Upgrades for CLR and DVN - Dec 16
Posted: Wed Dec 16, 2020 2:41 pm
Barclays Equity Research has updated their price targets
Continental Resources (CLR) from $18.00 to $19.00
Devon Energy (DVN) from $14.00 to $20.00
Jeanine Wai, Energy Sector Analyst for Barclays
Cash returns vs. balance sheet repair: why we care about which it is. Since we now forecast FCF after dividend for nearly every company in our coverage, other nuances are by default becoming more important. One of these nuances is the allocation of FCF to either cash returns via variable dividends/share buybacks or balance sheet repair.
We understand why some investors are more focused on the absolute FCF vs. the allocation of it, and many view balance sheet repair also as a cash return to equity holders. However, the E&P sector is in the 'proof of concept' phase for sustainable FCF and capital discipline. Immediately paying out FCF lowers the 'risk' that the cash will be reinvested for growth. This goes a long way in
repairing the trust between managements and investors, the value of which shouldn't be underestimated. However, the catch is that only E&Ps with good balance sheets and lower leverage can reasonably adopt this FCF "in/out" payout mechanism, which is also an important step toward stocks starting to recouple with the commodity. Thus, until sentiment meaningfully improves and/or we see materially higher oil prices, we favor E&Ps that can provide accelerated cash returns via special dividends/buybacks while maintaining attractive leverage of 1-1.5 x Net Debt/EBITDAX at current strip of ~$45 flat WTI.
This is one of the primary drivers of our OW ratings for COP/DVN/EOG/PXD/XEC and our EW ratings for CLR/FANG/OXY and UW rating for OVV. DVN is the poster child for FCF 'in/out.' DVN will implement its variable dividend strategy upon closing of the WPX deal. Management plans to pay out up to 50% of excess FCF on a quarterly basis if it meets certain criteria. While we think management will leg into the 50%, DVN could pay its 1st variable dividend as early as Q1/Q2'21.
Variable dividends are attractive but so is a strong balance sheet. While these are not mutually exclusive, variable dividend payouts by definition slow down de-leveraging . So what's the trade-off between providing tangible "goodwill" in a disliked sector and de-leveraging? For DVN at avg. strip pricing of ~$45 WTI, investors receive roughly ~1% extra FCF yield (EV) over the next 3 years and de-leveraging slows by only a modest ~0.14x with YE'23 leverage still an attractive 1.3x. This is a trade-off we think is worth making.
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MY TAKE: If you are investing primarily for yield then I agree with Miss Wai that you should focus more attention on FCF distributions. Devon Energy's "variable dividend" plan is attractive. However, if you are investing for capital gains then you want to own upstream companies with an active drilling program because building up production and proven reserves is what makes E&P companies more valuable. Keep in mind that any upstream company can create FCF just by stopping spending on drilling & development, but they won't last long.
Continental Resources (CLR) from $18.00 to $19.00
Devon Energy (DVN) from $14.00 to $20.00
Jeanine Wai, Energy Sector Analyst for Barclays
Cash returns vs. balance sheet repair: why we care about which it is. Since we now forecast FCF after dividend for nearly every company in our coverage, other nuances are by default becoming more important. One of these nuances is the allocation of FCF to either cash returns via variable dividends/share buybacks or balance sheet repair.
We understand why some investors are more focused on the absolute FCF vs. the allocation of it, and many view balance sheet repair also as a cash return to equity holders. However, the E&P sector is in the 'proof of concept' phase for sustainable FCF and capital discipline. Immediately paying out FCF lowers the 'risk' that the cash will be reinvested for growth. This goes a long way in
repairing the trust between managements and investors, the value of which shouldn't be underestimated. However, the catch is that only E&Ps with good balance sheets and lower leverage can reasonably adopt this FCF "in/out" payout mechanism, which is also an important step toward stocks starting to recouple with the commodity. Thus, until sentiment meaningfully improves and/or we see materially higher oil prices, we favor E&Ps that can provide accelerated cash returns via special dividends/buybacks while maintaining attractive leverage of 1-1.5 x Net Debt/EBITDAX at current strip of ~$45 flat WTI.
This is one of the primary drivers of our OW ratings for COP/DVN/EOG/PXD/XEC and our EW ratings for CLR/FANG/OXY and UW rating for OVV. DVN is the poster child for FCF 'in/out.' DVN will implement its variable dividend strategy upon closing of the WPX deal. Management plans to pay out up to 50% of excess FCF on a quarterly basis if it meets certain criteria. While we think management will leg into the 50%, DVN could pay its 1st variable dividend as early as Q1/Q2'21.
Variable dividends are attractive but so is a strong balance sheet. While these are not mutually exclusive, variable dividend payouts by definition slow down de-leveraging . So what's the trade-off between providing tangible "goodwill" in a disliked sector and de-leveraging? For DVN at avg. strip pricing of ~$45 WTI, investors receive roughly ~1% extra FCF yield (EV) over the next 3 years and de-leveraging slows by only a modest ~0.14x with YE'23 leverage still an attractive 1.3x. This is a trade-off we think is worth making.
-----------------------------
MY TAKE: If you are investing primarily for yield then I agree with Miss Wai that you should focus more attention on FCF distributions. Devon Energy's "variable dividend" plan is attractive. However, if you are investing for capital gains then you want to own upstream companies with an active drilling program because building up production and proven reserves is what makes E&P companies more valuable. Keep in mind that any upstream company can create FCF just by stopping spending on drilling & development, but they won't last long.