Oil prices have fallen hard off their highs notched in late September. Despite ongoing conflicts in the Middle East, the fundamental supply-demand balance is not all that bullish given record-high U.S. oil production and easing demand for some refined products. West Texas Intermediate is now near $80 while Henry Hub natural gas is in the mid-$3s β rather cheap for this time of year as the U.S. winter heating season gets underway.
Despite macro challenges and technical risks, I have an overweight rating on Devon Energy Corp. (DVN, Financial). The stock features a low valuation, strong dividend yield and impressive free cash flow, though the technical situation, which I will detail, is less than sanguine ahead of third-quarter earnings.
Oil Prices Dip From Third-Quarter Highs
Company description
According to Bank of America Global Research, Devon is an independent oil and gas exploration and production company with significant assets across key shale regions of the CONUS. It drills for oil, natural gas and natural gas liquids with fourth-quarter 2022 daily production of approximately 315,000 barrels of oil and 150,000 barrels of natural gas liquids, and more than 1 billion cubic feet of natural gas. Assets are in the following areas: Delaware, Anadarko, Williston, Eagle Ford and Powder River Basin.
Key data
The Oklahoma-based $30.3 billion market cap oil and gas exploration and production company within the energy sector trades at a low 6.5 trailing 12-month GAAP price-earnings ratio and pays a fixed and variable dividend, currently at a 7.3% forward yield, according to GuruFocus. Ahead of earnings, which come out on Tuesday night, the stock had a moderate 38% implied volatility percentage and a short interest of just 1.8%.
Earnings review
Back in August, Devon reported second-quarter results that were generally in line with expectations. Adjusted earnings per share verified at $1.18 while higher oil production and operational efficiencies helped the company hit the upper end of its target production range. Free cash flow summed to $527 million in the face of ongoing OPEC+ production target cuts. The management team maintained its full-year capital expenditure plans and appears committed to returning capital to shareholders β GuruFocus lists the total shareholder yield near 13%.
A pair of key megadeals has helped support sentiment among small and medium-sized exploration and production companies, though there may not be much dry powder for the major integrateds to go after a large cap like Devon. Still, analysts at BMO Capital list Devon as an S&P 500 high-yield name that is expected to outperform over the next 12 months.
Valuation and dividends
On valuation, analysts at Bank of America see earnings have fallen sharply in 2023, but per-share profits are expected to snap back in 2024 with an earnings per share growth rate acceleration by 2025. The consensus forecast currently calls for close to $6 in earnings per share next year, though sales growth may not be all that impressive.
Still, dividends are expected to climb significantly over the coming quarters. With a current forward operating earnings multiple near 8, the stock trades significantly cheaper than the energy sector average and the S&P 500's average. Moreover, Devon is expected to produce strong free cash flow per share over the next 12 months, resulting in a free cash flow yield close to 10% using out-year estimates.
If we assume normalized earnings per share of $6 and apply the stock's five-year average forward operating price-earnings multiple, then shares should be near $72, putting it significantly undervalued today. Key risks include lower oil prices and natural gas liquids prices as well as a further de-rating of the cheaply priced energy sector. A possible upside catalyst is ongoing merger and acquisition activity in the oil patch.
Devon: Earnings, Valuation, Dividend, Free Cash Flow Forecasts
Looking ahead, corporate event data provided by Wall Street Horizon show a confirmed third-quarter earnings date of Nov. 7 with a conference call the following morning. You can listen live here. No other volatility catalysts are seen on the calendar.
Corporate Event Risk Calendar
The technical take
With a favorable valuation and strong free cash flow ahead of what should be an important earnings report and outlook, the chart warrants some caution. Notice in the graph below that shares broke down from an ascending triangle pattern back in September. The stock broke to fresh lows not seen since early 2022 before oil prices ticked up in the wake of the attacks on Israel a month ago. I see possible downside to the low to mid-$30s based on an air pocket of volume in that zone β there is a small price gap from September 2021 that could be filled, too.
I would like to see Devon rally through the mid-$50s to help support the case for a reversal of what has been a bearish downtrend since shares put in a double top from the second quarter to fourth quarter last year. Also take a look at the long-term 200-day moving average β it is in a bearish downtrend, and the stock met selling pressure on a test of that late trendline indicator on an upward thrust two months ago. So a rally above $51 to $52 would also help the bulls' cause. But with a high amount of volume by price in the $45 to $55 area, it could be tough slogging for those long shares given that significant overhead supply in play.
Overall, it is a troubled chart, and risk management must be applied ahead of and through the upcoming earnings release.
DVN: Shares Remain Under key Resistance, Mid-$30s Long-term Support 
The bottom line
I have an overweight rating on Devon. I see the stock as cheap given its robust free cash flow and profitability, but the chart leaves something to be desired ahead of its earnings report.
