Could This Cheap Energy Stock With A 7% Dividend Yield Be Right for Your Portfolio?

-Devon Energy continues to take advantage of higher oil prices.

-Delaware Basin production continued to drive production for the quarter.

-Operating cash flow rose by 14% to $1.8 billion, and free cash flow rose to $1.3 billion.

-Net income came in at $1 billion, with earnings-per-share coming in at $1.48 per share.

Devon Energy NYSE: DVN continues to witness strong results as energy prices continue to provide a tailwind to the company. Devon is an energy company primarily engaged in hydrocarbon exploration in the United States. They currently have between 1600-1800 million (barrel oil equivalent) BOE of oil compromising of petroleum, natural gas, and natural gas liquids.

Energy outlook

Oil and natural gas prices remain high, with the latest price, WTI, trading at $122 a barrel. On the other hand, natural gas prices currently trade at $8.60 per MBTU. Both these prices should remain elevated as demand continues to outpace supply over the next couple of quarters, with analysts expecting that the price of oil could rise to $140 a barrel. This bodes well for Devon energy and its stock.

The cost of exploration and fewer barrels of oil being explored has led to an environment where oil supplies remain tight; as a result, global oil prices have likely made a complicated bottom and will likely remain elevated in the future. Moreover, beyond exploration issues, OPEC has indicated it does not wish to increase supply, and other major oil-producing countries agree with the bloc. All these factors will continue to provide a tailwind to oil in the near future, which should create a longer term favorable environment for oil stocks.

Financial Outlook

Despite the favorable backdrop, Devon‘s management has indicated that it will continue operational execution as planned. Production plans are expected to be anywhere from 570,000 to 600,000 BOE, with capital spend coming in at around $2 billion.

Revenue is expected to come in at around $18 billion for the year, but if energy prices remain elevated, that number could increase to $20-22 billion for the year, increasing cash flow significantly. The current operating margin for Devon energy is expected to be around 30-35%, and the net income margin is expected to come in at approximately 25%. That would translate into a net profit of about $4.5-5 billion for the year, bringing forward price-to-earnings (P/E) to around 10x, and at that valuation, the stock could be considered relatively cheap. In addition, one-time operational costs added about $7 per barrel in the previous quarter, and those costs should no longer be present in the coming quarters, thereby increasing operating profits during the next couple of quarters.

On top of a great valuation, the company continues to provide a very high dividend yield of 7.5%. Therefore, even if cash flow was reduced significantly, and the dividend was cut, the valuation would still be inexpensive.

On a DCF basis, the stock is currently valued at $120, and even if the price of oil were to fall, there remains a significant margin of safety for the stock, which should help calm the nerves of investors who are worried about volatility.

Management’s Outlook

Management continues to focus on operational efficiency and maintaining discipline. They continue to emphasize that oil prices are volatile and remain resolute in not overspending on capital to increase production.  Furthermore, management is focused on bringing net debt to 0 by the end of the year by retiring debt due in 2022 and 2023 on an earlier timeline. They have also stated that return on capital employed should rise to 40% this year as cash flow increases, which should only further help push the stock price up.

Economic headwinds could weigh on the stock

The price of oil continues to increase as global demand remains robust. But consumers are increasingly struggling as inflation takes a toll on purchasing power. In addition to the inflation, rising interest rates will affect the economy, and due to lower consumption and investment, overall energy demand should come down from 2021. Both these factors are likely to put downward pressure on oil prices. In addition, supply from countries like Venezuela may also affect oil prices, decreasing oil prices to below $100 a barrel.

And as the Fed continues to tighten, higher rates and quantitative tightening are likely to reduce the overall liquidity in the market. All these factors are headwinds and should be considered before investing. Historically shale-oil stocks have always been volatile, and while balance sheets are much more stable than before, liquidity risk always remains an issue.

Note: Analysts continue to increase the price target for this stock, with Barclay’s being the latest bank to increase their target to $90 per share.