2024-01-05 23:51:08 ET
Summary
- Devon Energy's shares have soared due to favorable energy prices in recent years.
- The company has significant assets in top U.S. shale basins and has benefited from higher average prices for its products.
- Devon Energy achieved free cash flow margins in excess of 20% in Q3'23 as well as in the past.
- Devon Energy returns cash to shareholders through stock buybacks and increased dividends, and its valuation is attractive.
Shares of independent E&P company Devon Energy ( DVN ) have soared in 2022 and 2023 due to favorable tailwinds for energy prices during this time. Devon Energy is a multi-basin independent E&P company with considerable scale and impressive free cash flow margins. The producer company also returns a ton of cash to shareholders through stock buybacks, and the energy company has significantly increased its dividend payment in the last three years as well. Shares are currently trading at 7.3X FY 2024 earnings and have an attractive risk profile, in my opinion!
Previous coverage
I recommended Devon Energy more than two years ago as a play on a reopening U.S. economy after COVID-19: I Just Bought This E&P Company For Its Huge Upside . Shares have soared 134% since, but not for the reason why I recommended them. Russia’s invasion in Ukraine and follow-up price support measures by OPEC+ members, especially Russia and Saudi Arabia, have led to a profit windfall for Devon and other independent E&P companies which has been reflected in the massive increase in the company's valuation. While shares are up big, strong free cash flow margins and high capital returns are the reasons why I still see Devon Energy as a strong buy.
Strong free cash flow and pricing picture
Devon Energy is a multi-basin independent E&P play with considerable assets in top basins in the U.S., including Delaware, Eagle Ford, Anadarko Williston and Powder River. These basins produce strong production growth and have been instrumental in driving the U.S. towards energy independence in the 2010s.
Devon Energy is mostly focused on crude oil (48% of production mix as of Q3’23), gas (27%) and NGL (25%). In the third-quarter, Devon Energy's total production totaled 665 MBOED and the energy company has guided for a fourth-quarter production volume of 650 MBOED.
Devon Energy, like so many of its rivals, benefited profoundly from higher average prices it gets to sell its products for. In the third-quarter, Devon Energy reported an average price of $82.06 a barrel compared to $73.76 a barrel in Q2’23, showing an increase of 11%. The Russia-Ukraine conflict still affects crude oil and natural gas supplies into Europe and although Russia has rerouted energy products to the east, supply fears are still present in the market. OPEC+ members recently announced voluntary production cuts to support prices in 2024 as well.
Although Devon Energy has seen a decline in its revenue and free cash flow pictures in the last year, due to a consolidation in energy markets, the company still maintains very attractive free cash flow margins.
In the third-quarter, Devon Energy generated $843M in free cash flow on $3.84B in revenues which calculates to an impressive free cash flow margin of 22%. In three of the last five quarters, Devon Energy’s free cash flow margin exceeded 20%.
Q3'22 | Q4'22 | Q1'23 | Q2'23 | Q3'23 | Growth Y/Y | |
Revenues () | $5,432 | $4,299 | $3,823 | $3,454 | $3,836 | -29% |
Operating Cash Flow () | $2,104 | $1,911 | $1,677 | $1,405 | $1,725 | -18% |
Capital Expenditures | -$628 | -$804 | -$1,012 | -$1,079 | -$882 | 40% |
Free Cash Flow () | $1,476 | $1,107 | $665 | $326 | $843 | -43% |
FCF Margin | 27% | 26% | 17% | 9% | 22% | - |
(Source: Author)
Attractive capital returns
A large percentage of this free cash flow is being returned to shareholders through stock buybacks and an increase in the dividend rate. In the third-quarter, Devon Energy returned a solid $492M in cash to shareholders, which represented approximately 58% of its free cash flow.
Since the beginning of FY 2022, Devon Energy has reduced the number of its outstanding shares by 3% and increased its dividend significantly as well: in FY 2020 Devon Energy paid a dividend of only $0.68 per-share compared to $2.87 per-share in FY 2023, showing an increase of 322%.
Valuation of Devon Energy
Devon Energy and other E&P companies like Marathon Oil ( MRO ) and EOG Resources ( EOG ) are cheap based off of earnings, with DVN being the second-cheapest after Marathon Oil.
Devon Energy is valued at 7.3X FY 2024 earnings and considering that the company still achieves free cash flow margins in excess of 20%, I believe shares are a bargain. Assuming a reasonable 9X earnings multiplier (DVN traded at a higher multiplier in FY 2022), shares of Devon Energy could have a fair value closer to $56, implying 22% upside revaluation potential. The average 1-year price-to-earnings ratio for Devon Energy was 6.4X, so shares are trading at a 14% premium to this average.
Risks with Devon Energy
As an independent E&P company that is focused on production, the biggest risk for Devon Energy obviously is a decline in average prices and therefore a cyclical correction in its free cash flow. Since Devin Energy is returning a large amount of its cash back to shareholders through stock buybacks and dividend payments, a decline in pricing would also mean lower capital returns for shareholders in an energy down-market.
Closing thoughts
Devon Energy is a well-run and profitable energy company with a broad footprint in key shale areas across the U.S. The single biggest reason to buy Devon Energy is the firm's ability to generate high free cash flow margins and return a considerable amount of cash back to shareholders through buybacks and dividends. Obviously, Devon Energy faces cyclical free cash flow and earnings risks, but since shares continue to trade at an attractive P/E ratio, I continue to believe that the risk profile remains skewed to the upside for long term investors!
For further details see:
Devon Energy: A Strong E&P Play With Attractive Capital Returns