Shares of Devon Energy (DVN 0.19%) have slumped about 35% over the past year. That's largely due to lower oil prices, which affected the company's oil-fueled variable dividend. The variable payout had steadily declined over the past year before rebounding along with oil last quarter.
Devon Energy's dynamic dividend is one way it returns its excess free cash to shareholders. The other way is with share repurchases. The oil company plans to ramp up its repurchase rate next year to capitalize on the incredible bargain it sees in its shares.
A dirt cheap oil stock
Devon recently provided its preliminary outlook for 2024. The company plans to trim its capital spending by about 10% and keep its production rate flat. It estimates that this capital plan will enable it to produce 20% more free cash flow in 2024, assuming oil averages around $80 a barrel (a little higher than the current price in the upper $70s).
The company estimates it can produce about $3.2 billion in free cash flow (FCF) next year at that $80 price. This number implies Devon trades at about an 11% FCF yield at its current share price. That makes its stock significantly cheaper than the broader market indexes:
Image source: Devon Energy.
CEO Rick Muncrief highlighted the company's valuation on the recent third-quarter earnings conference call, saying, "With this strong outlook, that translates into a uniquely attractive free-cash-flow yield of 11%, which is up to three times higher than what the broader equity markets can offer." Devon's shares trade at more than a 50% discount to the S&P 500 and are even cheaper than the Nasdaq.
Returning its gusher to investors
The company plans to return the bulk of its FCF to investors next year. Muncrief said on the call, "With the stream of free cash flow, as we've done in the past, we plan to target a cash return payout of around 70%, which is in line with our average annual payout to shareholders since we unveiled this industry-first model in 2020."
He said that the company will continue sending shareholders most of its FCF. It intends to use the remaining 30% to strengthen its already-elite balance sheet by retiring debt as it matures and building up its cash position.
However, its priorities for allocating excess FCF will shift a little, Muncrief said: "A key priority heading into next year is to continue to grow our fixed dividend. We believe the certainty that comes with a fixed dividend is valued by shareholders and is better capitalized within our equity price, especially if the yield is competitive with that of the broader markets."
The company has steadily increased that base payout over the last few years, providing investors with a higher income floor.
Muncrief added: "With the remainder of our free cash flow, we will stay flexible as we always have been by judiciously allocating toward the best opportunities, whether that be increased stock buybacks, variable dividends, or taking additional steps to improve our balance sheet. However, given our current stock price, we expect to pursue buybacks at a level that will most likely result in our variable payout being below the 50% threshold in the near term to capture the incredible value our equity offers at these trading levels."
This statement represents a slight change to the company's capital allocation strategy. It had targeted paying up to 50% of its excess FCF after its base-dividend payout in variable dividends. But given the current bargain in its share price, the company plans to use more of its FCF to repurchase shares.
Devon has about $900 million remaining on its $3 billion repurchase authorization. The prior repurchases have already reduced its outstanding shares by 6%. Given its current share price, it could retire 9% of its outstanding shares by completing the program.
A bargain too good to pass up
Devon Energy expects to generate a lot of cash next year, and with its stock at a significant discount, it is shifting from emphasizing variable dividends to increased share buybacks. That plan could create more value for shareholders over the long run.
