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DEVON ENERGY CORPORATION
STUDENT MANAGED FUND
4 DECEMBER 2014
BEN KERLEY. OLUWANAYOWA AKINDELE,
SIMON URIBE, TAYLOR NIELSEN
DEVON ENERGY (NYSE:DVN)
Ticker: DVN (NYSE)
Industry: Oil, Gas & Consumable Fuels
Current Price: 59.38
Recommendation: Not Buy
DVN STOCK PRICE
Company Devon Energy Corp.
Price and Market Info
Current Price 59.38
52-week high 80.63
52 week low 53.34
Market Cap 24,309
Shares Out 409.1
Daily Volume 19.69
Accounting, Ratio, and Multiples Info
Current Ratio 1.2
Profit Margin 28.76
We are placing a do not buy position on
Devon Energy. We believe the stock to be
currently overvalued using our set
valuation techniques. The massive
increase in the crude oil supply has taken
a toll on oil prices and we feel that the
timing is not right to invest in a company
such as Devon Energy. With the recent
meeting with OPEC it seems that oil prices
are going to continue to drop until a point
that it will unprofitable for US O&G
companies. Although Devon Energy is a
great company, we feel like it would not be
a wise investment for the SMF portfolio
due to the volatility of the current O&G
Devon is a leading independent energy company focused in the exploration, production, and
development of oil, gas, and natural gas liquids. The firm was founded in 1971 and went
public in 1988. Devon has 5,900 employees and is headquartered in Oklahoma City,
Oklahoma. Currently, Devon’s predominant oil and gas plays are on-shore positions in the
United States and Canada. DVN produces ~2.4 billion cubic feet of natural gas a day, which
exceeds 2% of the total gas consumed in North America in a year. While predominantly
focusing on E&P, DVN also owns majority interests in natural gas pipelines, plants, and
treatment facilities, making them one of the largest processors of natural gas in America1.
A SHIFT TO OIL E&P
Since 2008, Devon has doubled their North American production and begun to focus more on
E&P in oil in North America, particularly light, sweet crude. This shift towards oil production
is largely attributable to their acquisition of GeoSouthern Energy.
GeoSouthern Energy Acquisition
On November 20, 2013, Devon acquired GeoSouthern Energy’s assets in the Eagle Ford for
$6 billion in cash. Geosouthern was acquired at ~7x 2013 EBITDA and 2.5x 2015E EBITDA.
The deal was immediately accretive to debt-adjusted cash flow per share. Post-acquisition,
GeoSouthern will account for ~25% CAGR of DVN’s oil production and includes a current
portfolio production of 53,000 barrels of oil equivalent per day.
1 DVN 10-K, p. 3
Devon has focused on divesting their non-core North American assets. On June 30, 2014,
DVN announced a $2.3B sale of non-core oil and gas properties, at a trading multiple of 7x
EBITDA. This sale, combined with a divestiture of DVN’s Canadian conventional gas
business at 7x EBITDA, DVN has a non-core asset divestiture programs totaling >$5B.
EnLink Midstream Venture:
In March of 2014, Devon combined all of their midstream assets with tCrosstex Energy and
formed a general partner entity and a master limited partnership under the names of EnLink
Midstream, LLC and EnLink Midstream Partners, LP, respectively (collectively “EnLink
EnLink’s assets are located in the top O&G plays in N.A. including the Barnett Shale, Permian
Basin, Cana and Arkoma Woodford, Eagle Ford, Haynesville, Gulf Coast, Utica, & Marcellus
Through the acquisition of a primary position in the Eagle Ford and Permian Basin, non-core
asset divestitures, and the consolidation of midstream assets, Devon has aggressively
transformed their onshore portfolio with a focus on crude production.2
2 DVN 10-K, p.4
A CLOSER LOOK AT DVN’S O&G POSITIONS
Source: Devon investor presentation with BAML, slide 4
Source: Devon investor presentation with BAML, slide 8
This basin is located in Oklahoma (Canadian, Blaine, Caddo, & Dewey Counties) and is a non-
conventional reservoir that produces natural gas, NGLs, and condensate. Devon is the largest
leaseholder in this region. In 2013, DVN increased production by 14% and have several thousand
undrilled locations. In 2014, DVN expects to drill 95 wells in the Anadarko Basin
This region is located in Texas (Denton, Johnson, Parker, Tarrant and Wise Counties) and is a
non-conventional reservoir producing natural gas, NGLs, and condensate. DVN Acquired a
position in Barnett in 2002, and is one of their top producing fields in N.A. Devon also maintains
midstream pipeline assets here as well and plans to drill 80 more wells in 2014
The Mississippian-Woodford is located in Northern Oklahoma and Southern Kansas and is
currently being explored with joint venture, Sinopec. DVN plans to drill 230 wells here in 2014.
