Why I'm Still Bullish on Devon Energy

Why I'm Still Bullish on Devon Energy

Devon Energy recently reported solid third-quarter financial results, driven by robust growth in liquids production volumes from its U.S. operations. Adjusted earnings came in at $526 million, or $1.29 per diluted share, up 47% from the third quarter of 2012.

Yet despite robust production growth across most of its core operating regions, shares fell by about 7% last week. Let me explain why this decline could be a buying opportunity, and why I'm still bullish on the company over the long term.

Strong liquids production growth with gas upside
The first reason is Devon's outstanding North American asset portfolio, which includes premier positions in the Permian Basin, the Barnett and Cana-Woodford shales, and Alberta's oil sands. In the third quarter, the company reported 16% year-over-year growth in total oil production, fueled by solid performance from its U.S. operations, especially in the Permian Basin and the Mississippian-Woodford trend, which delivered 38% year-over-year oil production growth.

Another encouraging sign for Devon is a much-improved commodity mix. In the third quarter, oil and natural gas liquids accounted for 43% of the company's total production, up from 37% a year ago, and oil sales now represent almost 60% of the company's total upstream revenues. Yet despite its aggressive push into liquids-rich plays, Devon still has plenty of long-term upside from a recovery in natural gas prices, thanks to its massive position in the Barnett shale and other gassy plays across North America.

Benefits from Crosstex merger
In addition to a robust upstream business, Devon has a massive midstream business currently valued at about $6.5 billion. Last month, the company announced that it will merge its U.S. midstream assets with those of Crosstex Energy , a midstream company, to form a new midstream business that will include two publicly traded entities: a master limited partnership and a general partner entity.

Under the terms of the agreement, Devon will have a controlling stake of 70% of the general partnership and a 53% stake in the MLP. The deal will effectively merge Devon's sizable midstream capabilities in Texas and Oklahoma with Crosstex's extensive assets in the Permian Basin and Eagle Ford shale, the Barnett, Marcellus, Haynesville, and Utica shales, as well as the U.S. Gulf Coast, providing benefits such as greater scale, improved knowledge and synergies with Crosstex, and an investment-grade credit profile for the new company.

Attractive valuation
While Devon's shares are up about 15% year to date, they've declined 15% over the past five years. The company currently trades at just under 5 times cash flow and 12 times forward earnings. Furthermore, if you take out the company's midstream business, which is valued at roughly $6.5 billion, from its enterprise value of roughly $30 billion, then Devon's upstream business is valued at just 3 times its forward EBITDA of $7.9 billion.

On an enterprise value-to-EBITDA basis, Devon also lags most of its peers. The company's EV/EBITDA ratio is currently around 5.5, compared with roughly 7.5 for peer EOG Resources , 6.25 for Anadarko Petroleum , and 5.5 for Chesapeake Energy . Only Apache, which has an EV/EBITDA of around 3.5, is cheaper than Devon on this basis. I think such a deep discount is unwarranted, given Devon's increasing share of liquids in its commodity mix and robust oil production growth and outlook.

The bottom line
With liquids now accounting for 43% of the company's production, Devon has achieved a much better commodity mix that should help insulate it from continued stagnation in natural gas prices, while its liquids-rich plays offer solid growth prospects. With an attractive valuation and a disciplined, shareholder-friendly management team, I think Devon has the ideal characteristics of a company I'd buy and hold for a long time.

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The article Why I'm Still Bullish on Devon Energy originally appeared on Fool.com.

Fool contributor Arjun Sreekumar owns shares of Chesapeake Energy and Devon Energy and owns shares of Devon Energy and EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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