Crude oil prices have bounced around quite a bit this year. They were recently around $75 per barrel, which is about 5% higher than they began the year. It's a great price point for most oil companies, which can produce a lot of cash at that level.
That's certainly the case with Devon Energy(NYSE: DVN). It can produce a gusher of free cash flow at the current price point. Despite that, the oil stock trades at a bottom-of-the-barrel valuation (even more so after factoring in a highly accretive acquisition it's working to close). Because of that, it's an incredible bargain these days for those seeking a value play in the oil patch. It also offers an attractive income stream (4% forward dividend yield at its most recent combined payment).
A free-cash-flow machine
Devon Energy has worked tirelessly over the years to build a low-cost, U.S.-focused oil and gas producer. That strategy has paid dividends in more recent years. Devon has grown into one of the country's largest onshore producers with a very low-cost resource base. Its crown jewel asset is the Delaware Basin, which has a break-even level of around $40 a barrel.
Devon's low costs enable it to produce lots of cash. It generated $587 million of free cash flow during the second quarter. That was 80% above the year-ago level, fueled by its growing production, capital-efficient spending, and improving commodity pricing. Devon returned $532 million of that money to investors via share buybacks ($256 million), fixed base dividends ($138 million), and variable dividends ($138 million).
The company's strong free cash flow has it trading at a bottom-of-the-barrel valuation. Devon trades at about a 10% free cash flow yield based on its 2024 forecast at $75 oil. That's about three times higher than the Nasdaq's 3% free cash flow yield and more than double the S&P 500's 4% yield. A higher free cash flow yield implies a cheaper valuation. This discount is why Devon's dividend yield is around 4% compared to a 1.3% yield for the S&P 500 and 0.8% for the Nasdaq.
Getting even cheaper
Devon Energy recently took a major step to enhance its ability to generate free cash flow. It agreed to buy Grayson Mill Energy for $5 billion. The transaction will be immediately accretive to its earnings, cash flow, and free cash flow. That's because it's buying Grayson Mill at a 15% free cash flow yield (assuming $80 oil).
The company expects Grayson Mill to grow its cash flow per share by about 10% in the first year while improving its free cash flow by 15%. Because of that, Devon will trade at an even cheaper valuation once it closes that highly accretive deal.
Dirt cheap, and doing something about it
Devon Energy firmly believes its stock trades at an attractive valuation. That has led the company to shift its capital allocation strategy this year. It has de-emphasized its variable dividend in favor of repurchasing more shares. Nearly half of its capital return in the second quarter was share repurchases, while the variable dividend was around a quarter of its return. That's down from its original plan of using up to half its excess free cash flow to pay variable dividends.
The oil company plans to continue buying back its stock hand over fist following the Grayson Mill deal. It expanded its share repurchase program by 67% to $5 billion through the middle of 2026. That adds to the $2.7 billion of stock it has repurchased since launching the program in late 2021. In addition to ramping its repurchases following the Grayson Mill deal, Devon expects the acquisition will be accretive to its dividend payout in 2025 and beyond.
An attractive oil stock
Devon Energy is an incredible bargain these days, given the cash it can produce at current oil prices. Meanwhile, it will be even cheaper once it closes the Grayson Mill Energy acquisition. That deal will give it more fuel to repurchase its dirt cheap stock and pay dividends. Add it all up, and Devon is a compelling option for those seeking income and upside potential from the oil patch.
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Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
