4 Cookies From Devon Energy

Summary

• Four favorable pieces of news out of Devon Energy Corporation.
• Debt reduction, a truly non-core asset sale, a dividend increase, and share buybacks.
• Going over Devon Energy Corporation's latest news.

On March 7, after the brutal trading weeks following Devon Energy Corporation’s (NYSE:NYSE:DVN) latest earnings report, management offered investors four cookies. The first cookie was a 33% bump in its quarterly dividend to eight cents a share, good for a modest 1% yield at current prices. Devon Energy Corporation also decided to initiate a $1 billion share buyback program that will be completed over the next 12 months, equal to 6% of its outstanding shares at current prices.

Management is also cognizant of the need for Devon Energy Corporation to further pare down its debt load, which is why the firm launched a tender offer to buy back $1 billion of its notes. A truly non-core divestment is helping fund these endeavors. Let’s dig in.

Another divestment

Devon Energy Corporation announced that it just sold off part of its Barnett shale position, a Tier 3 natural gas play in Texas, for $553 million. The company is selling producing properties in Johnson County, TX. That acreage is currently pumping 200 million net cubic feet of natural gas equivalent (meaning some natural gas liquids is produced alongside dry gas), and was estimated to produce $100 million in cash flow this year before including overhead costs.

Devon is losing some cash flow, but it's worth mentioning that its Barnett shale output has been steadily trending lower over the past few years and will continue to do so without meaningful capital expenditures being allocated to the region. Economical development opportunities in the Barnett are largely limited to refracking old wells with new completion methods to boost EUR (estimated ultimate recovery) rates, and those types of projects still require higher natural gas prices to make sense.

The Barnett play just isn’t economical unless Henry Hub is closer to $4/Mcf (well above strip), and it isn’t competitive with other gas plays in the US. If Henry Hub rallies, Devon has other ways to capitalize on higher dry gas prices.

Whoever acquired the position most likely wants to use the asset as a perpetual call on higher gas prices in the future, and may already have a position in the Barnett play (economies of scale can make the Barnett a tad more competitive). Devon’s remaining Barnett position will probably get wound down over time; I wouldn’t be surprised to see the company exit the region by the turn of the decade (aided by a potential upward movement in Henry Hub before then). Those proceeds will likely end up furthering management's debt reduction efforts.

Will Devon have enough cash?

At the end of 2017, Devon Energy had $2.673 billion in cash on hand, and pro forma for the partial Barnett divestment, that climbs to $3.226 billion. Aided by free cash flow generation in the current oil price environment, Devon has the funds to follow through with its ambitious guidance. The debt reduction will free up around $50-70 million per year as high-yield debt is retired.

Devon had $6.864 billion in debt at the end of 2017 that was recourse to its upstream and Canadian divisions, and when adding debt from its midstream spin-offs, that goes up by $3.542 billion to $10.406 billion. Bringing that down to more manageable levels now that oil prices are cooperating is a great idea.

Management noted that additional debt repurchases may be on the way during Devon’s Q4 conference call:

We [Devon Energy Corporation] will finalize size and timing of our initial debt tender in the coming weeks, but I expect this initiative to reduce our absolute debt by as much as $1.5 billion during 2018. Beyond this initial debt repurchase, we will balance additional debt repurchases against our other financial priorities, but will remain committed to sustain our targeted net debt-to-EBITDA ratio in a $50 WTI price environment.

In light of its free cash flow positive position, Devon Energy will have the ability to pursue another debt repurchase tender offer later on this year.

FCF on the horizon

Devon noted that “at $60 WTI pricing, we would be able to generate $2.5 billion of cumulative free cash flow over the next three years.” Management went on further to state “as this excess cash flow manifests itself during 2018 and beyond, I emphasize again, we will reward our shareholders through higher dividends and opportunistic share buybacks.” It appears that moment has come.

By focusing on fiscal discipline, management has put Devon Energy in a position to lower its interest expenses, buyback shares, cut its debt load, and boost its dividend - all while its production base grows across top-quality unconventional plays in North America.

This year, Devon expects to spend around $2.475 billion on capital expenditures, up from $2.169 billion in 2017. With 528 million outstanding shares on a diluted basis at the end of 2017, its dividend payments should cost $170 million per year before factoring in the impact of its upcoming share buybacks. That is good for a combined cash outflow of ~$2.65 billion.

Devon generated $553 million in operating cash flow from its upstream unit and pocketed $66 million from EnLink (NYSE:ENLC) (NYSE:ENLK) in Q4 2017. While its EnLink distributions will rise in 2018, the real gain will be from sharply higher oil and NGLs realizations combined with production base propelling Devon Energy to positive free cash flow territory. Management expects the firm's retained oil production will rise 14% this year versus 2017 levels, with growth weighted towards the second half of 2018.

Final thoughts

As a shareholder of Devon Energy Corporation that has been suffering through the past month, this was welcome news. I'm writing this piece before the market open, but based on DVN's after-hours action, it looks like Wall Street approves of these maneuvers. Debt reduction, share buybacks, dividend growth, and a truly non-core asset sale reinforces my bull thesis that Devon Energy Corporation is a top quality play on a recovering oil market.

My view is that the market is underestimating how well America's unconventional upstream industry will do now that WTI is back over $60 a barrel, particularly those with Tier 1 oil-weighted assets. Thanks for reading, let's see how the market reacts to these four cookies.

Analyst’s Disclosure: I am/we are long DVN. 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.