Devon Energy: Love Is In The Air (NYSE:DVN)

Thesis

Devon Energy’s (NYSE:DVN) stock has been beaten down this year as earnings have declined. We believe that the selloff is overdone. The company is trading at an attractive valuation and is set for positive earnings momentum going in H2 thanks to higher prices for oil and gas. M&A activity in the sector could end up being a rising tide that lifts all boats. We believe Devon is a buy at these levels.

The Basics

For those unfamiliar with the company, Devon Energy is an independent oil and natural gas exploration and production company whose operations are focused onshore in the United States. Devon’s operations are located in five geographic areas: the Delaware Basin, Eagle Ford, Anadarko Basin, Powder River Basin and Williston Basin.

Assets located in the Delaware Basin are Devon’s most valuable assets, and as we will discuss later is a reason they may become an acquisition target. Many oil and gas companies have infrastructure in the area and purchasing Devon could be a way for them to activate synergies and cost efficiencies while bolstering their position against peers.

A Rough 2023

This year Devon has been punished by the market and their stock is down much more than similar firms. A potential reason the market may be discounting Devon is due to doubts about the quality of their assets and outlook for growth, and fears about where we are in the cycle. The market may view competitors as being in a stronger position than Devon, but we believe even if that is the case the current discount is too wide.

In their most recent quarter Devon earned $690 million down from $1.932 billion in the year ago period. This comparison is a little misleading as commodity prices spiked hard in the year ago period and were at relative lows during Q2 2023. This pattern of lower earnings is common among all oil and gas exposed companies. Thanks to higher commodity prices, the outlook for Devon’s operating profitability is looking much better for the second half of this year than it did in the first. Analyst estimates are calling for $5.80 in earnings over the next twelve months. We will be referencing this $5.80 earnings estimate when talking about forward PE for valuation purposes.

The decline in Devon’s earnings does not warrant such poor year to date performance and the stock should be tracking their peers more closely.

Devon’s valuation has continued to get more attractive relative to peers and now trades at an attractive forward PE of 8.47. Most notable is their discount to Pioneer (PXD) as Pioneer is set to be acquired by Exxon (XOM). This sets the standard for what sector valuation multiples should trend towards, and it is likely that Devon’s valuation trends higher to narrow that gap. Their valuation discount could make Devon an acquisition target. In the event of an acquisition it seems reasonable to assume that this discount would narrow considerably.

The M&A Party

Exxon buying Pioneer could open the door to more M&A in the oil and gas sector. Chevron (CVX) has been looking to get active in M&A and apparently has passed on acquiring Occidental (OXY). These two events are a sign that activity is set to heat up in the sector and company managements are looking to make moves from a position of strength. Now that Exxon has officially made their move, it puts pressure on other supermajors and midsized firms to strengthen their asset base or risk getting outcompeted. These competitive forces are even stronger in commodity markets than other areas of the economy, and as a result deal activity can spread like wildfire.

Devon’s assets are complementary to many US oil and natural gas operators as there is a bit of infrastructure overlap in the industry. Due to their discount to peers and attractive Delaware Basin assets, Devon is no doubt looking like an attractive acquisition target. This could help to put somewhat of a floor on the stock, and could stoke investor appetite for the sector. For Devon investors, the main benefit of M&A activity heating up is that it adds optionality to what is already an attractive investment. In this way M&A can be a rising tide that lifts all boats.

Our bullish thesis on Devon isn’t reliant on M&A, and the possibility of M&A is merely a bonus. We believe that Devon represents an attractive buying opportunity for a few reasons. The company is fundamentally undervalued relative to their peers. The outlook for oil and gas is improving into the end of the year. M&A activity in the sector could favor Devon due to the nature of their assets and discounted valuation. At worst this could put a floor on the stock, and at best they get bought out at a premium to where the stock currently trades. Lastly, investing into Devon provides exposure to US-based oil and gas production, which can serve as a hedge against both geopolitical risks and inflation risks, helping to further diversify a portfolio.

Valuation and Price Action

As we covered earlier, the price action for Devon has been lackluster this year. We believe that the price action will improve going into year-end as commodity prices firm up and M&A speculation builds.

Devon is trading at an attractive forward PE of 8.43. As we all know, this forward PE is a bit misleading due to the nature of the industry. Their actual earnings over the next 12 months could be much lower if commodity prices decline again, but they could also be much higher. The important thing investors should ask themselves is this: Does an investment in Devon help to diversify my portfolio and/or meet my investment objectives? The variable component of the dividend means that Devon may not be the best choice for income investors. On the other hand, Devon provides more leverage to oil and gas prices than some other investments in the sector, and is a great way to act on a bullish thesis regarding oil and gas. We believe that Devon is a fundamentally attractive investment at these prices and can be a way for even the most tech focused investors to hedge their portfolio against geopolitical and inflation risks.

We believe that Devon should trade at a forward PE of 10.8, which is 90% of Pioneer’s forward PE of 12. This is based on our opinion that Pioneer has slightly better assets.

Devon’s free cash flow leaves a bit to be desired, but the company is planning to cut back on capital expenditures in the second half of the year. Due to the cyclical nature of the industry capital expenditures can be somewhat lumpy. We aren’t too concerned about the relatively elevated price to free cash flow ratio.

Looking at Devon’s balance sheet we can see the company has done well to limit their debt levels. While we would prefer for the company to de-leverage further their long term debt is only about 1 year’s worth of normalized profits, which is more than manageable. Considering the capital intensive nature of their business this is a reasonably conservative level of financial leverage.

Devon is fundamentally undervalued, has earnings momentum going into H2 2023, and a clean balance sheet. There are multiple catalysts on the horizon that could help to bridge the gap between price and value, including possible M&A. We believe that bullish investors can feel good about accumulating shares at these levels.

Risks

A risk to the bullish thesis is the potential for oil and gas prices to decline to 2020 levels and remain at those prices for an extended period of time. This would financially challenge the entire sector and damage the fundamental thesis for Devon. That being said, we have a long-term outlook on oil and gas that calls for stable or increasing prices as global economic activity increases and debt begins to be monetized by governments around the world. Even in a worst-case scenario we think Devon would be fine over the long-term as their cost base can support much lower pricing, but in such a scenario the variable dividend would be much lower.

We view the risk/reward as being attractive. Investors should understand that there are always risks to investing in commodity sectors. Investments into commodity sectors are not suitable for all investors due to the inherent volatility.

Key Takeaway

Devon is fundamentally undervalued and the stock could end up getting a boost into year end from improving earnings and M&A speculation. We believe that current prices represent an attractive buying opportunity for investors who are bullish on oil and gas. Devon can be a long-term buy and hold regardless of what ultimately happens regarding M&A.