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Is Talisman Energy Inc. a Good Opportunity or a Value Trap?

Talisman Energy Inc. (TSX: TLM)(NYSE: TLM) fell over 5% on significantly higher than normal volume, as an article in the Wall Street Journal said that Talisman’s talks with Spanish Energy company, Repsol, have stalled. In fact, the stock has declined over 6% year-to-date, compared to the S&P/TSX Energy Index, which has seen an over 18% rise since the beginning of the year. Is this a good opportunity or a value trap?

Similar to EnCana Corp. (TSX: ECA)(NYSE: ECA), which last year unveiled a new strategy of more focused capital spending and a renewed focus on capital efficiencies and lowering its cost structure, Talisman is also in the process of changing its strategy to one that involves a greater focus of capital spending, focusing on North America and Asia Pacific.

Strong performance from core areas

While overall production increased 4% year over year, digging deeper uncovers numbers that investors can really get excited about. Production from ongoing operations within Talisman’s core regions increased 12% year over year and 4% sequentially. North American production, which represents 47% of production, increased 19% year-over-year and 7% sequentially.

In another move similar to EnCana, Talisman is focusing its North American production on liquids rich production, as this will produce near-term value and cash flow for the company. As such, growth in liquids from the Americas and Asia Pacific was strong. Production came in at 115,000 boe/d, which is an increase of 20% year over year and 5% versus last quarter. And this is significant, as 80% of total liquids production comes from core areas.

And isolating the North American liquids business, we see an even stronger growth profile. North American liquids production came in at 45,000boe/d last quarter, which is a 36% year-over-year increase and a 7% increase versus last quarter. So digging even deeper into the production numbers, we see another very positive trend.

Cash flow generation improving

Cash flow in the second quarter increased 8% to $567 million despite dispositions, and free cash flow was approximately $60 million. After much time spent in a state of negative free cash flow and a deteriorating balance sheet, this is a promising trend.

Related to the improving cash flow generation, the balance sheet is improving as well. The company currently has $450 million in cash and cash equivalents sitting on the balance sheet, with only $3 million drawn on its credit facility, so there is flexibility should it be needed.

Good exposure to natural gas

Natural gas represents over 60% of total production, and with the strong growth rates that the company is seeing in its natural gas production, this will continue to rise. I view this exposure as positive for the company, as I believe that natural gas prices will strengthen into next year.

Asset dispositions

Asset dispositions have been slower than expected, but the CEO has stated that they will not give assets away on the cheap, so they will remain patient. Lately there has been more interest in the Duvernay joint venture, and discussions are promising. The sale of assets in Kurdistan is delayed due to hostilities in Iraq.

Creating shareholder value

Lastly, investors should keep in mind that the involvement of billionaire shareholder activist Carl Icahn is a positive for the stock. He is well known for taking a large enough position in troubled companies to secure a seat on the board and then swooping down on management in order to engineer big turnaround stories. At least it tells us that Mr. Icahn believes Talisman is undervalued. And judging by his track record, this is a vote of confidence that is welcomed.

Challenges

Of course, the problems at Talisman are well documented. The biggest one is the North Sea. The company has recorded an $826 million asset and goodwill impairment charge related to the North Sea operations. These assets are riddled with operational problems. It is a mature basin with escalating costs and it will be difficult for Talisman to resolve this situation, as the company has a commitment for future spending there based on its joint venture agreement with Sinopec, and there don’t appear to be buyers for these assets. But on a more positive note, 90% of production is from its two core areas, North America and Asia Pacific.

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Fool contributor Karen Thomas owns shares of Talisman and EnCana.

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