DEVON ENERGY CORPORATION

FNCE 3361-1

STUDENT MANAGED FUND

4 DECEMBER 2014

BEN KERLEY. OLUWANAYOWA AKINDELE, SIMON URIBE, TAYLOR NIELSEN

DEVON ENERGY (NYSE:DVN)

Ticker: DVN (NYSE)

Sector: Energy

Industry: Oil, Gas & Consumable Fuels

Current Price: 59.38

Recommendation: Not Buy

DVN STOCK PRICE

Company Info

Company Devon Energy Corp.

Ticker DVN

Exchange NYSE

Price and Market Info

Current Price 59.38

52-week high 80.63

52 week low 53.34

Market Cap 24,309

Shares Out 409.1

Daily Volume 19.69

Accounting, Ratio, and Multiples Info

EPS 4.91

DPS 0.70

Current Ratio 1.2 Debt/Total Assets 28.04

Profit Margin 28.76

ROA -0.05

ROE -0.11

P/E 11

EXECUTIVE SUMMARY

We are placing a do not buy position on

Devon Energy. We believe the stock to be

currently overvalued using our set

valuation techniques. The massive

increase in the crude oil supply has taken

a toll on oil prices and we feel that the

timing is not right to invest in a company

such as Devon Energy. With the recent

meeting with OPEC it seems that oil prices

are going to continue to drop until a point

that it will unprofitable for US O&G

companies. Although Devon Energy is a

great company, we feel like it would not be

a wise investment for the SMF portfolio

due to the volatility of the current O&G

industry.

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BUSINESS DESCRIPTION

Devon is a leading independent energy company focused in the exploration, production, and

development of oil, gas, and natural gas liquids. The firm was founded in 1971 and went

public in 1988. Devon has 5,900 employees and is headquartered in Oklahoma City,

Oklahoma. Currently, Devon’s predominant oil and gas plays are on-shore positions in the

United States and Canada. DVN produces ~2.4 billion cubic feet of natural gas a day, which

exceeds 2% of the total gas consumed in North America in a year. While predominantly

focusing on E&P, DVN also owns majority interests in natural gas pipelines, plants, and

treatment facilities, making them one of the largest processors of natural gas in America1.

A SHIFT TO OIL E&P

Since 2008, Devon has doubled their North American production and begun to focus more on

E&P in oil in North America, particularly light, sweet crude. This shift towards oil production

is largely attributable to their acquisition of GeoSouthern Energy.

GeoSouthern Energy Acquisition

On November 20, 2013, Devon acquired GeoSouthern Energy’s assets in the Eagle Ford for

$6 billion in cash. Geosouthern was acquired at ~7x 2013 EBITDA and 2.5x 2015E EBITDA.

The deal was immediately accretive to debt-adjusted cash flow per share. Post-acquisition,

GeoSouthern will account for ~25% CAGR of DVN’s oil production and includes a current

portfolio production of 53,000 barrels of oil equivalent per day.

1 DVN 10-K, p. 3

Asset divestitures:

Devon has focused on divesting their non-core North American assets. On June 30, 2014,

DVN announced a $2.3B sale of non-core oil and gas properties, at a trading multiple of 7x

EBITDA. This sale, combined with a divestiture of DVN’s Canadian conventional gas

business at 7x EBITDA, DVN has a non-core asset divestiture programs totaling >$5B.

EnLink Midstream Venture:

In March of 2014, Devon combined all of their midstream assets with tCrosstex Energy and

formed a general partner entity and a master limited partnership under the names of EnLink

Midstream, LLC and EnLink Midstream Partners, LP, respectively (collectively “EnLink

Midstream”).

EnLink’s assets are located in the top O&G plays in N.A. including the Barnett Shale, Permian

Basin, Cana and Arkoma Woodford, Eagle Ford, Haynesville, Gulf Coast, Utica, & Marcellus

Shales.

