Devon Energy (DVN 0.17%) has become a big-time dividend stock over the past year. The oil company introduced a fixed-plus variable dividend framework right as oil prices started soaring. That's giving the company the fuel to pay an increasingly bigger dividend.
Devon recently unveiled its latest combined payment, which is 22% above the prior level. That pushed its annualized dividend yield up over 10% at the current stock price. Here's a closer look at Devon's big-time dividend and whether it can continue rising in the future.
Another cash flow gusher
Devon Energy recently reported its second-quarter results. The oil company produced $2.7 billion of operating cash flow in the quarter, more than double what it delivered in the year-ago period, thanks to its rising production and higher oil prices. The company reinvested 22% of those funds into drilling new wells and other capital projects to maintain and grow its production. That left it with $2.1 billion of free cash flow, the highest quarterly total in the oil company's 51-year history.
Devon used that excess cash to further strengthen its balance sheet, repurchase shares, and pay dividends. It added $832 million to its cash balance, ending the quarter with $3.5 billion in cash while reducing its leverage ratio to 0.4 times, well below its 1.0 times target. It also bought back $1.2 billion of stock, reducing its outstanding share count by 4%. Finally, Devon increased its base dividend payment by 13% while boosting the overall dividend outlay by 22% to $1.55 per share for the quarter, pushing its annualized dividend yield at that payment rate into the double digits.
That's more than six times the dividend yield of the S&P 500. It's also more than double the yields paid by dividend-friendly sectors like energy, real estate, and utilities.
Can Devon's dividend continue going higher?
With its latest raise, Devon has increased its total dividend payment every quarter since it launched its fixed-plus variable dividend framework early last year. Devon has increased the fixed portion of that payment twice, boosting it from $0.11 per share each quarter to the current level of $0.18 per share. Meanwhile, the variable dividend payment has grown from $0.19 per share to $1.37 per share.
Devon could continue growing its dividend in the coming quarters. One growth driver is higher oil prices. The company pays out 50% of its excess free cash flow each quarter (calculated after subtracting the base dividend and capital expenses). Thus, if oil prices continue rising, cash flow should keep growing, giving Devon the fuel to increase the variable dividend. However, the converse is also true. If oil prices decline, cash flow could follow, possibly leading Devon to pay a smaller variable dividend in the future.
Another potential dividend fuel is an increase in its variable dividend payout ratio. Several oil companies followed Devon's blueprint and set up similar fixed-plus-variable dividend frameworks with payout ratios of as much as 75% of their free cash flow. Given Devon's minuscule leverage ratio, it could opt to increase its payout ratio to keep growing its dividend if oil prices cool off.
A third way Devon could continue growing the dividend is by making additional accretive acquisitions. The company recently completed its $865 million purchase of assets from RimRock Oil and Gas in the Williston Basin. That deal added to Devon's cash flow, enabling it to increase its base dividend by 13% while also helping support a higher variable dividend. If the company can make similar acquisitions of cash-flowing oil and gas assets, it could have more fuel to grow the dividend.
This big-time dividend could keep growing
Devon Energy has become a big-time income producer this year, thanks to surging oil prices and its variable dividend framework. If oil continues to rise, the payout will follow crude prices higher. Meanwhile, the company has other potential dividend growth drivers even if oil prices cool off.
However, even with all those dividend drivers, there's a risk the payout heads lower in the future if oil prices cool off. So, while the current payout is attractive, income-focused investors need to keep in mind that Devon Energy is a higher-risk, higher-reward dividend stock.