Here’s a great article on Devon You have to take ownership of what you all do Oct. 09, 2023 Ronald Ferrie Devon Energy's stock has fallen nearly 19% in the past month, creating a price to value dislocation. The price decline is illogical compared to other producers and despite high crude prices. Devon Energy's high level of public versus institutional ownership makes its share price more susceptible to volatility. Devon Energy's stock price is currently undervalued and represents an attractive entry point. big bear (Ursus arctos) Tadoma/iStock via Getty Images Thesis Devon Energy (NYSE:DVN) has flat out taken a beating over the last 30 days, falling nearly 19% since the beginning of September. This has occurred while other companies in its peer group have been able to tread water, with share prices dropping less than 5% over that same span. I last covered DVN in July to identify a trading pattern that developed for sudden price drops following earnings. I correctly predicted the dividend payout and response following earnings in Q2. In this article, I use the same methodology to show that DVN's recent price performance makes it undervalued today. I propose an explanation for investors looking to understand this price performance as well as a target price to accumulate shares. The current price creates a valuable value to price dislocation for DVN that can be extremely valuable both in the near and long term. The Bears Are Running Wild I will be blunt. The current price decline for DVN is simply not rooted in logic in any sense of the word. Other producers who sell the exact same product do not show the same dismal share performance. For comparison, there is a 25% difference in price performance between DVN and FANG over the last three months (I did not count PXD due to the 10% spike in share price prior to this article being published). The last time I checked, both of these companies sell oil, NGLs, and natural gas into essentially the same market. What can possibly explain this Simply put, WE are the cause of this. DVN has an extremely high exposure to individual investors versus institutional investors compared to its peer group. As a result, its investor base has shown to be more erratic to market events than typical. This is in part created by its share price relative to its peers and the lack of a major shareholder like Warren Buffett in the case of OXY. DVN has 1.5x to 3x the amount of public ownership exposure compared to Occidental, Pioneer, or Diamondback Energy. I believe the recent price performance is the culmination of individual investors finally having enough after several quarters of falling dividends. While in my opinion this should not have been expected, the market as a whole never tends to respond rationally. To prove this thesis, the impact of this can again be seen in the volatility of Devon's share price. DVN exhibits a significantly higher beta than either of the other three companies. Most investors would call this a negative, but I view this as one of my fundamental differentiators for why I invest in DVN and not either of the other three stocks. Having a higher beta ensures two things. Higher highs and lower lows. This presents investors with the opportunity to invest at more attractive entry points, and also the opportunity to trim their profits when they potentially become overvalued. You may need a strong stomach at times, but this can be counteracted by having a clear vision of what price DVN represents for a solid value purchase. Thanks to a fairly simple business model and highly public commodity prices, this can be derived from some basic math. The Numbers Hold The Truth According to the EIA, the average WTI price in Q3 was $82.30/barrel. This is up from $73.76/barrel in Q2, a very sizeable increase. Yet, DVN is now at the lowest price so far in 2023, even exceeding the low set in March during the brief banking 'crisis' that developed after the run on Silicon Valley Bank. Further, DVN has guided both an increase in production and a drop in capital expenses for the quarter and the remainder of the year. DVN has guided for capex to run about $890 million at the midpoint. This is down from $1.036 billion in Q2. Production is guided to rise to 326,000 barrels of oil production per day, up from 323,000 barrels per day in Q2. Running these variables through my model and the slight increase in average natural gas price in Q3 of $2.59/MCF generates net earnings of about $1.07 billion. This is up 53% from Q2 when DVN only registered net earnings of $698 million. This number was calculated using midpoint projections provided by DVN for production, price realizations, taxes and expenses. If the base dividend remains unchanged ($0.20/share), I expect the total dividend for Q3 to register between $0.65 and $0.75 per share. This is a sizeable increase from the $0.49/share that was paid out in Q2. I expect the headlines of a 40% increase in the dividend will help push the share price higher towards a more reasonable valuation in line with its peers. At its current price, an annualized quarterly dividend of $0.70/share results in a 6.4% yield. More importantly, this level of income also leaves around $300 million that stays internal to DVN as its 50% portion of FCF. This will go toward rebuilding the cash reserves and being opportunistic with share repurchases. Right now, repurchasing shares looks to be a tremendous opportunity. The P/E ratio of DVN shows that it is leading the pack in terms of value. DVN has the lowest P/E of the four companies by a wide margin. Repurchasing shares at this level looks to be an excellent use of the company's dollars, even if it does delay the cash reserve rebuild The market is very quick to both forget and react. The good news is that this is all following the plan laid out by Devon's management during the last quarter's earnings call. The CFO (Jeff Ritenour) very clearly laid out exactly what has happened so far to date. Going forward, where we are from a cash balance and a framework standpoint, as we generate excess free cash flow here in the back half of the year given the lower capital spend we expect, and the higher oil prices that we are projecting in the back half of this year, we should generate significant free cash flow, we are going to look to build our cash balance back. And then with the remainder of the cash, we are going to focus on, obviously, the variable and the stock buybacks on an opportunistic basis. Investors should not be worried about the current price dip. This represents a unique opportunity in two ways. First, it represents an opportunity for the individual investor to start or grow their position in DVN at an attractive price. Second, management has the opportunity to increase every shareholder's ownership stake by retiring more shares. Every shareholder will be getting a bigger slice of the pie thanks to the mispricing. Price Target We all need to remember that energy is a cyclical industry. As such, to determine relative value, we must have a rough gauge for what the average of that cycle is. It is very apparent that OPEC+ desires to maintain a price floor of $80/barrel. To build in some protection, I will assume that the cycle average is $78/barrel. Under the same capital spend model, this hypothetical average price yields a dividend of approximately $0.60/share. A highly cyclical stock also needs to be highly rewarding to make tolerating the volatility worthwhile as an investment. My personal metric is to achieve no less than a 5% dividend at average market conditions. I can work backward from my payout projection of $0.60/share to derive a conservative mid-cycle price of $48/share. This shows that DVN is being valued at a price that is 10% undervalued compared to a fair mid-cycle price. Risks With all the negative sentiment, there is a tangible risk of breaking through support levels for the stock. Fellow SA Analyst, JR Research, recently posted a bearish thesis that identifies that DVN is currently sitting near its lower support level of $44/share. Should the stock break through this level of support, there could be a near term shock to the share price. I have laid out my bullish case for Devon over a long term horizon. I acknowledge that, as pointed out by JR Research, the irrationality of the stock market may overpower logic here in the near term. It is something investors should at least be cognizant of, both from a risk perspective and also for another potential buying opportunity. Summary Being the lowest share price of your peer group can be a two-edged sword. It can help a company obtain slightly higher multiples, but can also leave its share price susceptible to impatience and irrationality. I believe the investor behavior being displayed over the last three months is certainly the latter of the two scenarios. Devon Energy has been oversold as a result of a high percentage of individual investor ownership and being the lowest share price in the independent producer peer group. This allows the stock to be extremely volatile and has created a buying opportunity. I view the stock as at least 10% undervalued compared to mid-cycle oil prices. Using known commodity prices in Q3, I have shown how the company is projected to produce solid earnings and even increase its variable dividend by approximately 40% versus the prior quarter. As a result, I rate DVN as a buy under $48/share. Time to start hunting the bears.
Posted by Suze at 2023-10-11 22:44:05 UTC