Energy Prospectus

Devon Energy Corp. (DVN) on Tuesday reported fourth-quarter profit of $183 million.

The Oklahoma City-based company said it had profit of 35 cents per share. Earnings, adjusted for one-time gains and costs, were 38 cents per share. < Compares to my forecast of $0.64

The results missed Wall Street expectations. The average estimate of 10 analysts surveyed by Zacks Investment Research was for earnings of 60 cents per share.

The oil and gas exploration company posted revenue of $3.98 billion in the period, exceeding Street forecasts. Four analysts surveyed by Zacks expected $3.55 billion.
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Revenues came in above my forecast, so I am digging into the weeds now to see what caused the bottom line miss.

My forecast was 555,000 boepd of production for Q4.

Timing of Non-Operated Activity Limits Fourth Quarter Production

Devon’s net production averaged 548,000 Boe per day in the fourth quarter of 2017. Of this total, oil production in the quarter totaled 246,000 barrels per day, which was 14,000 barrels per day below the company’s midpoint guidance.

In the fourth quarter, net production in the U.S. was limited by approximately 9,000 barrels per day primarily due to the timing of well tie-ins associated with non-operated activity in the STACK. This timing issue has been resolved with the tie-in of more than 50 non-operated wells around year end in the STACK (see “February 2018 Production Update” section for more details.)

In Canada, net production averaged 134,000 Boe per day in the fourth quarter, an 8 percent increase from the prior quarter. Facility modifications and temporary steam constraints at the company’s Jackfish complex curtailed production by approximately 5,000 barrels per day in the fourth quarter.

This has a lot to do with the Net Income miss:

Devon Converts to Successful-Efforts Accounting Method

As previously announced, in the fourth quarter, Devon changed its method of accounting for oil and gas exploration and development activities from the full-cost method to successful efforts. All reported financial results contained within this release reflect this change in accounting policy. The company has provided a supplemental information packet related to its conversion to successful efforts on its website at www.devonenergy.com, which includes a reconciliation of financial results from full cost to successful efforts for prior financial reporting periods.

So what does all this mean for your future expectations?

The switch to "Successful Efforts" caused almost all of the EPS miss. Higher NGL prices offset most of the production miss.

Devon has the most complicated accounting of all the Sweet 16 companies, so I really need to spend more time with their annual report before I adjust my valuation.

Successful Effort is much more conservative than Full Cost accounting, primarily because all exploration costs are expensed in the current period. So...this is a prime example of why I stress focusing on operating cash flow and not reported earnings.

Devon generated $5.55/share cash flow from operations in 2017 and (assuming $55 WTI) they should generate $6.50 to $7.00 cash flow from operations in 2018. < This compares to First Call's current CFPS estimate of $6.83.

It looks like Devon will generate over $1 Billion of free cash flow in 2018, which is something the Wall Street Gang has been screaming that they want.

Negative headlines are driving down the share price today, but if you believe we now live in a $60+ oil world, the noise should settle down. Devon has some high quality assets, especially in STACK, and they appear to have steady production growth and strong cash flows locked in. Production should rebound nicely in Q1 because a lot of new STACK wells were completed in December and January.

Bloomberg:

•RBC analyst Scott Hanold, who rates DVN at Outperform, expects shares to trade down today as investors may take a wait-and-see attitude for now.

•Cowen’s Charles Robertson, who also rates the stock at Outperform, says DVN's earnings call should focus more on the company’s potential for cash return in dividends and buybacks after it pays down debt.

•J.P. Morgan’s Arun Jayaram says 2018 is off to a slower start for DVN but the firm retains a positive bias on shares over next 12-months, given the company's plans to balance growth and free cash flow generation.

In the last 3 months, 12 ranked analysts set 12-month price targets for DVN. The average price target among the analysts is $49.75. Price target range from $39.00 to $68.00.

Companies that "Over-Promise and then Under-Deliver" (i.e. - miss their own production guidance) ALWAYS have to spend time in the Wall Street "Penalty Box". Therefore, I am lowering the multiple of operating cash flow that I am using to value Devon from 10X to 8X. This lowers my valuation by $17.50/share to $50.00.

Keep in mind:
> Devon is profitable
> Devon is on-track to generate $1 Billion of FREE CASH FLOW FROM OPERATIONS in 2018

My updated forecast/valuation model will be posted to the EPG website this afternoon.