Through the acquisition of a primary position in the Eagle Ford and Permian Basin, non-core

asset divestitures, and the consolidation of midstream assets, Devon has aggressively

transformed their onshore portfolio with a focus on crude production. 2

2 DVN 10-K, p.4

A CLOSER LOOK AT DVN’S O&G POSITIONS

Source: Devon investor presentation with BAML, slide 4

Source: Devon investor presentation with BAML, slide 8

Anadarko Basin:

This basin is located in Oklahoma (Canadian, Blaine, Caddo, & Dewey Counties) and is a non-

conventional reservoir that produces natural gas, NGLs, and condensate. Devon is the largest

leaseholder in this region. In 2013, DVN increased production by 14% and have several thousand

undrilled locations. In 2014, DVN expects to drill 95 wells in the Anadarko Basin

Barnett Shale:

This region is located in Texas (Denton, Johnson, Parker, Tarrant and Wise Counties) and is a

non-conventional reservoir producing natural gas, NGLs, and condensate. DVN Acquired a

position in Barnett in 2002, and is one of their top producing fields in N.A. Devon also maintains

midstream pipeline assets here as well and plans to drill 80 more wells in 2014

Mississippian-Woodford:

The Mississippian-Woodford is located in Northern Oklahoma and Southern Kansas and is

currently being explored with joint venture, Sinopec. DVN plans to drill 230 wells here in 2014.

Permian Basin:

The Permian is located in various counties in Texas and Southeast New Mexico and is focused on

exploration and low risk-development opportunities. DVN became a major player in the Permian

through their joint venture opportunity with Sumitomo in 2012, which gave DVN access to ~650K

acres in the Cline, Midland, and Wolfcamp shale areas. The Permian consists of conventional and

non-conventional reservoirs of oil and NGLs. DVN plans to drill 350 wells in 2014

Rockies Oil:

The Rockies Oil region is located in Wyoming and DVN has ~150,000 net acres in which they

have identified ~600 risked locations across formations. DVN plans to drill 25 wells in Powder

River Basin in 2014.

Canadian Heavy Oil:

Devon is the first and only independent provider to operate the bitumen oil sands in Canada. Devon

has two key projects in this region, the Jackfish and Pike Projects in Alberta, Canada. The Jackfish

project is a heavy oil project in non-conventional oil sands and Devon increased production by 8%

in 2013. Currently, the Pike Project has no proven reserves and is undeveloped.3

Source: Devon Q3 Slide deck

3RD QUARTER RECAP

3RD QUARTER RECAP

DVN achieved record oil production. DVN increased 2014 production outlook by 300 basis

points from 11% to 14% with no changes in capital spending profile.

Improved margins and profitability. DVN exceeded Street estimates by $0.10 with pre-tax cash

margins expanding 20% Y/Y

DVN finished their non-core asset divestiture program. On August 28, DVN closed a $2.3B

sale on non-core American assets, which concluded their year-long non-core divestitures in North

America.4

3 DVN 10-K, p.5-7 4 DVN Q3 FactSet Earnings Call transcript, p.3

INDUSTRY OVERVIEW

The oil and gas production industry is composed of two different segments, the production

of crude oil and natural gas.

Natural gas accounts for 25.6%

of industry revenue while

crude oil brings in 74.4%.

Although the industry is a very

mature one, during the past

five years since the recession,

the O&G production industry has been booming, growing at an average rate of 12.8%.

Through the year 2019, the industry revenue is expected to increase at an average rate of

2.4%. The main key economics drivers of the industry are world price of crude oil and natural

gas, as well as consumer demand for those products. 5

MARKET SHARE

O&G companies here in the United States have been benefitting from advances in technology

and new techniques in regards to extracting natural resources. They have been able to

accomplish more efficient

way of obtain said resources.

