DevX Energy (ticker symbol DVXE)is company engaged in production of and exploration for oil and natural gas. DevX is primarily a gas company with 92% of it’s proved reserves gas. For 2001, only 17% of DevX’s production is hedged on the upside, which means that DevX will be able to take advantage of the high commodity prices this year. DevX conducts all of its activities onshore in the United States.
DevX is a simple story of undervaluation. Although there are many undervalued smallcap o & g companies out there, they usually don’t have the clean balance sheet that DevX has. I believe that DevX is undervalued because only a short time ago DevX was a penny stock trading over the counter, with a crushing debt load and zillions of preferred shares and warrants. (The low gas prices prior to 2000 left a lot of small companies in pretty bad shape.)
On 10/31/2000 DevX had a recapitalization which involved a 1/156 reverse split, elimination of all warrants and preferred shares, buyback of $75 million of debt, and issuance of issuance of new shares for which DevX realized $65 million. And a few weeks later some more shares were issued for $9.6 million. DevX today has long term debt of $64 million plus a good amount of cash on hand, and a market capitalization of $104 million.
Because so much of DevX’s value depends upon the price of natural gas, it’s important to address the future of natural gas prices in North America. The outlook is very bullish. Demand is at an all-time high. The goings on in California this winter demonstrate that the nation is facing a shortage of electrical generating capacity. Ninety percent of new electricity generating plants being built run on natural gas. The addition of new natural gas plants will continue to increase demand for gas. The low levels of water in western reservoirs mean that there will be less hydro-electric power throughout the year (unless they start getting some rain out there). This means that more electricity will have to be generated from gas. Natural gas storage is already dangerously low, 40% below average levels for this time of year. Despite the increase in drilling activity, there was a recent Wall Street Journal Article pointing out that the fourth quarter earnings releases of publicly traded companies reveal that natural gas production has actually declined. There may not be enough gas for next winter. I anticipate gas averaging at least $5/mcf for the next year.
Going back to DVXE, I believe that the two most important factors for valuing oil and gas companies are cash flow and proved reserves.
DVXE has proved reserves of 145 bcfe as of 6/30/2000. To compare gas companies, it’s helpful to calculate enterprise value (EV) /mcfe. EV is market cap plus net debt. I calculate net debt by looking at all debt and subtracting current assets, and ignoring non-current assets. After the recapitalization events, DVXE would have net debt of $47 million, resulting an EV/mcfe of $1.06/mcfe. For comparison I did a similar calcuation on Barrett Resources (BRR), a natural gas company that has been in the business news this week because Royal Dutch has made an unsolicited offer for the company that BRR has refused. Based on Friday’s closing price, BRR has $1.84 EV/mcfe. Just a short while ago, BRR was an undervalued company with $1.23 EV/mcfe, but then the price skyrocketed on the takeover news.
Looking at cash flow, for the quarter ending 9/31/2000, DevX had cash flow per share of $0.35. On a going forward basis, lower interest payments will contribute an additional $0.21/share. With higher gas prices, I predict cash flow for the quarter ending 12/31/00 of $0.71/share. On an annualized basis, this would give DevX a price/cash flow ratio of 2.9. That’s pretty low. For comparison, BRR had cash flow for the same quarter of $1.95/share, and at a share price of $62.5, on an annualized basis that would come to a P/CF ratio of 8.01. Considerably higher than DevX.
Earnings aren’t as important for these companies as cash flow, but the less sophisticated investors tend to look at earnings more than anything else. The good news is that I predict earnings per share for the fourth quarter of $0.51, using the same model I used to calculate cash flow. This is far above what the lone analyst is predicting. On an annualized basis, this would come to a PE ratio of 4.0.
(1) I think that the strong earnings that the company will be reporting throughout the next year will be catalyst enough. The company’s 10K for 2000 will be released by March 31st . The earnings will be good, and after this release, financial databases will be updated to reflect the new DevX. None of the financial websites, such as Quicken, Microsoft, or Yahoo, show the correct information about this company. (2) There will be increased buyouts of natural gas companies during the next year, because it’s a lot faster for big companies with high stock valuations to buy up small undervalued companies than for them do their own exploration. This will boost the stock prices of all undervalued natural gas companies. (3) DevX has a good chance of being sold. Strome Investment Management, with a 9.8% stake in DevX, says in an SEC filing dated 3/7/2001, that “management should be focused on increasing shareholder value through a sale of the company.” Based upon what BRR is being bid for, DevX should be worth $16/share to an acquiring company.