Can Devon Energy Dig Up Great Value?

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Warren Buffett just can’t stop buying shares of Occidental Petroleum (NYSE: OXY).

He now holds almost 25% of all Occidental shares through his conglomerate Berkshire Hathaway (NYSE: BRK-A).

But if you are interested in owning an oil and gas producer, I’m not sure Occidental is the one to go for.

Devon Energy (NYSE: DVN) is cheaper, is growing faster and has an intriguing dividend.

With more than 650,000 barrels per day of production, Devon is one of the largest independent producers focused exclusively on the United States.

Roughly two-thirds of that production comes from the highly prolific Delaware Basin, located in the massive Permian Basin.

Unlike most of the larger oil and gas producers – which are now planning on keeping production flat – Devon is going to grow in 2023.

Management’s guidance is for year-over-year production growth of 9% per share.

This growth is impressive because Devon is going to accomplish it while still pumping out significant free cash flow. That’s unusual in this business.

As investors, we want to see strong free cash flow. This is cash flow that can be distributed to shareholders as dividends or through share repurchases.

Usually, to grow at a nearly double-digit rate, producers must reinvest all their cash flow. That leaves little to no free cash flow for shareholders.

With nearly double-digit growth and free cash flow, Devon is letting shareholders have their cake and eat it too.

In the chart below, you’ll see that management has quantified how much free cash flow the company can generate at various oil prices.

Chart: Devon's Free Cash Flow Capacity at Various Oil Prices
With oil at $70 (around where we are today), Devon is expected to generate nearly $3 billion in free cash flow for the year.

That equates to an impressive 8% free cash flow yield on Devon’s current share price.

Management intends to distribute this free cash flow to shareholders through a combination of dividends and share repurchases.

It’s the dividend that has my attention.

Devon’s management adjusts its dividend based on how much free cash flow the company is generating – meaning it has a variable dividend.

If oil prices and free cash flow go up, management will increase the dividend. And vice versa. That is why the Safety Net system gave the company an “F” for dividend safety back in March.

But has it redeemed itself since?

With oil at $70 currently, Devon’s dividend yield is about 6%.

That looks pretty good when compared with the 1.7% average dividend yield of the companies in the S&P 500 and the measly 0.9% average dividend yield of the companies in the Nasdaq.

Chart: Devon Offers a Superior Dividend Yield
You have to have an opinion on where oil and gas prices are going.

Personally, I’m bullish on oil prices.

I believe that our supply and demand balance for oil is going to be tight in the years ahead even as we transfer to greener energy sources.

With Devon trading at an 8% free cash flow yield at current oil prices and offering a 6%-plus dividend, I think this stock provides a compelling opportunity today.

If oil prices go higher, then buying Devon Energy at current prices is going to work out very well.

There is upside in the stock, and the 6% dividend will pay you well to wait for it to be realized.

Assuming a bullish view on oil prices, The Value Meter rates Devon Energy as “Slightly Undervalued.”

The Value Meter

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