not unlikely, even if the geopolitical tensions subside and oil heads back below $100. Inferences from the PV-10 certainly have drawbacks (for example, the measure doesn't factor in future cost increases), but I think there is room to absorb significant calculation error and Talos would still be undervalued. Moreover, most of Talos' reserves are developed which takes off some uncertainty around capex.

Strong management guidance

The Q4 earnings release was also very strong in terms of operational guidance:

Q4 production totaled 68.7K boe/day (69% oil, 77% liquids); for the full-year, output was 64.4K boe/day (same proportions of oil and liquids), capital spending was $338M, and free cash flow came in at $134.5M.

Talos announced capex of $450M-$480M for 2022, weighted to Q3 and Q4, with about half of the drilling and completion program targeted to generate production beginning in 2023; production guidance was essentially flat.

Importantly, the company said it expects to generate more than $1B in free cash flow through 2025 despite the negative short-term impact of its hedges. The $1B free cash flow is almost 20% yield on the current market cap.

Optionality outside the core properties

Talos is continuing its progress with the CCS business. It has several CCS sites on the U.S. Gulf Coast which it is developing in collaboration with different partners:

Talos Energy

No major updates were announced with regard to the company's Zama asset offshore Mexico. For a quick prehistory on Zama, Talos made an offshore discovery in Mexico following which the Mexican regulator forced unitization with an adjacent PEMEX block and designated PEMEX as the operator. Since a final investment decision has not been taken and the unitization terms are subject to dispute, Talos still treats the Zama asset as an unproved property.

It is not easy to value the CCS business or even the Zama discovery based on the information in the public domain, and that is why I prefer to view these developments as potential option for Talos. In the worst case they will be worth zero, but possibly they will be worth something. In the presence of a strong valuation case based on the core properties alone, the CCS business and Zama are only potential icing on the cake.

Selling pressures

Talos has been very transparent about the gradual exit of Apollo and Riverstone, the private equity players who took the company public:

Talos Energy Investor Presentation

It makes sense for the PE funds to exit since their business model would dictate using the capital for another PE opportunity rather than holding shares in a now publicly traded company (which their investors could do directly if they so wished). Talos management also made some equity purchases in late 2021 although the share price was lower then compared to now. Overall, the float has been increasing.

Conclusion

Talos Energy is a compelling value play not just for $100 oil, but also for a $60-$70 oil world. The company's carbon capture business and its offshore interests in Mexico present further optionality which may also translate into tangible value at some point in the future.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TALO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

My articles, blog posts, and comments on this platform do not constitute investment recommendations, but rather express my personal opinions and are for informational purposes only. I am not a registered investment advisor and none of my writings should be considered as investment advice. While I do my best to ensure I present correct factual information, I cannot guarantee that my articles or posts are error-free. You should perform your own due diligence before acting upon any information contained therein.