Devon Energy’s Future Looks Brighter Than Ever After Deal With LINN Energy

Following the sale of its remaining noncore assets to LINN Energy, Devon Energy is poised for strong growth in oil production, earnings, and cash flow.

Jul 1, 2014 at 10:00AM

Devon Energy (NYSE:DVN), the Oklahoma City-based independent oil and gas producer, just announced a transformative transaction that essentially marks the end of its asset sale program. Let's take a closer look at the deal's details and why it bodes well for Devon going forward.

Devon Energy Permian Basin

Photo credit: Devon Energy

Devon to sell remaining noncore assets
Devon announced on Monday that it will sell all of its noncore U.S. oil and gas assets to LINN Energy (NASDAQ:LINE) and LinnCo (NASDAQ:LNCO), a limited liability company that owns units in Linn, for $2.3 billion, or roughly $1.8 billion after tax. The assets, which are located in the Rockies, onshore Gulf Coast, and Mid-Continent regions, had been previously identified as candidates for divestiture.

The assets are currently producing 275 million cubic feet of gas equivalent per day, of which approximately 80% is natural gas. They had proved reserves totaling 1.242 trillion cubic feet of gas equivalent at year-end 2013 and generated $350 million in EBITDA last year. With the move, expected to close in the third quarter of this year, Devon has essentially completed its portfolio transformation.

Good transaction metrics
From a valuation perspective, it looks like Devon received a very fair price for the assets, which will go for roughly 6.6x 2013 EBITDA (5.1x after-tax) and will bring in $1.8 billion in after-tax proceeds, which is significantly higher than the high-end range of $1.2-$1.4 billion Wall Street analysts were expecting.

I think the reason for this is because LINN Energy is willing to pay more for gas-rich assets right now than other companies because, as a publicly traded limited liability company with partnership tax status that hedges its production out for several years, it takes a much longer-term view on its assets.

Due to LINN's MLP-like corporate structure, it is required to pay out the lion's share of its cash flow to investors through regular distributions and therefore tends to seek out long-lived assets with low decline rates that can provide consistent growth. This makes Devon's properties, which are relatively mature, low-decline assets that produce at steady rates, a perfect fit for LINN's unique business model.

Debt reduction and focus on liquids
In addition to better-than-expected transaction metrics, Devon's sale will help further reduce its debt and allow it to focus on its most lucrative, liquids-rich opportunities. In combination with other recent asset sales, Devon expects to reduce its net debt by more than $4 billion this year, which will further bolster its already fortress-like balance sheet and help maintain its investment-grade credit ratings.

With Devon's portfolio transformation now complete, the company is free to accelerate its oil and liquids production growth. Since liquids production is currently much more profitable than dry gas production, this should continue to boost margins and cash flow. For instance, stronger oil production growth in the first quarter helped boost operating margins and operating cash flow by 54% and 41% year over year, respectively.

This year, Devon plans to direct the largest portions of its $4.8-$5.2 billion capital budget toward the Eagle Ford shale and Delaware Basin, which should drive oil production growth in excess of 20%. It will also result in a much more liquids-weighted production mix, with liquids expected to account for nearly 60% of the company's production by year-end.

Looking beyond this year, Devon's Eagle Ford, Delaware Basin, and Canadian oil sands assets should deliver double-digit oil production growth for years to come. Due to the strong economics of these assets, they are expected to generate significant free cash flow after 2015, which will give Devon even greater financial flexibility to pursue additional liquids-rich acquisitions and return cash to shareholders.

Investor takeaway
With the sale of its remaining noncore properties to LINN Energy, Devon has completed its portfolio transformation process. Not only was the transaction negotiated at a favorable price, but it will also help reduce Devon's debt and allow it to focus on its most lucrative opportunities that should drive significant growth in oil production, earnings, and cash flow for years to come.

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Arjun Sreekumar owns shares of Devon Energy. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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