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Devon Energy (DVN) announced last month its plans to acquire GeoSouthern Energy's oil assets in the Eagle Ford shale for $6 billion. The purchased acreage currently outputs around 53,000 barrels of oil per day and contains roughly 12,000 undrilled locations. The acquisition in Eagle Ford would be enough for Devon shareholders to get excited about but it's not the only reason to be excited about what's in store for the company in 2014.
Eagle Ford acquisition
Devon's acquisition in Eagle Ford sends a clear message that it wants to be a bigger player in the oil space. According to the company, oil accounts for about 25% of the company's production but would climb closer to 31% if the new Eagle Ford position were included. The acquisition is sitting on an estimated 400 million barrels of harvestable oil reserves and would ramp up current production of around 691,000 barrels a day by an additional 140,000.
Companies have been anxious to obtain land in high potential plays like Eagle Ford and the Permian Basin that Devon needed to pay a premium price for the acquisition. However, the development of the land coupled with the large oil reserve sitting below the surface means that Devon will see a nice return on this investment. With this acquisition, Devon becomes a significant player in the shale boom.
Greater exposure to higher margin oil
As mentioned earlier, Devon is primarily a natural gas producer. While the company will remain primarily a natural gas producer even after the acquisition, Devon gains a larger position in the higher margin oil production space.
The Eagle Ford acreage is currently producing 53,000 barrels a day but Devon plans on ramping that up significantly. The company forecasts 2014 production to be over 70,000 barrels and by 2017 expects to be producing upwards of 135,000 to 145,000 barrels of oil equivalent per day.
Devon states that the acquisition is expected to be immediately accretive by virtually all metrics. Additionally, the company says that it expects pretax cash margin numbers to improve by over 10% and earnings per share to rise by over 20%.
Analysts have already indicated that they are bullish on the potential from the Eagle Ford purchase. Argus raised its rating on Devon to buy from hold on news of the acquisition and RBC Capital reiterated its outperform rating also noting the Eagle Ford acquisition.
Analysts are currently maintaining a median price target north of $70 compared to Monday's closing price of $60.70.
Merger with Crosstex (XTXI)
Devon made news back in October by announcing that they planned on canceling an MLP spinoff and instead choosing merge its mainstream assets with those from Crosstex Energy (XTEX). The merger would create two new companies - one general partner that Devon will maintain a 70% stake in an MLP where Devon will control 53%.
This merger will create an additional lucrative revenue stream based to incentive distribution rights that are expected to come with the deal.
With a major transaction like this you need to judge the company not on where it is but where it will be. Five years ago when Devon was primarily a natural gas producer, the stock price tumbled as natural gas prices plummeted. Prospects look better today as it diversifies its operations but there's more to like her outside of the potential for higher margins.
As mentioned above, the GeoSouthern acquisition is expected to be immediately accretive to earnings and result in margins and earnings markedly improving. Since the acquisition was made almost entirely in cash, that's turning a zero earning asset into a potentially substantial earning asset. That's a pretty good tradeoff and that's not even considering the tax advantages the company will enjoy with the establishment of the MLP.
Before the acquisition was announced, Devon was an underperformer in 2013. The stock has returned a respectable 15% but that return lags the S&P 500's 25% gain and the energy sector's 20% advance. Fundamentally, the stock still looks undervalued. It's forward P/E is just 11 compared to the broader market P/E of around 15. Devon's PEG ratio currently stands at 0.73 further reinforcing the idea of the company's value profile. Taken together, this means the stock still has room to run as it catches up to the indices and begins seeing returns in Eagle Ford.
The company has also delivered recently. Devon has beaten earnings estimates for the last several quarters and analysts are beginning to raise forward expectations. Throw in a dividend of 1.4% and there's a lot to like here.
The fact that Devon Energy is a $25 billion company and is using roughly $6 billion in low earning cash and equivalents that are just sitting on the books to make such a large play in Eagle Ford with plans to significantly increase oil production in the area signals how confident the company is in the potential of the area. Natural gas continues to trade cheaply and it's become almost necessary for the company to begin making strides in other energies like oil. This is a big step in that direction.
One caveat would of course be the strength of oil prices as the development of the United States as a major oil producer could put pressure on prices over the long term. Even with that in consideration it's tough to see how this is a bad move for Devon. The efficiencies approaching from the Crosstex merger, the oil production potential from Eagle Ford and the ability to generate higher margins in the future could portend a big upward move for the stock price.