![]() We are initiating a position in Devon Energy (DVN), buying 750 shares at roughly $44.35. In addition, we are buying 75 shares of Morgan Stanley (MS) at roughly $93.84.
Following the trades, the Charitable Trust will own 750 shares of Devon Energy and 1,000 shares of Morgan Stanley. These buys will increase DVN's weight in the portfolio from 0.00% to 0.88% and MS's weight in the portfolio from 2.32% to 2.49%.
Devon Energy
Devon is an oil and natural gas exploration and production (E&P) company. The stock was the single best-performer in the S&P 500 in 2021, thanks in large part to a strategic capital allocation shift on the part of management, which decided to implement a fixed-plus-variable (determined by cash flow) dividend strategy.
This strategy allows Devon to both reward shareholders during the good times without overextending itself to maximize cash flow while at the same time preventing harsh dividend cuts when cash flows pullback on lower commodity prices. The fixed portion can be kept a bit lower at a level that is sustainable despite downswings in commodity prices, while investors can rest assured that they will benefit in line with upswings. Devon was a leader in implementing this capital return strategy, and it has proven so successful that several peers have since implemented it as well.
Of course, we have to ask ourselves if we are late to the party following a nearly 180% gain in 2021. On that metric alone, one might think so. However, while price alone may tell us what we are paying, it does not tell us anything about the value we are getting. As it stands now, shares trade at roughly 8x FY22 earnings estimates; flip that, and you get a 12.5% earnings yield — which highly attractive in a market concerned with rising rates, quantitative tightening and inflationary dynamics.
Then there is that attractive dividend dynamic. We touched on this on Friday and in today's Morning Meeting video, but as a reminder: Devon's quarterly fixed dividend is currently $0.11 per share or $0.44 per share annually, and it is based on a target payout of up to 10% of the company's operating cash flow. Given a share price of ~$45, the fixed yield stands at about 1%. That's nothing to write home about, but again, it's sustainable in almost any environment. The variable dividend, however, is exciting. It is calculated quarterly and can amount to as much as 50% of excess free cash flow in the quarter.
The company announced in November that its third-quarter fixed-plus variable dividend was $0.84 per share. Annualizing that, we achieve a yearly payout of $3.36 per share, which amounts to a dividend yield of ~7.5% based on a ~$45 share price. Looking ahead, RBC estimates the variable dividend to be boosted to $0.90 per share in the fourth quarter; add in the $0.11 fixed payout, and we get a quarterly payout of $1.01, a ~2.2% yield on the quarter and ~9% on an annualized basis.
Of course, the definition of variable is that it will change quarter to quarter. Since the variable portion is tied to cash flow and that's tied to commodity prices, we must take a view on the current level of oil prices. On this front, we believe that prices can sustain, if not advance, for two reasons.
First, at the industry level, producers have finally learned that pumping for the sake of pumping is not a good long-term strategy. Second, current geopolitical turmoil is supportive of prices and could push them higher should tensions rise. While the current focus is Russia-Ukraine, China-Taiwan remains a top geopolitical risk and could certainly intensify depending on how the former plays out. Finally, as the economy reopens and people start to take cruises and travel more, demand will be coming back on line as we work through the year and serve as additional support for oil prices.
So, the takeaway is that we are optimistic that the recent price action in oil will sustain, support Devon's cash flow generation and therefore provide a healthy variable dividend in the quarters ahead. As a result, with a 12.5% earnings yield and an annualized dividend yield in the range of 7.5% to 9% in the quarters ahead, we see plenty of upside still to be realized in the best S&P 500 performer of 2021.
Other supportive factors include a $1 billion share repurchase program in place through FY22, amounting to ~3% of the market cap and a management team intent on reducing leverage (calculated as net debt-to-EBITDAX) to 1.0x or less. As for valuation, based on a ~10x FY2022 earnings estimate of $5.39 per share, we get a price target of $54. This multiple is well below the average historic 17.4x forward p/e multiple that shares have traded at over the past five years, however, it's a target that we believe more than adequately accounts for a market intent on utilizing lower valuation multiples than it has in recent years given Fed tightening and inflation fears.
Another way to look at valuation is through the lens of an EV/EBITDA multiple. Shares currently sport a 6.6x multiple on FY2021 estimated EBITDA. If we roll the EBITDA out to FY2022 (~$7.11 billion) and reduce that multiple to 6x we realize an enterprise value of ~$42.66 billion. Subtract ~$4.2 billion of net debt and divide by the shares outstanding and we get a price target of ~$56 per share. Given these two targets, we will average out our two targets and set our initial price target at $55 per share.
Morgan Stanley
We also see the decline in Morgan Stanley as a good opportunity to add to our position. Shares are now trading below levels from before the company's strong fourth-quarter report, which you can read more about here, and this seems silly to us. One of the excuses for the selling in the market has been that investors are fearful that earnings will disappoint, but we already know Morgan Stanley had a great fourth quarter. Plus, the company has the makeup of what we like to buy in the current environment. The bank is a beneficiary of higher interest rates, management buys back a ton of stock every quarter, and we like the nearly 3.0% yield at the current price.
Ford
Separately, we are monitoring the decline in Ford (F), as the stock has now fallen about 20% from where we sold a huge chunk of our position last Tuesday. After a decline of this magnitude, the question we must ask ourselves is at what price would we buy back what we sold much higher?
Back in December, Chair Bill Ford bought 412,500 shares at $20.62 per share. See, insiders sell their stock for various reasons, but there is only one reason why an insider would ever buy stock: to make money.
If Bill Ford thinks around $20.62 is a good level to add to a position, then we think it is only right for us to get more constructive on Ford now that shares down about 5% from his buy price. That's why we are upgrading our Ford rating to 1 from 2. We aren't adding to our position today because we already own so much Ford, but we think the price has gotten attractive if you have patiently been waiting to start or add to a position.
As a reminder, we give every stock in the portfolio a 1 through 3 rating. A stock rated "1" means we would buy it right here. A stock rate "2" means we would wait for a pullback before buying it. We generally classify a pullback as a decline of about 5%, but volatile times calls for wider levels. Finally, a "3" rated stock is a position we would sell into strength. Currently, there are no "3" rated positions in the portfolio. You can view the entire portfolio at the link here.
(Jim Cramer’s Charitable Trust is long DVN, MS, F. 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. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade.
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