Oil continued to slide in Tuesday's trading, with WTI crude below $100 per barrel, as Covid-19 lockdowns started again in China, taking out some short-term demands. With oil stocks following the commodity down, it’s the third day in a row of big declines — we think it's a good time to pick up shares of Devon Energy (DVN). We traded this name earlier and benefited from the recent run-up in oil amid the Russia - Ukraine invasion: purchased a 3% position at average cost basis of $54, selling at $59 (9% gain). After refusing to chase the stock higher, DVN has finally seen a good-enough sell-off to a level we find very attractive. We were able to make a 0.70% purchase at an average cost basis of $51.95/share. At roughly $52 per share, the stock’s fixed-plus-variable dividend ($1.0 per quarter, $4.0 per year) yields 7.70% in dividend. This is one of the best dividend yielder in the market, and we are confident the company will be able to sustain it because the CEO said they are good as long as crude oil stays above $30; we don't see oil losing this elevated level any time soon. Additionally, we like how the company is aggressively repurchasing stock. Alongside Devon’s fourth-quarter-earnings report, it announced it expanded its repurchase authorization to $1.6 billion, representing about 5% of its outstanding shares.

Devon Energy (DVN)

Devon is an oil and natural gas exploration and production (E&P) company. The stock was the single best-performer in the S&P 500 in 2021, thanks in large part to a strategic capital allocation shift on the part of management, which decided to implement a fixed-plus-variable (determined by cash flow) dividend strategy.

This strategy allows Devon to both reward shareholders during the good times without overextending itself to maximize cash flow while at the same time preventing harsh dividend cuts when cash flows pullback on lower commodity prices. The fixed portion can be kept a bit lower at a level that is sustainable despite downswings in commodity prices, while investors can rest assured that they will benefit in line with upswings. Devon was a leader in implementing this capital return strategy, and it has proven so successful that several peers have since implemented it as well.

Of course, we have to ask ourselves if we are late to the party following a nearly 180% gain in 2021, and a 16.3% gain in 2022. On that metric alone, one might think so. However, while price alone may tell us what we are paying, it does not tell us anything about the value we are getting. As it stands now, shares trade at roughly 7x FY22 earnings estimates, 6x FY22 free cash flow estimates, all are highly attractive valuation multiples in a market concerned with rising rates, quantitative tightening and inflationary dynamics.

Then there is that attractive dividend dynamic. Devon’s quarterly fixed dividend is currently $0.16 per share or $0.64 per share annually, and it is based on a target payout of up to 10% of the company’s operating cash flow. However, what's more exciting is the variable dividend. It is calculated quarterly and can amount to as much as 50% of excess free cash flow in the quarter.

The company announced in February when it reported Q4 FY21 results that its Q4 FY21 fixed-plus-variable dividend was $1.00 per share, payable on 30th March 2022 to shareholders of record as of 14th March 2022. Worthy of note, there was a 45% increase in the fixed dividend portion compared to the last quarter (which was 0.11$ per share quarterly). The company continues to commit that the variable dividend portion will come from 50% of excess free cash flow that the company generates.

Of course, the definition of variable is that it will change quarter to quarter. Since the variable portion is tied to cash flow and that’s tied to commodity prices, we must take a view on the current level of oil prices. On this front, we believe that prices can sustain, if not advance, for three reasons. First, at the industry level, producers have finally learned that pumping for the sake of pumping is not a good long-term strategy. Second, banning of oil exports from Russia will keep oil prices at these elevated levels, unless the world can immediately replace ~11 million barrels a day that Russia used to supply. Finally, as the economy finally reopens for good, people start to take cruises and travel more, demand will be coming back on line as we work through the year and serve as additional support for oil prices.

So, the takeaway is that we are optimistic that the recent price action in oil will sustain, support Devon’s cash flow generation and therefore provide a healthy variable dividend in the quarters ahead. 

Other supportive factors include a $1.6 billion share repurchase program in place through FY22, amounting to ~4.5% of the current market cap of $35.21 billion and a management team intent on reducing leverage (calculated as net debt-to-EBITDAX) to 1.0x or less.

Price Target

We're looking for a price target of $74.4/ share on DVN, arrived from applying a 10x multiple on FY2022 earnings estimate of $7.44 per share. This multiple is well below the average historic 17.4x forward p/e multiple that shares have traded at over the past five years. Why don't we use the 17.4x multiple: we're trying to account for a market intent on utilizing lower valuation multiples than it has in recent years, given Fed tightening and inflation fears.

Another way to look at valuation is through the lens of an EV/EBITDA multiple. DVN exited 2021 with an EV/EBITDA multiple of 7.2. If we roll the EBITDA out to FY2022 ($8.4 billion) and use a 6x multiple, we realize an EV of $50.4 billion. Subtract $2.58 billion of net debt and divide by 666.3 million shares outstanding, we get a price target of ~$71.77 per share.