This week was a rough one for U.S. oil and gas giant Devon Energy (DVN 0.78%). Shares of the fast-growing shale driller tumbled on Wednesday after its fourth-quarter results missed the mark, falling nearly 12% for the week. That pushed the oil stock down more than 25% for the year.
However, while the value of the stock has declined, the value-creating potential of the company has only increased given the growth it has in the forecast. Because of that, shares look like an even more incredible bargain after getting marked down again this week.
Devon Energy's stock might be down now, but the recovery looks to be just ahead. Image source: Getty Images.
Looking past the headlines
Two related factors drove Devon Energy's sell-off this week. The intertwined issue was that core earnings only came in at $0.38 per share, which was a stunning $0.25 per share below expectations because oil production came in a surprising 14,000 barrels per day below the midpoint of Devon's guidance. However, while the big miss on those two metrics made the headlines, there was more to the story.
The primary problem was that 50 wells drilled by Devon's partners didn't come online in the fourthquarter as expected, which pushed their production into early 2018. Meanwhile, Devon had to complete some unplanned maintenance at its Jackfish oil sands facility in Canada, which forced it to curtail some output in the quarter. However, both problems were just temporary setbacks.
The miss on those headlines numbers caused the market to overlook the fact that Devon Energy still turned in an excellent year. For starters, the company delivered the best well productivity in its 46-year history. Those strong well results, when combined with falling costs and higher oil prices fueled a jaw-dropping 94% surge in cash flow from operations, with the oil producer pulling in $2.9 billion last year. Add in the $2.7 billion in cash it has on the balance sheet, with no debt due until the middle of 2021, and Devon has a rock-solid balance sheet.
The gusher is coming. Image source: Getty Images.
The upcoming gusher of cash flow
Devon's success in 2017 sets it up to deliver gaudy growth in the coming years. The company's current three-year plan will see it increase its oil production in the U.S. by a mid-teens compound annual rate through 2020. That growth should fuel a more than 15% compound annual growth rate in cash flow at $50 oil. That said, at the current $60 oil price, the company is on pace to produce enough money to finance that high-return drilling program and generate a gaudy $2.5 billion in free cash flow over the next three years. Add in the cash the company already has on the balance sheet along with the potential to sell up to $5 billion in non-strategic assets, and Devon Energy has upwards of $10 billion at its disposal over the next three years to allocate in creating value for shareholders. For a $28.5 billion company, that's a boatload of cash.
In the near term, Devon plans to use up to $1.5 billion of its cash on hand to reduce debt further, pushing its leverage ratio even closer to the industry leaderboard. After that debt repayment, the company intends on returning future excess cash to investors through share buybacks and dividend growth.
Those cash returns could be the catalyst that turns Devon's sinking stock around since that's what similar strategies have done for peers. U.S. oil giant ConocoPhillips (COP 1.23%), for example, unveiled a plan in late 2016 to sell non-core assets so it could repurchase $3 billion of its stock. The company would go on to sell more assets than expected, which, along with improving oil prices, gave it additional cash to repurchase shares, with it now on pace to buy back $7.5 billion in stock by 2020. What's worth noting is that since announcing this plan, ConocoPhillips' stock has risen more than 25%. For comparison's sake, the average oil stock is down 4% over that timeframe, while Devon's has plunged 29%.
We've seen similar outperformance by Anadarko Petroleum (APC) after deciding to use some of its cash to repurchase $2.5 billion in shares last fall. Since that announcement, Anadarko's stock has rallied nearly 22%, while most rivals are up less than 2%, and Devon's stock price has slumped 13%. Meanwhile, Anadarko added another $500 million to that plan this year thanks to its growing cash flow, which could add more fuel to keep its stock running higher.
Too cheap to ignore given the catalyst coming down the pipeline
After selling off again this week, investors marked Devon Energy down as if it were broken merchandise. However, that's clearly not the case since this oil stock is on pace to grow cash flow at a significant rate over the next few years, which will give it a substantial amount of free cash to repurchase its dirt-cheap stock. Given that forecast, bargain hunters could potentially scoop up a real gem.
