Devon Looks Like a Table-Pounding Buy

 | Jan 11, 2013 | 9:30 AM EST  | Comments
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We've written about Devon Energy (DVN) over the last year. After declining 20% in 2011, the stock was beaten down another 15% in 2012. Despite or perhaps because of the significant decline over the last two years, we believe Devon is a table-pounding recommendation for 2013.

Very simply, Devon has great North American oil and natural gas assets, has significant earnings power and trades at a big discount to its asset value. Its underperformance in the last few years has left the stock way too cheap and its shareholders extremely frustrated. Importantly, the high-quality management team is also feeling very frustrated. We believe the company is fixing some of its 2012 operating missteps and has a lot of non-operating levers to improve the stock price.

Devon's stock suffered last year from issues that affected the entire energy industry, including the sluggish and uncertain economy, slowing earnings growth and collapsing natural gas prices. The company was also hurt by a bumpy start-up of a new subterranean oil-sands project in Canada.

The outlook for 2013 looks brighter. Devon and the entire industry dramatically scaled back natural gas drilling during the second half of 2012. The improved supply/demand balance has raised prices markedly, though prices still lag typical levels. Better economic growth in 2013 in North America and globally should improve demand and pricing, even given the U.S. shale oil revolution. Finally, Devon seems to be progressing on its problematic startup.

Most important to shareholders will be the company's commitment to drive value in the stock this year, especially after two disappointing years. Management has demonstrated its focus here before, with a major sale of non-core assets and a subsequent hefty share-repurchase program. Devon has also been creative in finding partners to fund large portions of costly but attractive speculative prospects, thus lowering developmental risks while keeping much of the upside.

Management has expressed its willingness to explore ways to boost shareholder value, perhaps by selling some mature Canadian conventional oil assets. Another possibility could be an IPO of its midstream assets (gas gathering and liquids processing) in the form of a master limited partnership. Devon was in fact moving in this direction in 2007 before the deterioration of the financial and energy markets forced it to cancel the plan. And Devon has shown that it is not shy about using proceeds from asset sales to repurchase stock.

Currently, the stock is valued at about 12.8x 2013 estimated depressed earnings per share of $4.20. As recently as 2011, Devon earned $6 a share, and current earnings power is probably even somewhat higher. Ultimately, if Devon persists at trading at such a low valuation while holding such important assets, it could become an irresistible acquisition target. A larger energy player could be attracted to its secure and successful North American production and prospects, similar to the Exxon-XTO hookup in 2009.

Devon is very out of favor because of operational misses, tough pricing and uncertain macro demand. While we believe that the macro factors will improve, what excites us about the company is that a very capable and frustrated management team is working to make the future far better for shareholders. Devon is a great play for 2013, and it should be aggressively bought here with an eye toward our long-term target of about $100.

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