Devon Energy: Buy For Steady Gains

May.17.12 | About: Devon Energy (DVN)

Devon Energy (NYSE:DVN) is one of the largest oil and gas E&Ps in the United States. With an exceptional potential for growth, Devon shares make an ideal investment over a slightly longer time frame. Devon Energy netted earnings of $393 million in the first quarter 0f 2012, a decrease of approximately $20 million for the same quarter last year. The decrease was partly due to wider than normal Canadian Oil price differentials which have stabilized at the end of the quarter. Devon's solid finances and an appealing overall model make the company highly competitive among other E&Ps.

I believe that Devon shares present a strong five year buy opportunity, though initiating positions for short-term return is somewhat risky. Other holdings such as Hess (NYSE:HES) represent a stock with a more dynamic 12-month outlook-Hess is rather undervalued over 12-month projections. On the other hand, over a 5-year time arch, Devon is uniquely positioned in Canadian and American oil holdings that, given its total amount of proven reserves, make it an attractive purchase for long-term growth portfolios.

Valuation and Risk

Projections for 2013 hinge on how well Devon's current price reflects the overall value of its liquid-rich holdings, particularly those of the Permian basin. My overall recommendation hinges on the fact that growth prospects seem to be reflected in Devon's current share price projection. It seems that shares are trading close to fair value and that no breakout correction should be expected to adjust for an inefficiency of the price to reflect overall value. Most technical indications-like cash flow, price/book ratio, and price/sales ratio-lie in the in the mid-range for E&P stocks. Thus, barring a surprise or particularly exceptional outperformance one quarter, the current share price reflects overall value.

That said, analysts have earnings per share projections of anywhere from $6.90 to $7.63 for 2013. Indeed, if oil production is uncommonly high and breaks projections, then, as some analysts note, a share price of around $85 could be in the future. This, however, seems ambitious given Devon's "steady growth" model. The on-shore, growth oriented company stands to steadily increase in value over the next five years, but it seems somewhat speculative to hold as a premise that the development model, described below, will yield such an increase in share price so precipitously. Indeed, Devon is a company that is meant to "play the bear" by avoiding fluctuations in commodity prices-it has solid financials and does not have exposure to unpredictable foreign interests.

Development-Oriented Growth

According to an IPAA OGIX New York slide presentation in April 2011, Devon is committing 86% of its $4.5 billion development and exploration budget to development of present assets. In 2012, practically the entire development and exploration budget will be allocated to liquids-rich opportunities. Devon's production mix in 2011 was approximately 68% gas and 32% oil and NGLs such as propane, butane, and ethane, with year-end reserves at approximately 60% gas and 40% liquids.

Devon's developmental plan involves a consolidated approach to North American holdings. In 2010, Devon netted about $10 billion pretax by selling its non-North American properties. Geographical consolidation tends to translate into improved cost base. Exploration requires less of an investment when properties are clustered, and production becomes streamlined with such clustering. Anadarko Petroleum (NYSE:APC), for instance, is bolder in its exploration strategies, which has lead to a larger debt/capital ratio (45%) as the company's cost base for properties is less favorable. The perk in Anadarko's case is that this approach has paid off quite well with a shoring of reserves. On the other hand, Devon has benefited from low-risk holdings like Barnett, Permian, and Jackfish for quite the opposite reason-they a geographically similar and have established production reputations.

In all, Devon's 2012 production is projected to increase 5% to 7% year-over-year, with oil production increasing 26%, natural gas liquids up 14%, and natural gas staying flat. As with other E&Ps, this decrease in gas production corrects for the uncompetitive $2/MMbtu present price of natural gas. Natural gas production has become so efficient as of late that increased supply has completely outpaced relatively stagnant demand. However, Devon is well-positioned long-term since 60% of its reserves are natural gas, such that a change in demand for natural gas will favor Devon.

Canadian oil holdings like Jackfish, Jackfish 2, and Jackfish 3 are invaluable long-term holdings for Devon. These properties represent a flat production profile that has an expected life of over 20 years. Total Jackfish production in 2012 is estimated to be around 43,000 b/d. In the adjacent Pike acreage, production is estimated at 35,000 b/d. The Permian shale-75% liquids-is up to 53,000 BOE/d, and other holdings at the Barnett Shale and Cana-Woodford Shale are efficient producers.

Consistent Finances

As noted in its 2011 annual report, Devon's strategy relies on its ability shore up proven oil and gas reserves. Devon has done an excellent job in this regard by consolidating its holdings and using practically all of available cash flow for new drilling efforts. Management's priority recently has been to reduce debt and to repurchase shares with the hopes to steadily increase earnings per share. The debt rating of Devon is BBB+ as rated by S&P, making it an investor-grade holding.

In its consolidation process in 2009, Devon sold its Gulf of Mexico holdings, which generated proceeds of $9 billion, before the Macondo fiasco. This stroke of luck allowed Devon to weather the subsequent hit in deepwater drilling.

Devon remains competitive against many of its competitors largely because of its solid finance structure. For instance, Chesapeake Energy (NYSE:CHK) is making extensive use of financial instruments to increase cash flow and to fund its capital expenditures. Furthermore, Chesapeake has historically used accounting tricks to enhance its financial guidance. This has not been a problem with Devon, nor has it been a problem with like-minded company strategies at work in companies like Apache (NYSE:APA). Both companies are consolidated, development-intensive E&Ps.

Conclusion

The most rational approach to commodity dependent companies is to invest based on potential growth fundamentals and low cost structure. Devon has long-term prospects in both of these metrics, thus making an excellent long-term investment with 15% growth likely to accrue to shareholders on a book-value, discounted-cash-flow and earnings multiple basis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.