The Permian is located in various counties in Texas and Southeast New Mexico and is focused on
exploration and low risk-development opportunities. DVN became a major player in the Permian
through their joint venture opportunity with Sumitomo in 2012, which gave DVN access to ~650K
acres in the Cline, Midland, and Wolfcamp shale areas. The Permian consists of conventional and
non-conventional reservoirs of oil and NGLs. DVN plans to drill 350 wells in 2014
The Rockies Oil region is located in Wyoming and DVN has ~150,000 net acres in which they
have identified ~600 risked locations across formations. DVN plans to drill 25 wells in Powder
River Basin in 2014.
Canadian Heavy Oil:
Devon is the first and only independent provider to operate the bitumen oil sands in Canada. Devon
has two key projects in this region, the Jackfish and Pike Projects in Alberta, Canada. The Jackfish
project is a heavy oil project in non-conventional oil sands and Devon increased production by 8%
in 2013. Currently, the Pike Project has no proven reserves and is undeveloped.3
Source: Devon Q3 Slide deck
DVN achieved record oil production. DVN increased 2014 production outlook by 300 basis
points from 11% to 14% with no changes in capital spending profile.
Improved margins and profitability. DVN exceeded Street estimates by $0.10 with pre-tax cash
margins expanding 20% Y/Y
DVN finished their non-core asset divestiture program. On August 28, DVN closed a $2.3B
sale on non-core American assets, which concluded their year-long non-core divestitures in North
3 DVN 10-K, p.5-7
4 DVN Q3 FactSet Earnings Call transcript, p.3
The oil and gas production industry is composed of two different segments, the production
of crude oil and natural gas.
Natural gas accounts for 25.6%
of industry revenue while
crude oil brings in 74.4%.
Although the industry is a very
mature one, during the past
five years since the recession,
the O&G production industry has been booming, growing at an average rate of 12.8%.
Through the year 2019, the industry revenue is expected to increase at an average rate of
2.4%. The main key economics drivers of the industry are world price of crude oil and natural
gas, as well as consumer demand for those products. 5
O&G companies here in the United States have been benefitting from advances in technology
and new techniques in regards to extracting natural resources. They have been able to
accomplish more efficient
way of obtain said resources.
O&G production and
extraction is very competitive and companies require massive amount of capital to sustain
themselves, so the barriers to entry are very high. The concentration of the O&G industry is
5 IBIS World, US Industry reports, Oil Drilling & Gas Extraction
very low, but there are a few major players. Those would be BP PLC, Chevron Corporation,
ConocoPhillips and ExxonMobil Corporation with 6.1%, 6.6% & 7.7% & 4.5%, respectively
of the market share. Devon currently has 2.0% market share, while the rest of the market is
fragmented among other smaller players. As economies around the world continue to grow,
emerging economies are expected to grow their infrastructure and their citizens will
increase their consumption of oil & gas products6.
OIL & NATURAL GAS PRODUCTION BOOM & DROP IN PRICE
The exponential growth of production here domestically has caused a drastic drop in the
price per barrel of crude oil, and with technology advances, it seems that the price will
continue to drop if there isn’t interference from OPEC. OPEC, the Organization of the
Petroleum Exporting Countries, is an intergovernmental organization whose objective is to
6 IBIS World, US Industry reports, Oil Drilling & Gas Extraction
co-ordinate and unify petroleum policies among members in the organization in order to
secure fair and stable prices for petroleum producers7.
Source: Factset, Markets Tab, Commodities Sub Tab
Crude oil prices per barrel have experienced an -31.54% YTD, while natural gas has gone
through a -15.87% change8. The unprecedented boom in oil has been fueled by the discovery
and extraction of oil in regions in the United States such as the Bakken Formation, Eagle Ford
Shale, and the Permian Basin. The graph above clearly illustrates how the recent boom in oil
production in the United States has affected the global price of crude oil per barrel. According
to the U.S. Energy Information Administration, 8,864 (thousand barrels per day) were
produced in the month of September 2014 compared to that of 5,609 in September 20109.