O&G production and

extraction is very competitive and companies require massive amount of capital to sustain

themselves, so the barriers to entry are very high. The concentration of the O&G industry is

5 IBIS World, US Industry reports, Oil Drilling & Gas Extraction

very low, but there are a few major players. Those would be BP PLC, Chevron Corporation,

ConocoPhillips and ExxonMobil Corporation with 6.1%, 6.6% & 7.7% & 4.5%, respectively

of the market share. Devon currently has 2.0% market share, while the rest of the market is

fragmented among other smaller players. As economies around the world continue to grow,

emerging economies are expected to grow their infrastructure and their citizens will

increase their consumption of oil & gas products6.

OIL & NATURAL GAS PRODUCTION BOOM & DROP IN PRICE

DOMESTICALLY

The exponential growth of production here domestically has caused a drastic drop in the

price per barrel of crude oil, and with technology advances, it seems that the price will

continue to drop if there isn’t interference from OPEC. OPEC, the Organization of the

Petroleum Exporting Countries, is an intergovernmental organization whose objective is to

6 IBIS World, US Industry reports, Oil Drilling & Gas Extraction

co-ordinate and unify petroleum policies among members in the organization in order to

secure fair and stable prices for petroleum producers7.

Source: Factset, Markets Tab, Commodities Sub Tab

Crude oil prices per barrel have experienced an -31.54% YTD, while natural gas has gone

through a -15.87% change8. The unprecedented boom in oil has been fueled by the discovery

and extraction of oil in regions in the United States such as the Bakken Formation, Eagle Ford

Shale, and the Permian Basin. The graph above clearly illustrates how the recent boom in oil

production in the United States has affected the global price of crude oil per barrel. According

to the U.S. Energy Information Administration, 8,864 (thousand barrels per day) were

produced in the month of September 2014 compared to that of 5,609 in September 20109.

INVESTMENT THESIS

DEVON’S RISK WITH OIL

According to Devon’s Q3 report, over the past 12 months Devon’s oil production has

grown by 75.45% while its natural gas production has decrease by 22.21%. As you can see in these

two graphs, Devon has

clearly been attempting

to move itself heavily

into the Oil Industry.

With their many recent

acquisitions in the U.S. and Canada, Devon expected oil prices to increase for the next few years.

7 Opec, Brief History 8 DVN FactSet, Industry Tab 9 EIA.Gov

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Q3 '13 Q4 '13 Q1 '14 Q2 '14 Q3 '14

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DVN Oil Production

Unfortunately, it looks as if this move was executed at the wrong time. The world is witnessing a

historic drop in oil prices primarily due to decreased demand in Asia and Europe and increased

supply in the U.S.,

Canada, and Russia.

Right now the price

of crude oil is

hanging right

around $70/barrel, down from over $110/barrel a few months ago. The decrease in prices has

forced Devon and the entire industry to take a huge hit in revenues. While Devon was expecting

oil prices to drop to around $90/barrel, the increased drop to $70/barrel is expected to take a

dramatic toll on the company. 10

OPEC’S STANDOFF WITH THE U.S.

With Saudi Arabia led OPEC’s massive influence

over world oil prices, it was expected that it would

reduce their amount of oil in the markets, to increase

prices back to normal levels. However, their meeting

on November 27 in Vienna solved nothing, and as

you can see in the graphic to the left, oil prices have

remained on the decline ever since. The cartel used

history in their decision. When the prices fell in 1980 Saudi Arabia decreased production in order

10 Plumber, Brad. Vox

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DVN Natural Gas Production

to increase prices, but the prices continued to decrease for some time, and the country lost giant

shares of the market. Knowing this, Saudi Arabia planned for it to happen again and announced

that they can survive this decline in prices for a little while longer. OPEC is hoping that the North

American production will turn unprofitable and shut down. They plan to do this by decreasing

prices even further in a price war with the U.S. OPEC knows it is much more expensive to extract

oil from place in the Middle East than in the U.S., so they plan to wait and see if the low revenues

that U.S. companies will face in the coming months will turn them into unprofitable busts. 11 12

VALUATION

Discounted Cash Flow

Revenue Growth

An average of the sales growth in oil and gas and natural gas liquids for the last three

quarters was used as the forecast Q4 sales growth. Given that most of the fiscal year has already

pass, relying on the consolidated performance of the company year to date can provide accuracy

to estimates. Consequently, most pro forma estimates were done by multiplying the calculated

fourth quarter growth (24.06%) by the consolidated Q4 2013 results and then adding this to the

numbers released for the first three quarters of the year. For 2014 a 2% sales growth rate was

assumed considering the industry outlook, appendix D forecasts and Factset estimates (Appendix

D).

