Devon Energy: The Best Stock for a High-Inflation Environment (NYSE :DVN).

Summary

We believe Devon Energy Corporation (NYSE:DVNIf you want to make a profit in a high inflation environment, ) is the best stock to invest in. Their exposure to rising oil prices and high growth rate are some of the reasons.They are able to profit from their low break-even cost structure, and their unique focus of returning their rapidly growing free cash flow at a higher rate than their industry peers. DVN is the industry with the highest inflation rate. They offer the best combination of high rewards and low risk due to their high dividend yield and profit growth.

Devon’s Business

Devon Energy Corporation (“NGL”) is an independent energy company that focuses on the exploration, development, and production of oil and natural gas in the United States. The company’s operations are concentrated in four oil producing areas, including the Delaware Basin, Eagle Ford and Powder River Basin. Their commodity exposure is 50% oil and 25% natural gas. It operates more than 5100 wells, and is headquartered Oklahoma City, OK.

Inflation is a major profit for the oil and gas industry

The oil and gas industry is the best industry to invest when you are experiencing high inflation like we are. The best sector to invest is the exploration & production (“E&P”) segment. As you can see, the correlation between percentage changes in consumer prices inflation (blue) and oil prices is strong. Rising oil prices are the main reason for high inflation.

The crude oil prices for West Texas Intermediate (“WTI”) are at $102, which is the highest they’ve been in eight years. As shown below, oil prices relative the US GDP are still at historically low levels. This suggests that oil prices could rise significantly in the future, especially if inflation expectations remain high.

The Federal Reserve increased the money supply by 40% and the Russia-Ukraine war have both helped the energy industry rebound strongly from the covid collapse of 2020. The International Energy Agency predicts that oil demand will exceed 2019 levels due to strong global economic growth. Due to 25% lower energy industry capital expenditures than 2019, there is a favorable supply/demand imbalance which should lead to higher oil prices this year.

Rapid Growth in Earnings

DVN expects to increase revenues by 21% and EPS by 128% this year. Stocks tend to follow earnings so DVN stock will continue to perform well, with earnings expected to more than double this year. As shown below DVN has a strong record of exceeding EPS expectations and earnings growth should be rapid in the upcoming quarterly.

DVN gets an A+ Looking for AlphaRating on earnings revisions: All 25 recent earnings revisions for this calendar year were higher. They clearly have strong momentum in their business.

Industry Leaders in Profitability

DVN is a highly efficient and disciplined capital manager. Their profitability is significantly higher than their industry peers in most metrics, as shown below. EBITDA margins of 42% nearly double the sector median at 24%, Return on Total Capital of 17.5% more than three times the sector median at 4.7%, and Net Income per Employee of $1.76million is almost 24 times greater than the sector median at $73,490. DVN’s high profitability enables them generate strong excess cash flows to return shareholders.

Industry Leading Dividends

DVN has been paying dividends for the last 29 years. They pay a fixed quarterly and variable quarterly dividends, plus a portion of excess cash flow up to 50%.

DVN raised their quarterly fixed share dividend per share by 45%, or $0.64 per year, in their mid-February earnings reports. This implies a fixed dividend yield of 1.1%. This fixed dividend is very secure as it is based upon a fixed dividend payout ratio only 5-10%, and an extremely low $60-$65 crude oil price assumption.

They also announced a variable dividend per shares of $0.84. This assumes an oil price of $85, which is below the current $102 price.

This results in a total fixed-plus-variable quarterly dividend per share of $1.00 or $4.00 annually. This gives an implied dividend yield totalling 6.9%. This yield is nearly 5x higher than the S&P 500 yield of 1.44%, and almost 2.5x higher than that of the 10-Year Treasury of 2.82%. It is also significantly higher than the overall Energy sector’s dividend yield of 1.44% and nearly 2.5 times higher than all other sectors as shown below.

Over the past five years, dividends have grown at a rate of 40.8% per year. The $4.00 dividend implies a 56% payout rate.

Buybacks of aggressive shares

DVN increased their dividends by 60% and raised their share buyback program to $1.6 billion. They purchased back $589 million stock at $42 per share. This leaves $1 billion worth of buybacks, or 2.6% of the total shares outstanding.

Industry leading Total Cash Return

Their total cash return to shareholders in 2018 will likely be at least 9.5%. This is a record for the E&P sector and any other sector. The 2022 free-cash flow yield will be at least 13 percent, with $5 billion of cash flow this year, more than 70% higher that in 2021.

Strong Balance Sheet

DVN has a strong balance sheet with net debt to EBITDA at only 0.8 times. They plan on reducing that to less than 0.5 times by 2022. The total debt to capital is 41.8%.

Reasonable Valuation

DVN scores very well on Seeking AlphaFactor Grades relative with peers for Growth (“A -“), Rentability (“A”), Momentum (“A”), and Revisions (“A +”), however it scores poorly on Valuation (“D”).

It is only natural for a stock to be lower in valuation if it ranks so high on technical and fundamental characteristics relative to peers. DVN’s high profitability also makes this grade biased downward. As shown below, DVN scores well (B to B+) on profit-based metrics like P/E GAAP FWD, EV/EBITDA, and EV/EBITDA, but poorly (D to D+) on other metrics like Price/Sales or Price/Book. These other valuation metrics are inflated by DVN’s high margins.

DVN’s EV/EBITDA value of 7.64 times seems reasonable in light of its history over the past ten years, as shown below.

Key Risks

The key risks to DVN stock’s stock are the significantly lower-than expected oil, natural gas, and NGL prices. The Federal Reserve’s aggressiveness in raising interest rates to lower inflation is the main driver of this risk. This is a major risk for any stock which benefits from inflation. DVN has very low breakeven points of $30 for WTI prices, and $2.50 Henry hub natural gas prices.

Unexpected regulatory changes could also pose a risk, as they may prohibit DVN from developing acreage on Federal lands. Approximately 60% of DVN’s Powder River Basin leases, and 55% of its Delaware Basin leasings, are located on Federal land. President Biden had temporarily halted new drilling permits. DVN, however, noted that Federal permits were being renewed and it had a four-year supply based on the current pace of drilling.