Shares of Devon Energy (DVN 1.76%) tumbled after the oil and gas producer reported its third-quarter results. The primary issue weighing on shares was a reduction in the company’s dividend. While Devon’s combined fixed-plus-variable dividend payment of $1.35 per share for the third quarter was up 61% year over year, it was down 14.8% from the record $1.55 per share it paid in the second quarter.
Even though Devon’s dividend is down from the peak, the oil company has a potential catalyst that could push it higher in the future. Here’s a look at what could fuel a higher dividend in the coming quarter and beyond.
Adding another wedge
Devon Energy’s fixed-plus-variable dividend framework sees it pay a fixed-rate base quarterly dividend (currently set at $0.18 per share) and a variable dividend of up to 50% of its excess free cash flow each quarter. The company produced about $1.5 billion of free cash during the third quarter, down from the record $2.1 billion it achieved in the second quarter, due primarily to lower oil prices. It paid half that money via its variable dividend ($1.17 per share).
While oil prices have been the primary catalyst fueling Devon’s cash flow in recent quarters, another factor will help drive its cash flow in the fourth quarter. That’s because Devon recently closed two highly accretive acquisitions. CEO Richard Muncrief discussed their upcoming impact during the company’s third-quarter conference call. He stated:
The acquired assets were funded entirely from cash on hand and purchased at levels as low as two times cash flow and free cash flow yields ranging up to 30% at strip pricing. Furthermore, the addition of this incremental wedge of free cash flow also allows us to accelerate the return of cash to our shareholders through higher dividends and positions us to further compound per-share growth through our ongoing stock buyback program.
The CEO points out that the company paid cash for these cash-gushing oil properties. Because of that, they’ll boost its free cash flow in the coming quarter. Based on current oil and gas pricing, the company estimates its free cash flow will rise 25% year over year in the fourth quarter. That will give it more free cash to pay dividends and repurchase its shares.
The potential to add more fuel sources in the future
On the one hand, Muncrief made it clear on the call that “deals such as these that check every box are exceptionally rare.” Because of that, investors shouldn’t expect Devon to be a serial acquirer.
However, he stated, “[W]e’re going to continue holding consolidation as an important part of our overall strategy.” He cautioned that the company wouldn’t “always find those deals that check every box, and we’re not going to overpay. We’re going to be very disciplined.”
But there could be others in the future. The company is open to deals that enhance its drilling inventory and are accretive to its financial metrics.
The company has the financial resources to make additional acquisitions if compelling opportunities arise. Even after paying $2.5 billion to close two deals last quarter, Devon ended the period with $1.3 billion in cash. It also has a strong investment-grade balance sheet, finishing the period with a 0.5 times leverage ratio, which is 50% below its targeted level. That gives it ample financial flexibility to pounce if another highly accretive deal presents itself.
Oil isn’t the oil dividend fuel source
While oil prices are a big driver of Devon Energy’s cash flow, they’re not the only factor. The company can also boost its cash flow by making accretive acquisitions, which it did last quarter.
Even though it’s rare to find highly accretive deals, Devon has proven they’re out there. With plenty of financial flexibility to continue making deals, Devon has another potential dividend fuel source, even if oil prices don’t rebound.
Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.