Devon inks a deal to add to earnings, shareholder returns and oil production right away
Club name Devon Energy (DVN) announced Wednesday evening that it will acquire the leasehold interest and related assets of RimRock Oil and Gas, a privately held company of Warburg Pincus. RimRock is located in the Williston Basin, a resources-rich body of land that stretches across Montana, North Dakota, South Dakota, and Canada. At a total cash consideration of $865 million, this is a small deal relative to Devon’s size and roughly $50 billion market cap, but it is one worth exploring due to its numerous financial benefits. Deal benefits Devon management outlined four key highlights of the transaction. First off, thanks to the attractive valuation of 2.2 times cash flow and a free cash flow yield greater than 25% at strip-pricing that Devon is paying for the asset, management expects this deal will be immediately accretive to all relevant per-share metrics in the first year. Accretive is M & A slang for increase, meaning the deal will be additive to Devon’s earnings, cash flow, free cash flow, and net asset value by about 3% to 5%, according to the company. The free cash flow per-share bump is important because that’s the determining factor of Devon’s dividend strategy. Remember, Devon has adopted a fixed plus variable dividend with the fixed set at $0.16 per share a quarter and the variable worth up to 50% of excess free cash flow – this is the main source of cash return upside. Williston Basin This brings us to the second financial benefit. Due to the accretive nature of this deal, Devon said its board plans to approve a 13% increase to the fixed quarterly dividend after the closing of the transaction in the third quarter. In addition, Devon expects this deal will be accretive to the variable dividend payout in 2022 and beyond, meaning this transaction will give Devon the ability to pay out even more cash to shareholders. It is hard not to like that. Third, Devon can fund this deal without any real damage to the balance sheet. Devon has one of the cleanest balance sheets in the industry, with its net debt-to-EBITDAX expected to be 0.2x by year-end. The little debt on the balance sheet provides management with tremendous flexibility. EBITDAX stands for earnings before interest, taxes, depreciation, amortization and exploration. Fourth, the deal works so well because Devon already has a presence in the Williston Basin. The transaction adds 38,000 net acres that sit adjacent to Devon’s existing position. RimRock’s first-quarter production was approximately 15,000 barrels of oil equivalent (Boe) per day, of which 78% was oil. Devon expects volumes will increase to an average of 20,000 Boe per day over the next year and the company will spend approximately $100 million of capital expenditures after the deal closes to fund development. Club take We think this use of cash by Devon makes plenty of financial and strategic sense as it only adds to management’s ability to return even more cash to shareholders based on strip prices over the next year. This is important to us because dividends and buybacks are one of the key tenets of our investing philosophy in this volatile market — the others being is the company profitable and does it trade at a reasonable valuation. Devon checks all the boxes. This bolt-on acquisition is also a way for Devon to increase earnings, cash flow, and production volumes without meaningfully investing in new capacity. This is so important because if Devon Energy broke discipline and decided to increase spending to ramp up production, others would follow and that would ultimately cause the market to flood with additional supply, pushing prices down, and ending the good times that energy investors have enjoyed for the past two years. But through this deal, Devon can add high margin production without a major step up in capital expenditures. It is clear the market likes the deal too. Shares of Devon Energy were bucking the trend Thursday, trading modestly higher on a day when the price of American benchmark West Texas Intermediate crude was slightly lower and many independent energy stocks are in the red. It’s worth noting that WTI was still around $122 per barrel. Due to the positive reaction in DVN’s stock price and the handful of price target bumps by analysts, one thing we are wondering is will this deal kick off a wave of more acquisitions of private companies. (Jim Cramer’s Charitable Trust is long DVN. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. 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