Devon Energy stock: 9% yield, but there could be more on the table (NYSE: DVN)

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Investment thesis

Devon Energy (NYSE: DVN) is an onshore oil and gas company. Based on Devon’s sensitivity estimates, the stock price is less than 7 times free cash flow. Meanwhile, Devon has a capital return program of around 8.9% return via dividends and share buybacks.

While I would argue that Devon Energy is a compelling investment opportunity, I would like to see Devon be slightly less aggressive in paying down its debt and more aggressive in returning capital to shareholders.

Additionally, I argue that energy companies with very clear shareholder return programs are the stocks the market rewards the most.

All in all, while I’m bullish on the name, I’m hopeful that management can improve its capital allocation policy.

Why Devon Energy? Why now?

At first glance, the bullish case for Devon Energy is simple. With oil prices slightly above $115 WTI, Devon Energy will generate strong free cash flow in 2022.

Devon Energy Free Cash Flow

Devon Energy Investor Presentation, May

For its part, Devon Energy has what it claims is an attractive capital return program.

Devon Energy has a fixed and variable dividend of $1.27, which annualizes at 6.7%. It also has about $1.1 billion left on its $2 billion share buyback program. In total, this return on capital amounts to approximately 8.9% return at current prices.

And that leads me to discuss Devon’s capital allocation priorities.

Devon Energy Free Cash Flow Priorities

Devon Energy Investor Presentation

Devon Energy has signaled its ambition to buy back large amounts of debt. On the earnings call, management said:

The next step in our debt reduction plan is to fully withdraw the $390 million of 2027 notes that will become redeemable in October of this year. We will have the option to repay another $600 million in debt in 2023 with a call of our 2028 notes in June followed by the maturity of another note in August.

And that hardly makes sense. Why redeem 2027 Notes with a 7.5% coupon when your stock has a free cash yield of at least 16%? In fact, the vast majority of 2027 notes have a coupon of 5.85%, which makes the redemption benefit of these notes even less attractive.

Devon Energy Short Term Debt Maturities

Devon Energy Investor Presentation

To be so aggressive in repaying the debt when we are so optimistic about the oil environment seems a little too cautious.

Devon Energy has achieved its financial leverage target

Devon Energy Investor Presentation, May

Additionally, in the first quarter of 2022, Devon’s net debt to EBITDA was already 0.6x. I personally believe that Devon does not need to be so aggressive in repaying its debt. As a result, Devon Energy could define a clearer capital allocation policy.

A clear capital allocation policy?

I’ve followed enough oil and gas companies to know that investors reward the most companies that have a very clear capital allocation strategy.

Companies that return capital without clear return on capital mandates are not rewarded as significantly.

To illustrate my point, consider the following table:

Price of Devon Energy vs. Marathon Oil vs. Suncor Energy
Data by YCharts

Marathon Oil (MRO) has an unambiguous capital allocation policy.

Marathon Oil Capital Allocation

Introducing Marathon Oil

I talked about Marathon Oil here. At least 40% of cash flow to be returned to shareholders. You can look at the price of WTI and make estimates as to your return on capital. Simple.

And you can push back and say Marathon Oil is a higher beta stock, so it will do better in a bullish period. But I can assure you that is not the case.

Even outside of oil and gas, for other energies and commodities, companies with a clear mandate are better rewarded.

Here is another example, in the oil and gas sector, Suncor Energy (SU). In fact, in Suncor’s case, the company had such a poor capital allocation strategy that investors were completely ignoring its full potential.

This led Elliott, the shareholder activists, to take a stand for this purpose. Clarify and improve the capital allocation strategy.

Yet all of these oil and gas companies have things in common. Most analysts who follow this sector expect oil prices to come back down in the second half of 2022. And things will come off a cliff in 2023.

And while I don’t claim to have the power to see into the future, what I do know is that people honestly believed a little over a month ago that the oil supply shock that has brought oil to $120 WTI was a one-time event that would dissipate quickly.

In fact, I’ve heard investors say they won’t touch energy stocks because oil prices will drop rapidly in 2023 as electric vehicles start hitting the road in droves. These ideas are so crazy. It’s like, just look at a map of the world!

From China to India to Africa, billions of people need oil for everything.

My argument goes further, just because oil companies have seen their stock prices rise, it’s hard to argue that these companies are valued at a high valuation. Something we will discuss next.

DVN Stock Valuation – Less than 7x Free Cash Flow

If we assume that oil prices stay around $100 for the next twelve months, that puts Devon Energy at around 7 times free cash flow.

Now here’s the thing, as I look far and wide to other sectors, especially in tech, there aren’t any significant companies that are priced below 20 times free cash flow once we consider management’s stock-based compensation.

And haven’t we learned anything in the past 12 months that investing in technology can also be very volatile? In fact, 12 months ago everyone investing in technology was a long-term investor.

Right now, investors are just happy that most of the earnings season is behind them. Nobody wants to adopt another Netflix (NFLX), Upstart (UPST) or Snap (SNAP) experience.

The essential

There’s no denying that commodity companies have grown significantly over the past year. Especially in the last 6 months. But that’s as far as the bear thesis goes.

Similarly, many investors claim that tech companies are down more than 65% from their highs, in countless cases, therefore, this space must be undervalued.

While I’m not making any arguments anyway, what I will say is that looking back tells you nothing about the company’s future prospects.

For now, the market is still playing with the strategy that has worked so well over the past decade. Stay in technology for a long time and avoid commodity companies. But what if geopolitical risks, high energy prices and high inflation persist longer than we imagine? Then what ?

I don’t know the answer to this question. But to me, paying in single digits for a commodities company is a better bet than paying around 30 times free cash flow for a technology company, once we factor in stock-based compensation.

With the commodity company, the risks are in your face. Everyone knows the risk. Oil prices will suffer at some point from the destruction of demand. In other sectors of the market, it is the opposite, the risks are always there, but they are hidden, but bubbling.

About Florence L. Silvia

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