11 Dvn Q3, Quarterly Results, Historical Production 12 Lastest Price & Chart for Crude Oil Brent – Source: Nasdaq, Crude Oil Brent

FCF and Capital Expenditures

Fixed capital investment for the year was assumed to be equal to the capital expenditure

thru Q3 adjusted for depreciation expense given that no significant changes in capital expenditures

are likely to happen according to management guidance. Furthermore, free cash flow to the firm

will be $-9.26 million for 2014, which is in line with the lower end management predictions and

Factset estimates. In 2015 the company will be able to capitalize on its sales growth and core asset

operations to generate a positive free cash flows to the firm of $340.87. Capital expenditures will

remain at similar levels in 2015; as stated, Devon is shifting its focus to highest rate of return areas,

so while investments in some zones like the Midland Basin will see less investment, other

emerging reservoirs will see higher capital expenditures, but in general the budget will remain at

similar levels.13

CAPM and DCF Model

For the discounted cash flow model a WACC of 6.58% was use to find the implied stock

price of the firm. The model allocates a weight of almost 70% to the cost of equity and this is good

as it allows to consider the systematic risk and volatility of the stock by using a CAPM approach.

The cost of equity (CAPM) was found by using the 52 week average beta of 1.13 and by using the

current yield on a 10-year Treasury of 2.34%14. The cost of debt was found by choosing the highest

(conservative) yield to maturity of a 30 year bond issued by the firm15. Additionally, a 46% tax

rate (actual Devon’s LTM rate) was factored in the analysis16. This high rate is in line with high

industry tax rates between 40% -50%17. Moreover, a multiphase H-model was considered suitable

given the current situation of the firm. Devon is experiencing huge sales growth in 2014 that will

13 DVN Q3 FactSet Earnings Call transcript, p.5-7 & 13 14 DVN FactSet, Company snapshot ; Yahoo Finance, Bond Center 15 Yahoo Finance, Bond Center, Devon 16 DVN FactSet, Financials, Income Statement 17 IBIS World, US Industry reports, Oil Drilling & Gas Extraction

hit the rate of 74% according to current performance and last quarter estimates, but those rates are

expected to plummet in the course of one year to 2%18. Consequently, the long term growth

perspective of the firm will be determined by a mix of industry, firm and economic growth at

around 3.5%. Although sales will be at around 2.5%, improving efficiency and high margins will

drive company’s growth.

Gordon Growth

In order to compare the results obtained through the discounted cash flow model, a valuation

analysis using the Gordon growth model was done. Dividends per share forecasted for 2015 in the

pro forma analysis were used as an input in the model. Dividend growth was assume to be the last

5 year average growth in dividends of the firm equal to 6.318%19. The stable performance in the

last five years is representative of the expected long-term performance of Devon. Lastly, the

CAPM cost of equity approach was use with the same inputs utilize for the portion of the WACC

model regarding the cost of equity (CAPM).

Overvalued

Results for both the DCF and Gordon Growth model reveal that the firm is considerably

overvalued and there is a downward potential risk of around 45%.

