We believe that Devon Energy Corporation (NYSE:DVN) is the most attractive stock to invest in to take advantage of a high-inflation environment. This is due to their dependence on rising oil and gas prices, high growth and profitability, its low break-even cost structure, and its unique focus on returning its fast-growing free cash flow to shareholders at a much higher rate than industry peers. DVN is in the best industry for inflation and offers the best combination of high yield and minimal risk in its industry due to its high earnings growth and high dividend yield.
Devon Energy Corporation is an independent energy company focused on the exploration, development and production of oil, natural gas and natural gas liquids (“NGL”) in the United States. The Company’s operations are concentrated in four oil producing regions: Delaware Basin, Eagle Ford, Powder River Basin and Anadarko Basin. Their commodity exposure is 50% oil, 25% natural gas and 25% NGL. It operates over 5100 wells and is headquartered in Oklahoma City, Oklahoma.
The oil and gas industry benefits most from inflation
In a high-inflation environment like the one we’re experiencing now, the oil and gas industry is the best industry to invest in. Within this industry, the Exploration and Production (“E&P”) sector is the best sector to invest in. As this chart shows, the percentage changes in consumer price inflation (blue line) and oil prices (red line) are highly correlated. Because rising oil prices are the main cause of high inflation.
At $102, West Texas Intermediate (“WTI”) crude oil prices are the highest in eight years. However, oil prices relative to US GDP are still near historically low levels, as illustrated below. This points to the potential for much higher oil prices going forward, especially if inflation expectations remain elevated.
The energy industry has bounced back strongly from the 2020 Covid crash, helped by the Federal Reserve raising the money supply by 40%, and the Russia-Ukraine war. With strong global economic growth, the International Energy Agency expects oil demand in 2022 to exceed 2019 levels. With energy sector investment down 25% from 2019 levels, there is a very favorable supply/demand imbalance that should lead to rising oil prices this year.
Rapid earnings growth
This year, DVN is expected to grow revenue by 21% and earnings per share by 128%. As stocks generally follow earnings, DVN stock should continue to do very well, more than doubling earnings this year. As shown below, DVN has a history of beating EPS estimates and is expected to see rapid earnings growth in the coming quarters.
DVN receives an A+ Alpha wanted Earnings revisions rating with all 25 most recent earnings revisions higher for this year. They clearly have very strong momentum in their business.
Industry leading profitability
DVN is a very disciplined and efficient capital allocator. Their profitability is much higher than industry peers on most metrics as shown in the table below. For example, EBITDA margins of 42% are nearly double the industry median of 24%, return on assets of 17.5% is more than triple the industry median of 4.7%, and net income per employee of $1.76 million Dollar is almost 24 times higher than the sector median of $73,490. DVN’s strong profitability allows them to generate strong excess free cash flow, which is returned to shareholders.
DVN has been paying dividends for 29 years. They pay a fixed quarterly dividend plus a variable quarterly dividend of up to 50% of excess free cash flow.
In its Q4’21 earnings report in mid-February, DVN increased its quarterly fixed dividend per share by 45% to $0.16, or $0.64 annually, for an implied fixed dividend yield of 1.1%. That fixed dividend is very safe given that it’s based on a target fixed dividend payout ratio of just 5-10% and a relatively low oil price assumption of $60-$65.
They also announced a variable dividend per share of $0.84, which assumes an oil price of $85 below the current price of $102.
This results in a total fixed plus variable quarterly dividend of $1.00 per share or $4.00 annually, for a total implied dividend yield of 6.9%. That’s nearly 5 times the S&P 500 dividend yield of 1.44% and nearly 2.5 times the 10-year Treasury yield of 2.82%. It also significantly outperforms the dividend yield of the energy sector as a whole, as well as all other sectors, as shown below.
The company has grown its dividends 40.8% annually over the past five years, and the $4.00 dividend implies a 56% payout ratio.
Aggressive share buybacks
In addition to the big dividend increases, DVN also increased its stock repurchase program by 60% to $1.6 billion. They repurchased $589 million worth of shares last quarter at about $42 per share, leaving $1 billion in repurchases, or 2.6% of all outstanding shares.
Industry leading total cash return
With a 6.9% dividend yield plus 2.6% share buybacks, their total cash return to shareholders this year is likely to be at least 9.5%, which is among the highest in the E&P sector or any other sector. With free cash flow projected to top $5 billion this year, which is over 70% higher than in 2021, the free cash flow yield in 2022 is likely to be at least 13%.
DVN has a very strong balance sheet, with net debt just 0.8 times EBITDA. They plan to bring this down to below 0.5x by the end of 2022. Total debt is 41.8%.
DVN performs very well I’m looking for alphas Factor Grades compared to peers for Growth (“A-“), Profitability (“A”), Momentum (“A”), and Revisions (“A+”), but it performs poorly on Rating (“D”).
When a stock ranks so highly relative to its peers based on its fundamental and technical characteristics, it’s only natural that it ranks lower in the valuation. Furthermore, this valuation is skewed downwards due to DVN’s high profitability. As shown below, DVN performs relatively well (“B” to “B+”) but poorly (“D” through “D+”) for other metrics like Price/Revenue and Price/Book. These other valuation metrics are inflated due to DVN’s high margins and return on equity.
With an EV/EBITDA of 7.64, DVN appears reasonably valued compared to its history over the past decade, as illustrated below.
The main risks for DVN stock are significantly weaker than expected oil, natural gas and NGL prices. The main driver of this risk is how aggressively the Federal Reserve will raise interest rates to try to lower inflation, which is the main risk for any stock that benefits inflation. Fortunately, DVN has very low breakeven levels of $30 for WTI prices and $2.50 for Henry Hub natural gas prices.
Another risk is unexpected regulatory changes that prohibit the development of DVN’s acreage on federal land. Approximately 60% of DVN leases in the Powder River Basin and 55% of leases in the Delaware Basin are on federal land. President Biden had issued a temporary freeze on new drilling permits. However, DVN noted in May 2021 that federal permits were being reissued and had acquired a four-year inventory of such permits based on current drilling tempo.