Devon Energy's Stock Deserves a Break

 | Nov 21, 2013 | 12:00 PM EST  | Comments
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We value investors, like Rodney Dangerfield, often feel that we don't get any respect as we wait (and sometimes wait and wait) for the market to recognize the intrinsic value of our temporarily out-of-favor stocks.

So it has been with Devon Energy (DVN), a stock we have recommended a number of times over the past two years. While the stock is modestly higher over this time period, it has vastly underperformed the S&P 500 and its competitors in the energy sector.

What is particularly frustrating is that the company has been doing all the right things in running its business, including shareholder-oriented actions intended to boost the stock price. Two weeks ago, Barron's ran a very thorough focus piece on Devon, highlighting a number of these positive actions. Barron's also detailed a very sizeable valuation disconnect between Devon's assets and those in its peer group. Unfortunately, the market reaction was a big yawn.

Let's look at some of the actions that management has taken. It has repatriated $4.5 billion of proceeds from the previous sales of off-shore assets to the parent in the U.S., and reinvested them in Canada at an advantageous tax rate of only about 5%. It has created a master limited partnership (MLP) for its mid-stream gas processing facilities and pipelines (together with a merger of CrossTex Energy) in order to take advantage of the premium valuation the market imputes to MLPs.

Management is not done yet with its portfolio review, as it has stated that other assets might be of greater value to owners other than Devon. Operational issues at the company's Canadian oil sands operation have been resolved, and production has recovered there. Devon has partnered with others to offload some of the drilling expense in U.S. shale gas plays, while retaining favorable economic exposure to its potential successes.

Management has also hedged a significant portion of its production at prices above the spot market, a shift from Devon's historical aversion to locked-in pricing. Finally, the company continues to shift its production balance from conventional gas to higher-valued oil, benefiting from the development of its shale oil plays, in terms of both volumes and dollars.

Still, the conventional pushback is that Devon is primarily a natural-gas play, and pricing in that commodity is capped by all the gas produced in conjunction with the increased development of fracked oil. Devon has been mitigating this issue, through premium-priced hedging and increasing the oil/gas production ratio, with more oil development and the cessation of dry gas drilling. Having said all this, any improvement in gas demand and the resultant impact on prices would clearly result in a windfall for the company.

This week's announcement of the acquisition of GeoSouthern Energy's light oil play in the Eagle Ford shale for $6 billion in cash is another case in point. Devon has made a smart deal. It brought on high-quality oil assets, including both currently producing and new acreage, with lots of growth ahead. It paid an attractive price, using its repatriated cash and low-cost debt. And it meaningfully accelerated its resource shift toward higher-margin oil and liquids and away from natural gas. The deal is accretive to earnings, cash flow, and asset value in year one, and it pays for itself out of its own free cash flow.

As a by-product of this move, management also announced that it expected to monetize non-core and non-material assets during 2014, further aiding the resource shift and generating some cash to pay down the new acquisition debt. The market's reaction? Just a 4% move on the rumor and nothing further after the disclosure of the details. That's not enough, given the highly salutary effects on the company's growth profile, financial outlook and business mix.

Management's stated objective in running Devon is to maximize its cash flow per share, adjusted for debt, because the company is rightly convinced that this metric is the key to valuation for energy companies. It is achieving this objective by improving Devon's operating performance, by investing astutely and by effectively managing its balance sheet. We estimate the intrinsic value of the stock to be more than 50% higher from here, notwithstanding the challenging natural gas market.

Bottom line, we believe Devon's lack of stock price progress, despite significantly undervalued assets, intelligent capital deployment and a laser focus by management on enhancing shareholder value, sets the stage for a very strong 2014. We look for Devon to outpace both the overall market and the energy group next year.

Like Rodney, Devon Energy deserves a lot more respect from investors.

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