18 DVN FactSet, Financials, Income Statement & Estimates 19 DVN FactSet, Financials, Income Statement

Actual Price Implied

Price

Over/Under

DCF Model

$59.93

$38.15

Overvalued Gordon

Growth

$43.88

SENSITIVITY ANALYSIS

Super Growth Rate Assumption

Co

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f Eq

uit

y A

ssu

mp

tio

n

38.15 53.47% 62.90% 74.00% 85.10% 97.87%

7.96% 23.40 24.54 25.88 27.22 28.76

7.24% 28.17 29.55 31.17 32.80 34.66

6.58% 34.46 36.16 38.15 40.14 42.43

5.92% 44.17 46.36 48.92 51.49 54.44

5.33% 58.89 61.81 65.25 68.68 72.63

The discounted cash flow model sensitivity analysis shows that the probability of a downward

movement of the stock price is high. Only a decrease in the cost of equity will bring the price of

the stock above current market price which is unlikely to occur given the volatility of the market;

if anything cost of equity will rise. A similar situation occurs with the Gordon growth model, only

a lower cost of equity combined with a high stable growth will lead to a higher stock price.

Although the Gordon Growth model shows more upside potential compare to the DCF, it still

reveals that the stock is overvalued.

MULTIPLES ANALYSIS

A relative valuation and terminal value multiples analysis was done in order to compare

Devon with some of its closest

competitors. As seen an

Appendix I, the implied value

of the stock is excessively over

the actual price. We believe

that this is a result of

fundamental differences between competitors and it does not take into account many of the market

factors that are currently affecting the firm. We decided to rely more on the DCF and Gordon

Growth analysis which factors in some of the issues that are currently impacting Devon.

Actual Stock Price Implied Stock Price Over/ Under

Price/Earnings (x) 64.07 94.69 Undervalued

NTM P/E (x) 64.07 97.23 Undervalued

Price/Sales (x) 64.07 146.18 Undervalued

Price/Book Value (x) 64.07 155.18 Undervalued

Actual EV Implied EV Over/Under

Enterprise Value/EBITDA (x)39454 54110.05 Undervalued

Works Cited "Commodities: Latest Crude Oil Brent Price & Chart." NASDAQ.com. N.p., n.d. Web. 04 Dec. 2014. <http://www.nasdaq.com/markets/crude-oil-brent.aspx?timeframe=10y>.

Plumber, Brad. "Oil Prices Keep Plummeting as OPEC Starts a Price War with the US." Vox. N.p., 28 Nov. 2014. Web. 02 Dec. 2014. <http://www.vox.com/2014/11/28/7302827/oil-prices-opec>. Web. 5 Dec. 2014. <http://clients1.ibisworld.com/reports/us/industry/default.aspx?entid=103>. "Brief History." OPEC. Web. 5 Dec. 2014. <http://www.opec.org/opec_web/en/about_us/24.htm>. Web. 5 Dec. 2014. <http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=M>.

Devon Q3 FactSet Earnings Call transcript Investors Presentation, Bank of America Global Energy Conference. Nov 14, 2014. Web. 01.Dec.2014

Factset Yahoo Finance Devon 10-K

APPENDICES

APPENDIX A – STOCK SCREEN

Appendix B – Company Data

Income Statement

Balance Sheet

Cash Flow Statement

Ratios

Industry Metrics

Appendix C – Competitor Data

Apache Corporation

Income Statement

Balance Sheet

Cash Flows

Ratios

Pioneer Natural Resources Company

Income Statement

Balance Sheet

Cash Flows

Ratios

Chesapeake Energy Corporation

Income Statement

Balance Sheet

Cash Flows

Ratios

Continental Resources, Inc.

Income Statement

Balance Sheet

Cash Flows

Ratios

Appendix D – Company & Industry Forecasts

Data & Correlations - Industry

Soft Factors – Industry

Firm Sales Forecast

Soft Factors – Firm

Appendix E – Ratio Analysis

Industry Ratios

Ratios

Appendix F – Proforma Statements & FCF

Proforma Statements

\

Q4 Proforma

Free Cash Flows

Appendix G – Cost of Capital

Appendix H – DCF & Sensitivity

Gordon Growth Model

Multi-Phase H Model

Appendix I – Relative Valuation