DEVON’S RISK WITH OIL
According to Devon’s Q3 report, over the past 12 months Devon’s oil production has
grown by 75.45% while its natural gas production has decrease by 22.21%. As you can see in these
two graphs, Devon has
clearly been attempting
to move itself heavily
into the Oil Industry.
With their many recent
acquisitions in the U.S. and Canada, Devon expected oil prices to increase for the next few years.
7 Opec, Brief History
8 DVN FactSet, Industry Tab
Q3 '13 Q4 '13 Q1 '14 Q2 '14 Q3 '14
DVN Oil Production
Unfortunately, it looks as if this move was executed at the wrong time. The world is witnessing a
historic drop in oil prices primarily due to decreased demand in Asia and Europe and increased
supply in the U.S.,
Canada, and Russia.
Right now the price
of crude oil is
around $70/barrel, down from over $110/barrel a few months ago. The decrease in prices has
forced Devon and the entire industry to take a huge hit in revenues. While Devon was expecting
oil prices to drop to around $90/barrel, the increased drop to $70/barrel is expected to take a
dramatic toll on the company. 10
OPEC’S STANDOFF WITH THE U.S.
With Saudi Arabia led OPEC’s massive influence
over world oil prices, it was expected that it would
reduce their amount of oil in the markets, to increase
prices back to normal levels. However, their meeting
on November 27 in Vienna solved nothing, and as
you can see in the graphic to the left, oil prices have
remained on the decline ever since. The cartel used
history in their decision. When the prices fell in 1980 Saudi Arabia decreased production in order
10 Plumber, Brad. Vox
Q3 '13 Q4 '13 Q1 '14 Q2 '14 Q3 '14
DVN Natural Gas Production
to increase prices, but the prices continued to decrease for some time, and the country lost giant
shares of the market. Knowing this, Saudi Arabia planned for it to happen again and announced
that they can survive this decline in prices for a little while longer. OPEC is hoping that the North
American production will turn unprofitable and shut down. They plan to do this by decreasing
prices even further in a price war with the U.S. OPEC knows it is much more expensive to extract
oil from place in the Middle East than in the U.S., so they plan to wait and see if the low revenues
that U.S. companies will face in the coming months will turn them into unprofitable busts. 11 12
Discounted Cash Flow
An average of the sales growth in oil and gas and natural gas liquids for the last three
quarters was used as the forecast Q4 sales growth. Given that most of the fiscal year has already
pass, relying on the consolidated performance of the company year to date can provide accuracy
to estimates. Consequently, most pro forma estimates were done by multiplying the calculated
fourth quarter growth (24.06%) by the consolidated Q4 2013 results and then adding this to the
numbers released for the first three quarters of the year. For 2014 a 2% sales growth rate was
assumed considering the industry outlook, appendix D forecasts and Factset estimates (Appendix
11 Dvn Q3, Quarterly Results, Historical Production
12 Lastest Price & Chart for Crude Oil Brent – Source: Nasdaq, Crude Oil Brent
FCF and Capital Expenditures
Fixed capital investment for the year was assumed to be equal to the capital expenditure
thru Q3 adjusted for depreciation expense given that no significant changes in capital expenditures
are likely to happen according to management guidance. Furthermore, free cash flow to the firm
will be $-9.26 million for 2014, which is in line with the lower end management predictions and
Factset estimates. In 2015 the company will be able to capitalize on its sales growth and core asset
operations to generate a positive free cash flows to the firm of $340.87. Capital expenditures will
remain at similar levels in 2015; as stated, Devon is shifting its focus to highest rate of return areas,
so while investments in some zones like the Midland Basin will see less investment, other
emerging reservoirs will see higher capital expenditures, but in general the budget will remain at
CAPM and DCF Model
For the discounted cash flow model a WACC of 6.58% was use to find the implied stock
price of the firm. The model allocates a weight of almost 70% to the cost of equity and this is good
as it allows to consider the systematic risk and volatility of the stock by using a CAPM approach.
