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Is Devon Energy Being Unfairly Drilled?


One Thursday morning in February, well before the stock market opened, a large but obscure Oklahoma City company reported 2003 results. Sales had soared by 70%. With its product prices also up a ton, operating profits multiplied nearly by five. Better yet, more prosperity lay ahead. Wall Street, that locus of insanity, took this hale report on Feb. 5 from Devon Energy (DVN) and pummeled its shares. After peaking late in January at $61.12 a share, stock in the nation's top independent producer of oil and gas dipped that Thursday below $52.

FOR THIS CONFOUNDING REACTION, there are a few competing explanations. A familiar one is simply the seasonal story -- with springtime nearing, pressure on heating oil and natural gas prices will ease, hurting most energy stocks' near-term prospects. Another is that energy companies, no matter how well they do in any given period, deserve small credit because theirs is a commodity business, with meaningful growth too dependent on prices set in volatile commodities markets. Last year's blowout, investors seemed to worry, might be as good as it gets for Devon. Perhaps the most persuasive explanation, however, is specific to Devon. As this one goes, co-founder and CEO J. Larry Nichols is hooked on making acquisitions, and before shareholders can enjoy the fruits of Devon's prosperity, he will do another deal, possibly using a mega-load of borrowed money.

That last suggestion, Nichols told me, "is a cheap shot from someone who doesn't understand what we're doing." Maybe, maybe not. Who's to blame a prudent investor for fearing debt? But the market is missing the larger truth: Devon is strengthening with each barrel of oil or gas-equivalent it sells, 696,000 per day at last count. Petrie Parkman analyst Shawn Reynolds calls it "a free-cash-flow machine." While the top 25 oil and gas stocks trade on average for six times the past 12 months' cash flow, Devon goes for under four, even with 88% of its output from wells in North America. Given the political risks abroad, that relative security merits a premium.

A year ago, when Devon was closing a stock merger with Ocean Energy, investors had more reason to be skeptical. Devon then was working under so much debt that it made up 60% of total capital. Devon could hope, but hardly depend on, oil and gas prices going up and staying higher. They did, though, a lot. Average prices jumped 18% for crude oil and 61% for natural gas. With that, and the addition of Ocean's production, cash flow from operations more than doubled last year, to $3.8 billion on $7.4 billion in revenue. Even after $2.4 billion in capital spending, Devon had enough cash to retire plenty of debt, taking its net debt to capital ratio to 41% (table). That figure is headed for the mid-30s by 2005 as Devon expects to pay off borrowings totaling $1.3 billion that mature this year and next.

The windfall means that, even if oil and gas prices now decline, Devon stands as a far stronger company. In a year's time, book value per share has increased 58%, to $46.85. Yet the stock price, which has bounced back to nearly 59, is up about 18%. Crude oil is still selling near $36 a barrel, but even assuming a steep drop this year, with crude averaging, say, $26 a barrel, Reynolds figures Devon will generate at least $800 million in cash beyond its capital budget. Devon's board felt secure enough about prospects that on Feb. 26 it doubled the company's dividend, to 40 cents a year.

Might management undercut shareholders' good fortune by making a costly acquisition? It's a risk. Every year since 1998, Devon has done a sizable deal. Nor does Nichols rule out another. "It's been our stated objective to grow by acquisition," he said. "But we do acquisitions to fill specific needs...[and] there is no compelling weak hole that we see." More likely, he said, is further debt reduction. He also noted that Devon's dividend yield of just 0.7% remains well below its peers' average near 1.1%. In other words, there's still ample room for Devon's dividend to grow. Its stock price, too. By Robert Barker


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