Devon Energy (NYSE: DVN) has subtly adjusted its approach to capital return this year. The energy giant, which previously directed excess cash to shareholders through variable dividends, is now placing a greater emphasis on share repurchases in 2024.
The pivot towards share buybacks is rooted in Devon’s strong conviction that its own shares, as well as those in the broader oil sector, are currently undervalued. Here’s a closer examination of the factors influencing this perspective.
A bottom-of-the-barrel valuation
In discussions about Devon Energy’s capital return strategy during the fourth-quarter conference call, CEO Rick Muncrief highlighted the company’s anticipation of enhanced efficiency in the upcoming year. The decline in oilfield service costs and a concentrated effort on developing its prominent position in the Delaware Basin are expected to result in a 10% reduction in capital expenses. This positions the company to achieve a 20% growth in free cash flow, reaching $3.2 billion, assuming oil prices hover around $80 per barrel, slightly above recent levels.
Devon’s plan involves returning 70% of this increased cash flow to shareholders, while allocating the remainder to fortify its robust balance sheet further. The core of this return will be the base quarterly dividend, set to increase by 10% for the year 2024. With the remaining excess cash, the company aims to maintain flexibility and adaptability.
Illustrated by the accompanying slide, Devon currently boasts a compelling 9% free-cash-flow yield, positioning its valuation at a significant discount compared to broader market indexes. Given this valuation discrepancy, the company is strategically placing a priority on utilizing excess free cash flow to repurchase its undervalued shares. The plan involves employing the variable dividend to distribute any remaining excess cash to investors on a quarterly basis.
Since the initiation of its repurchase program in late 2021, Devon has successfully retired 6% of its outstanding shares. With its current stock price, the company has the potential to retire an additional 9% of its shares by fully executing its $3 billion repurchase authorization.
Tossed into the bargain bin
Devon Energy isn’t the sole energy stock finding itself in the bargain bin, as the entire sector is currently trading at historically low levels.
As highlighted in the presentation, the energy sector currently constitutes less than 4% of the S&P 500, despite contributing 10% of its earnings. Muncrief pointed out the significance of this discrepancy, stating, “This is noteworthy given the energy’s S&P weighting historically tracks its earnings contribution over time. I believe this gap exists due to extreme valuations in tech, combined with a pervasive misunderstanding of hydrocarbon demand over time.”
He emphasized the forecasted 50% increase in global energy demand by 2050, asserting, “the world is going to need growth from all sources of energy, including oil and natural gas.” Muncrief’s confidence in the industry’s enduring importance led to his belief that “peak oil demand is nowhere in sight, and our industry will be an important contributor of energy growth for the foreseeable future.”
Anticipating the rising demand for oil and gas, Devon is poised to boost its production, free cash flow, and returns to shareholders. Muncrief emphasized that high-quality companies like Devon offer substantial equity upside over time through outsized cash returns, underscoring the rationale behind the active share repurchases.
A great buy in a historically attractive sector
Devon Energy is convinced that transitioning its cash return strategy from variable dividends to share repurchases is a clear and strategic move. The stock currently trades at a considerable discount compared to broader market indexes, influenced in part by the heightened demand for tech stocks among investors. The expectation is that, over the long term, market conditions will normalize, leading to an uplift in the value of energy stocks such as Devon. Initiating share repurchases at the current discounted levels is seen as a proactive step by Devon to enhance value creation for shareholders over the extended horizon.
