Devon Energy (IL/A): Relative fundamentals improving making it a close call among "value" large-cap E&Ps, but we prefer APC just ahead of DVN and APA at this time - Goldman Sachs - February 01, 2006
We believe Devon Energy's fundamentals relative to its large-cap North American E&P peer group are improving, as drillbit reserve replacement results are much improved and in 2006 return on tangible capital should move toward the top of the peer group. In balancing onshore gas opportunities with longer-term projects like Canadian heavy oil and deepwater exploration in addition to returning increased amounts of cash to shareholders, we think Devon is well-positioned for long-run performance. We see Devon's relative risk/reward as favorable and among "value" large- cap E&Ps we think it is a close call between Devon, Anadarko, and Apache (all IL/A rated). At this time, we favor Anadarko of the three as we see somewhat better catalysts for it, including a more visible production ramp- up starting this year for Anadarko versus 2007 for Devon.
DEVON'S RISK/REWARD LOOKS FAVORABLE; AMONG LARGE-CAP "VALUE" E&Ps IT IS A CLOSE CALL BUT WE GIVE THE EDGE TO ANADARKO OVER DEVON AND APACHE AT THIS TIME In 2005, investors favored E&P companies that had multi-year, visible production growth from unconventional natural gas resource opportunities onshore North America. While Devon is well exposed to many of the key North America resource plays, the company has not grown onshore production as aggressively as some of its peers in recent years. Instead Devon has sought to balance its onshore gas exposure with longer-term growth opportunities in Canadian heavy oil and deepwater exploration, while also increasing the amount of cash it returns to shareholders. In our view, Devon's balanced exposure in terms of future growth opportunities positions the company well for long-term performance, even if coming at the expense of short-term production. In our view, the valuation and risk/reward of the more strategically/geographically diversified large-cap E&Ps like Devon, Anadarko, and Apache is increasingly looking very compelling vis-a-vis unconventional gas-focused companies like EOG Resources (IL/A). Devon, Anadarko, and Apache all trade between 4.6X-4.8X 2006E EV/DACF, well below EOG's 6.6X valuation. Asset value calculations that give credit for unbooked resources are also consistent with cash flow-based valuations in terms of showing a value discount for the diversified, large-cap E&Ps. The challenge is one of catalysts. In trying to prioritize between Anadarko, Devon, and Apache, we think Anadarko's improved production growth visibility starting this year stands apart from both Devon and Apache, with Devon's top-line production growth resuming in 2007. In Apache's case, its international production profile looks strong, but there is less certainty as to its US volumes in particular in the Gulf of Mexico. As such, despite it being a very close call given that all three stocks show about the same 25%-30% upside to estimated "traditional" peak value, we prefer Anadarko of the three at this time.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Production test at Jack discovery in deepwater Gulf of Mexico. Devon will participate in a production test at the Chevron-operated Jack discovery in the emerging Lower Tertiary play in the deepwater Gulf of Mexico. We see this as a key event in determining the commercial viability of Jack, with important implications for the broader Lower Tertiary play given investor and industry uncertainty over whether the reservoirs can produce at rates sufficient for commerciality. We believe the Street is not placing much value on Devon's leading position in the Lower Tertiary play, with a successful production test potentially being a key catalyst for its shares. Our net asset value for Devon gives less than $2 per share of credit for the Lower Tertiary. However, with a successful production test at Jack and given its substantial acreage and prospect inventory, proof of commerciality could drive a meaningful increase in the value of this play, as we have seen in several corporate transactions like Statoil/EnCana and Norsk Hydro/Spinnaker.
(2) Delivery of 410-440 mn BOE of targeted reserve adds in 2006. In contrast to much of the E&P sector, over the past two years Devon has reported improving organic (i.e., drillbit only, excluding acquisitions) reserve replacement and a DECLINE in finding and development (F&D) costs. Worldwide organic reserve replacement was 194% in 2005 and 94% in 2004, which compares favorably with the 68% 2001-2003 average. Similarly, drillbit F&D fell to $9.31/BOE in 2005 from $11.92/BOE in 2004 and the $23.91/BOE 2001-2003 average. Note, conversion of proved undeveloped (PUD) reserves in 2001-2003 skews the figures somewhat as do price-related revisions. But the point that Devon is adding NEW reserves from the drillbit at a competitive F&D cost we think holds. For 2006, the company is targeting 410-440 million BOE of reserve adds, which implies just under 200% reserve replacement at an F&D cost of around $11/BOE (using mid-point of CAPEX and reserve add ranges). We believe such drillbit results, if delivered, will prove competitive with other large-cap E&Ps.
(3) Resumption of top-line production growth in 2007. As Devon has transitioned away from acquisitions in the last two years toward longer-term exploration and development projects like Canadian heavy oil (Jackfish), deepwater exploration, and Azerbaijan oil--while also committing to return increased cash back to shareholders--near-term production growth has been lackluster. However, with some of the long-term projects coming to fruition and continued strong drilling results onshore North America, we believe competitive production growth is on-track to resume in 2007. Our estimate of just over 8% production growth in 2007 is consistent with the company's 8% guidance. We estimate mid-to-high single digit volume growth will continue over the remainder of the decade, with about 6% average annual growth forecast between 2007-2010.
(4) Continued share repurchase/dividend increases. We view favorably Devon's decision in 2005 to return an increasing amount of cash generated during the high commodity price environment back to investors. We note that share repurchases have occurred at a pace that has still allowed net debt-to-tangible capital ratios to improve to 32% at year-end 2005 from 58% at year-end 2003.
4Q 2005 RESULTS LARGELY IN-LINE
Devon Energy reported clean 4Q 2005 EPS of $2.33 ($2.14 on a reported basis including special items), essentially in-line with the $2.32 First Call consensus estimate and our $2.35 forecast. 4Q 2005 E&P production of 579 MBOE/d (thousands of barrels of oil equivalent per day) was close to our 582 MBOE/d estimate. The realized oil price of $39.64/bbl was just ahead of our $38.86/bbl forecast. Devon's realized natural gas price of $9.42/Mcf was just below our $9.69/Mcf forecast. "All-in" E&P unit costs in 4Q were $20.24/BOE, slightly higher than our $19.43/BOE estimate.
UPDATING EPS ESTIMATES AND INTRODUCING 2006 QUARTERLY ESTIMATES
We are introducing 2006 quarterly EPS estimates and updating our full-year 2006 and 2007 EPS estimates for Devon to reflect revised assumptions for production, commodity price realizations, and unit costs, which in part is based on the company's updated guidance filed in an 8-K report on February 1. Our 2006 1QE, 2QE, 3QE, and 4QE estimates are now $2.21, $2.11, $2.25, and $2.80, and our 2006 full-year estimate is now $9.35 ($10.30 before). Our 2007 EPS estimate is now $10.40 ($11.10 before). See Exhibit 1 for our summary financial model for Devon.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