The cost of equity (CAPM) was found by using the 52 week average beta of 1.13 and by using the
current yield on a 10-year Treasury of 2.34%14
. The cost of debt was found by choosing the highest
(conservative) yield to maturity of a 30 year bond issued by the firm15
. Additionally, a 46% tax
rate (actual Devon’s LTM rate) was factored in the analysis16
. This high rate is in line with high
industry tax rates between 40% -50%17
. Moreover, a multiphase H-model was considered suitable
given the current situation of the firm. Devon is experiencing huge sales growth in 2014 that will
13 DVN Q3 FactSet Earnings Call transcript, p.5-7 & 13
14 DVN FactSet, Company snapshot ; Yahoo Finance, Bond Center
15 Yahoo Finance, Bond Center, Devon
16 DVN FactSet, Financials, Income Statement
17 IBIS World, US Industry reports, Oil Drilling & Gas Extraction
hit the rate of 74% according to current performance and last quarter estimates, but those rates are
expected to plummet in the course of one year to 2%18
. Consequently, the long term growth
perspective of the firm will be determined by a mix of industry, firm and economic growth at
around 3.5%. Although sales will be at around 2.5%, improving efficiency and high margins will
drive company’s growth.
In order to compare the results obtained through the discounted cash flow model, a valuation
analysis using the Gordon growth model was done. Dividends per share forecasted for 2015 in the
pro forma analysis were used as an input in the model. Dividend growth was assume to be the last
5 year average growth in dividends of the firm equal to 6.318%19
. The stable performance in the
last five years is representative of the expected long-term performance of Devon. Lastly, the
CAPM cost of equity approach was use with the same inputs utilize for the portion of the WACC
model regarding the cost of equity (CAPM).
Results for both the DCF and Gordon Growth model reveal that the firm is considerably
overvalued and there is a downward potential risk of around 45%.
18 DVN FactSet, Financials, Income Statement & Estimates
19 DVN FactSet, Financials, Income Statement
Actual Price Implied
Super Growth Rate Assumption
38.15 53.47% 62.90% 74.00% 85.10% 97.87%
7.96% 23.40 24.54 25.88 27.22 28.76
7.24% 28.17 29.55 31.17 32.80 34.66
6.58% 34.46 36.16 38.15 40.14 42.43
5.92% 44.17 46.36 48.92 51.49 54.44
5.33% 58.89 61.81 65.25 68.68 72.63
The discounted cash flow model sensitivity analysis shows that the probability of a downward
movement of the stock price is high. Only a decrease in the cost of equity will bring the price of
the stock above current market price which is unlikely to occur given the volatility of the market;
if anything cost of equity will rise. A similar situation occurs with the Gordon growth model, only
a lower cost of equity combined with a high stable growth will lead to a higher stock price.
Although the Gordon Growth model shows more upside potential compare to the DCF, it still
reveals that the stock is overvalued.
A relative valuation and terminal value multiples analysis was done in order to compare
Devon with some of its closest
competitors. As seen an
Appendix I, the implied value
of the stock is excessively over
the actual price. We believe
that this is a result of
fundamental differences between competitors and it does not take into account many of the market
factors that are currently affecting the firm. We decided to rely more on the DCF and Gordon
Growth analysis which factors in some of the issues that are currently impacting Devon.
Actual Stock Price Implied Stock PriceOver/ Under
Price/Earnings (x) 64.07 94.69 Undervalued
NTM P/E (x) 64.07 97.23 Undervalued
Price/Sales (x) 64.07 146.18 Undervalued
Price/Book Value (x) 64.07 155.18 Undervalued
Actual EV Implied EV Over/Under
Enterprise Value/EBITDA (x)39454 54110.05 Undervalued
"Commodities: Latest Crude Oil Brent Price & Chart." NASDAQ.com. N.p., n.d. Web. 04 Dec. 2014.
Plumber, Brad. "Oil Prices Keep Plummeting as OPEC Starts a Price War with the US." Vox. N.p., 28 Nov. 2014.
Web. 02 Dec. 2014. <http://www.vox.com/2014/11/28/7302827/oil-prices-opec>.
Web. 5 Dec. 2014. <http://clients1.ibisworld.com/reports/us/industry/default.aspx?entid=103>.
"Brief History." OPEC. Web. 5 Dec. 2014. <http://www.opec.org/opec_web/en/about_us/24.htm>.
Web. 5 Dec. 2014. <http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=M>.
Devon Q3 FactSet Earnings Call transcript
Investors Presentation, Bank of America Global Energy Conference. Nov 14, 2014. Web. 01.Dec.2014