Having demonstrated solid execution in the past and planned strategic investments for the future, Devon Energy (DVN) may very well be the top oil & gas play of 2012. The company is rated near a "strong buy" on the Street versus a "buy" for industry gain for Occidental Petroleum (OXY). Based on my review of the fundamentals and DCF model, I find strong upside for Devon.
From a multiples perspective, Devon is the cheaper of the two. It trades at a respective 13.5x and 10.3x past and forward earnings with a dividend yield of 1%. Oxy, meanwhile, trades at a respective 13.6x and 10.9x past and forward earnings with a dividend yield of 2.1%. Both firms have around 20% more volatility than the broader market.
At the recent fourth quarter earnings call, OXY's management noted:
Net income was $1.6 billion or $2.01 per diluted share in the fourth quarter of 2011, compared to $1.2 billion or $1.49 per diluted share in the fourth quarter of 2010. Our consolidated pretax income from continuing operations in the fourth quarter of 2011 was about $2.6 billion, $2.02 per diluted share after tax, compared to approximately $2.9 billion, $2.18 per diluted share after tax, in the third quarter of 2011.
Major items resulting in the difference between the third and fourth quarter income included higher oil volumes and prices, which added $0.07 per diluted share after tax to our fourth quarter income; lower fourth quarter chemical and midstream income of $0.08 per diluted share; higher equity-based compensation cost of $0.05 per diluted share; higher exploration expense of $0.02 per diluted share; and higher fourth quarter operating costs of $0.08 per diluted share.
Occidental has strong a balance sheet, ROIC, and an impressive record of improving the oil recovery of mature assets. Its low debt positions the company well to acquire high-growth energy firms with minimal cash flow concerns. With that said, investors have become increasingly fearful about Occidental's lack of hedging and organic growth prospects. Volatile oil and gas prices, however, will help to drive high risk-adjusted returns as the firm penetrates under-developed plays.
Consensus estimates for OXY's EPS forecast that it will decline by 0.5% to $8.35 in 2012 and then grow by 14.6% and 3.6% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $9.53, the rough intrinsic value of the stock is $133.42, implying 28.3% upside.
Devon similarly has demonstrated strong execution. More capital is likely to be deployed in Canada than the $200M used in 2011. Particularly noteworthy was the firm's success with the Sinopec deal. Indeed, it has been so successful that management has expressed interest in exploring deals similar in nature. The fact that the company received competing bids makes me optimistic about the availability of future joint ventures. Devon is meanwhile drilling alongside Sinopec with a two-thirds stake in the 5 high-growth plays spanning around 1.4M net acres. And while low natural gas prices have made it difficult to realize a meaningful rate of return in sites like Barnett, the secular trends are pointing nowhere but up given environmental, foreign policy, and efficiency concerns. Going forward, I anticipate a repeat year of double-digit growth in liquids offsetting that of gas.
Consensus estimates for Devon's EPS forecast that it will decline by 7.5% to $6.04 in 2011 and then turnaround to grow by 7.5% and 17.1% in the following two years. Modeling a CAGR of 5.2% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $97.68, implying a 46% upside.