Is Devon A Buy?

Feb.11.14 | About: Devon Energy (DVN)

Devon Energy (NYSE:DVN) has gone from one of the first movers in the natural gas boom to quite possibly one of the best leading independent energy companies. The company has been a proven leader in using steam to produce oil from the Canadian oil sands with operations focused onshore in the U.S. and Canada. Here is a quick overview of Devon Energy's most important numbers.

Source: Company's Presentation

Recently, the company made two deals (1) the acquisition of GeoSouthern Energy's assets in Eagle Ford Shale and (2) a strategic midstream combination. In this article, I will be discussing how these deals can make a difference, if any, for shareholders.

Seeking Top Line Growth through Acquisitions

The company announced that it has reached a definitive agreement to acquire GeoSouthern Energy's assets in the Eagle Ford Shale oil play for $6billion in cash. With the help of this acquisition, the company will now have 82,000 net acres with almost 1200 undrilled locations. The acquired assets are currently producing 53,000 barrels of oil equivalent "BOE" per day.

Source: Company's Presentation

However, the company plans to significantly increase production. The company expects the 2014 production to be over 70,000 barrels and expects it to increase up to 135,000 to 145,000 barrels of oil equivalent per day by the end of 2017.

Source: Company's Presentation

The acquisition will not only result in increased production but will also have a considerable impact on improving the financial performance of the company. Due to the lower costs, the cash margins will improve and this will improve the bottom-line figures of the company. Devon believes that the pretax cash margins will improve by 10% while earnings per share are estimated to increase by over 20%.

Strategic Combination: Midstream Business

Devon announced it would collaborate with Crosstex to form a new midstream business. The new business will consist of two publicly-traded entities: (1) the master limited partnership and (2) a General Partner entity. The new company is expected to have an adjusted EBITDA of $700 million in 2014. The combination of extensive midstream systems, including gathering and transportation pipelines, processing, fractionation and logistics assets will provide the company with diversification and scale, along with an enhanced liquids-oriented growth profile.

The deal marks the latest step in the transformation strategy of the company. The company has been selling off international and offshore assets and focusing on North American operations. The transaction is expected to generate up to $45 million in annual operational and financial synergies in 2014.

Devon has long-term contracts in place to stabilize future cash flows and strengthen its capacity for cash distribution. The current understanding entitles it to 10-year fixed-fee contracts with rate escalators.

Possible Stock Price Catalyst

With the Eagle Ford deal relative oil production will continue to rise and the company is set to show decent production growth, but there is uncertainty about the possible divestiture of its non-core assets. The uncertainty regarding the selling price of these assets is pressuring the stock price of the company.

Investors need to keep a close eye on the developments as they emerge. A favorable price negotiation can take the stock price to the next level and vice versa.

Ample upside potential

Currently, the company is trading on a forward price to earnings ratio of 9.91, while the industry has been trading at an average of around 15. In anticipation of the future earnings capacity and the expected growth rate the stock price trading on such lower multiple does not seem to be justified. Assuming the price multiple of 12, the stock price gives an upside potential of almost 20% at $76 per share. In addition, the company currently stands at a PEG ratio of 0.76 which further strengthens the high value position of the company.

Going forward, with the recent developments improving the bottom line of the company, I believe that the stock price will be traded at least near the average P/E ratio of the industry.

Concluding Remarks

The production at Eagle Ford Shale is expected to increase at a considerable pace over the coming years. Devon is expected to benefit from the acquisition of assets in the Eagle Ford Shale. Having 82,000 acres in one of the most highly productive regions ensures a competitive advantage for the company. Though Devon paid a heavy price for its Eagle Ford assets with the increased production it will most likely be rewarded handsomely over the next several years. In addition, the merger deal with Crosstex Energy will provide a lucrative revenue stream over the next couple of years. However, keeping a closer eye on the updates regarding the selling price of non-core assets can give a clearer picture regarding the company's future direction.

The fundamental point is to judge the company not on where it is but where it will be in the next five years or so. With the enclosed deals, Devon Energy is now in good shape to capture growth opportunities going forward and provide investors with considerable upside potential of 20%.

The upside potential of the stock price coupled with the dividend yield of almost 1.5% makes the company a worthy investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.