Devon Energy: Bigger Doesn't Mean Cheaper

How much is a soldier's life worth? What's the value of a successful Presidency? What price the North Atlantic alliance? Those are inestimable. Add the cost of defending U.S. interests in the Persian Gulf -- estimates of an Iraq war alone run $50 billion to $200 billion -- and note how poorly many energy stocks have done. Then you will know this: North American oil and gas reserves go cheap.

Which, to me, is why it's hard to be bearish on most any energy producer with big reserves in the U.S. or Canada. These stocks, such as Anadarko Petroleum (APC ) or Devon Energy (DVN ), keep running in place, while oil and gas prices look like they're climbing Kilimanjaro. Just the same, there is cheap, and then there is cheaper. Now, with Devon's pending purchase of Ocean Energy (OEI ), the largest independent domestic producer is soon to be born. And that has me wondering: Will it be as cheap or cheaper than the rivals it stands to eclipse?

Based in Oklahoma City, Devon has grown by bounds, from revenues of $604 million as recently as 1998 to nearly $6 billion this year, if shareholders of both companies on Apr. 25 approve the Ocean merger. Along the way, Devon has piled up IOUs, a turnoff to some on Wall Street. "Devon has grown intelligently by acquisitions, but now they have a very high debt ratio," said Charles Maxwell, veteran oil analyst at Weeden & Co. "At $16 or $17 oil, Devon would be gone -- swept away."

As it happens, neither Maxwell nor executives at Ocean and Devon expect crude prices to go and stay anywhere near that low. But that's the No.1 risk, and Devon knows the Street is anxious to see its debt burden fall. Buying Ocean helps: Had the companies been one in 2002, it would have ended the year with long-term debt at 52% of total capital instead of 60% for Devon alone. By year's end, the merged company's debt may fall to 50% of capital, said Brian Jennings, Devon's senior vice-president of corporate development. Moreover, Ocean CEO Jim Hackett told me that as its deep-water wells in the Gulf of Mexico come on line, "our growth is accelerating."

If Devon does reduce its debt, the stock becomes a better bet. But after looking at the pro forma financials that show what Devon would have looked like had the Ocean deal been done in 2002, it's unclear its shares are the most alluring among domestic producers. To size Devon up this way, I compared its pro forma 2002 results with actual results of two leading rivals, Anadarko and Burlington Resources (table). I first found "enterprise value," which is each company's market capitalization plus its debt and a handy way to compare companies with starkly different balance sheets. Next, I compared enterprise values to energy reserves and EBITDA, or earnings before interest, taxes, depreciation, and amortization.

As a multiple of EBITDA, Devon turns out to be a bit cheaper. But what if you were to buy the whole company less for its current cash flow than for its assets? You would have spent $9 for each barrel of oil equivalent, a good bit more than the $7 or so that the reserves of Anadarko and Burlington would cost you. What does all of this tell me? Next to the true, full value of secure, North American energy assets, each of these stocks is cheap. Among them, the riskier one remains Devon.

By Robert Barker

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