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Thursday, November 02, 2006

Devon Energy (DVN) Still A Buy

By Yaser Anwar, CSC of Equity Investment Ideas

Readers of this blog know I highlighted Devon back on September 21st as a potential buy (was 62 then, 66 now). The reason I'm bringing this up is DVN reported yesterday and I was quite pleased with the report. So consider this a follow up, as I still believe DVN has room to go higher.

DVN reported 3Q06 EPS of $1.66, above Street consensus of $1.51-1.52. The results were driven by stronger than expected liquids realizations, better marketing and midstream margins, and a lower than expected tax rate. Production volumes and unit costs were largely in line with expectations.

DVN indicated that the company will slow investment in its conventional gas business in Canada in response to persistent cost inflation. The concept of deferring investment amid deteriorating conditions is not unique to DVN. What is unique to DVN though is the DVN’s deep inventory of investment opportunities in higher margin (heavy oil, Barnett) and growth (Lower Tertiary) areas. This should allow the company to effectively reallocate capital.

According to Morgan Stanley Investors should look for-

(1) Azeri-Chirag-Gunashli (ACG) oil project: DVN expects to reach full payout of its carried interest (5.6%) by year-end. ACG is expected to add production of 30 mboe/d net to DVN in 2007.

(2) Polvo (Brazil): Development drilling should commence in 1Q07. Expect first production in 3Q07 (26 mboe/d net to DVN).

(3) Jackfish I (Canada): Steam injection is expected in 2Q07 and production of 35 mboe/d in late 2008. At this point I think DVN is comfortable proceeding with the project alone rather than partnering to secure a downstream solution.

I believe DVN has transformed the company from a value-enhancing restructuring story to a production growth story as several long-term projects come online simultaneously in 07.

The announced lower tertiary Gulf of Mexico discovery has secured the DVN production growth story for the long-term, while its recent Barnett Shale acquisition will immediately help secure DVN's dominance in a core area.

With a large inventory of reinvestment opportunities, a pristine balance sheet and a strong FCF profile, DVN remains a good buy.

I believe several near-term catalysts, including the full impact of ACG, the start-up of Jackfish I, and a busy deepwater exploration program should allow the shares to trade at a premium to its large cap peers.

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