Why does Devon Energy stock keep rising and where is it going? (NYSE:DVN)
Devon Energy Corporation (NYSE: DVN) has performed stellarly over the past year, and its shares continue to soar in 2022. This is happening thanks to steadily improving company fundamentals and strong shareholder returns. As long as the price of oil the environment remains solid, which is likely, Devon Energy could climb further, as its valuation is not high at all.
Why is Devon Energy stock rising?
Devon Energy was the best performing stock on the S&P 500 index in 2021, rising 198% in just twelve months. In 2022, Devon continued to climb, with shares rising another 58% in less than five months. On top of that, investors have received significant dividends over the past year and a half. There are several reasons for Devon Energy’s strong performance during this period. First, the company is benefiting massively from the rise in oil prices we have seen over the past year, with both WTI and Brent surging above $110, the highest level in years. This results in a huge increase in cash flow and profits for Devon Energy, which naturally makes the business more valuable.
At the same time, Devon Energy was not an expensive stock in early 2021 or early 2022. The inexpensive forward valuation allowed the stock to climb further as the company’s fundamentals continued to weaken. improve. Had massive growth been factored into the stock in the past, Devon Energy’s performance would have been less stellar. Finally, it’s also worth noting that Devon is paying a dividend of just over 7% based on the last dividend payout of $1.27 per share. That’s attractive to income investors, which has further led to tailwinds for Devon’s share price as income seekers crowd into the stock.
Key NVD Stock Metrics
In the past, many oil producers pursued production growth at all costs, often posting weak or even negative free cash generation. This has fortunately changed for most oil companies in recent years as industry management teams shifted their strategy towards a shareholder-focused free cash flow maximization strategy. This also goes for Devon Energy, which highlights its current strategy in the following presentation slide:
The company is no longer looking for much growth, opting instead for a no-to-moderate growth model. For 2022, no growth is expected, which is also partly due to parts shortages, labor shortages, etc. The company indicates that it could continue to grow up to 5% per year in the future, but I think that actual growth will most likely remain below this level. This is due to the aforementioned parts and labor shortages, but also the fact that management needs to notice that the current non-growth approach is working very well for the company and its share price – this would not make much sense to deviate from this path.
Unlike some other oil companies that favor buyouts over dividends, such as Marathon Oil Corporation (MRO), Devon Energy operates with a clear ‘dividends first’ approach. Its dividends consist of a combination of fixed dividends, currently at $0.16 per quarter, and variable performance-based dividend payments — these totaled $1.11 per share in the last quarter. The payment of the variable dividend is made up of up to 50% of excess free cash flow. In the current environment, Devon and its peers are generating tremendous free cash flow, especially when they aren’t investing heavily for growth, as Devon is.
Returning much of this amount to investors via dividends results in an attractive dividend yield, but the company can still conserve cash for other purposes on top of that. This allows for buyouts and further deleveraging. In Devon’s case, the deleveraging seems rather pointless, as the company’s leverage ratio (net debt/EBITDA) is already at a rather low level of just 0.6, using the first quarter figures of the business. But there are still some advantages to paying down debt because interest charges will decrease and debt reduction will transfer some of the enterprise value of the company from debt holders to equity holders, all things otherwise equal. Devon’s redemptions aren’t extremely high, but they’re still significant. The company recently announced an increase in its buyback program to $2 billion, which equates to just under 5% of the company’s current market capitalization. The impact of that depends on how quickly Devon uses that buyout authorization, of course. But if the program is completed within the next year, investors could see a mid-single-digit tailwind in earnings per share and free cash flow per share, all other things being equal.
Is DVN stock overvalued now?
Devon Energy shares look pretty cheap when we assume oil prices will stay at or near current levels. It’s not guaranteed, of course, and if oil prices were to fall drastically, earnings and cash flow would also decline, driving DVN’s valuation higher.
However, I believe that there is a good chance that oil and natural gas prices will remain high. Many oil companies are no longer investing for much growth, and at the same time, global demand for oil is strong and could strengthen in the coming quarters as international travel picks up. The macro picture of oil is therefore positive, especially considering the current impact of the Russian-Ukrainian war. Despite oil outflows from the US strategic reserve, markets are not oversupplied at all, which is why oil prices are likely to remain at relatively high levels for the foreseeable future, I think. Even if oil prices fell back to the $90 they were at before the Russian-Ukrainian war, Devon Energy would still be quite profitable.
In the first quarter, Devon Energy generated free cash flow of $1.44 billion, or just under $6 billion annualized. On average, oil prices during the first quarter were lower than they are today, as the impact of the Russian-Ukrainian war only started towards the end of February. Devon Energy also notes in a recent investor presentation that its free cash flow is expected to be close to $6 billion this year, even in a $90 WTI scenario – right now oil is trading above $20. above this level. The free cash flow forecast with WTI at $90 gives a free cash flow yield of around 14%, indicating a rather inexpensive valuation. It wouldn’t take too aggressive a valuation for Devon to trade at a free cash flow yield of 10% to 12%, which would allow upside potential of 20% to 40% (the shares would trade between 86 and 100 $ in this scenario).
Of course, this is not guaranteed, as markets can be volatile and negative macro news (eg more lockdowns in China) could put pressure on oil prices. Still, I believe Devon is not trading at a high valuation today, considering the stock is pretty cheap, even in a scenario where oil is down $20 from current levels. It should be noted that the same is true for many other oil companies, so Devon is by far not the only still inexpensive energy play.
Is DVN Stock a buy, sell or hold?
Devon Energy has performed extremely well for those who bought their stocks amid the pandemic. Going long on energy when markets were very bearish has paid off so far. Stocks won’t continue to rise at the same pace seen over the past 18 months, but Devon still has considerable upside potential. If oil prices stay at $90 or above, stocks could rise further and the large dividends investors receive from Devon further boost total returns. Devon Energy expects to end the year with a net debt to EBITDA ratio of just 0.2, which will likely translate into an even greater focus on shareholder returns. More buybacks and even higher dividend payouts over the medium term would therefore not be surprising, I think, as long as oil prices remain constructive.
That being said, there are many other attractive energy names besides Devon Energy. Devon Energy is therefore not a go-to name, although it still looks attractive at current prices as long as we assume the oil price environment remains constructive.