Devon Energy (DVN) cut its dividend last quarter based on lower adjusted free cash flow, and it may do so again. But it still makes sense to short out-of-the-money (OTM)puts both for income and to average-cost buy in the stock over time. As it stands today at $47.19, DVN stock still looks worth buying in, especially if an OTM strike price short put trade is exercised.
This was discussed in my last article on May 29, “Devon Energy Stock Treads Water As Its Put Premiums Wither.” The quarterly dividend fell due to a cut in the variable portion of the dividend, which is based on 50% of the net free cash flow (FCF) produced each quarter.
Potential Dividend Cut
The fixed dividend portion was kept at 20 cents, and the variable portion was reduced from 79 cents to 52 cents. So, the total dividend is now $0.72, or $2.88 per share annually. So, at today's price of $47.19, DVN stock has an attractive 6.10% dividend yield.
That makes the stock attractive at this price. Moreover, even if the company has a lower FCF figure next quarter similar to the FCF drop last quarter, there would still be another dividend cut. For example, even if the variable dividend is cut to say 35 cents, a one-third cut due to significantly lower adjusted FCF, the total quarterly dividend would still be 55 cents. The annual dividend would fall just 23.6% to $2.20 from $2.88. The yield would fall to 4.66%, a very high yield.
However, that is a worst-case situation. Given the relative stability of the oil price in the past month or so, it's much more likely the adjusted FCF is down just 15% or so. That would make the new variable quarterly dividend 44 cents (64 cents total), and the new annual dividend would be $2.56. That gives DVN stock a 5.42% dividend yield.
Let's think about this cut. We can use this to help us set a price target. For example, the stock might fall further to $42.67 if it were to have a 6.0% dividend yield. This can be seen by dividing $2.56 by 6.0%. The answer is a price target of $42.66 or a drop of 9.6% from today's price of $47.19.
Shorting OTM Puts Using This Price Target
This means we could short out-of-the-money puts at $42.00 or $42.50 today. That means we collect the income for shorting the stock and wait to see if the stock falls to this price after a potential dividend cut.
Last month we wrote that shorting the $42.00 strike price puts made sense for the period ending June 23. Investors who followed this strategy collected 49 cents in premium, which worked out to an immediate yield of 1.167%. Today those puts trade for just 2 to 3 cents, so this trade was very profitable.
As a result, investors can now short $42.50 strike price puts for expiration on July 21, which is 28 days from now, and still collect a premium of 31 cents. Moreover, the $43.00 puts trade for 37 cents, which provides an immediate yield of 0.86%. That works out to an annualized return of 10.3% if the trade can be repeated each month for a year.
This means that the investor who secures $4,300 with their brokerage firm can enter an order to “Sell to Open” 1 put contract at $43.00. The account will immediately receive $37.00. In addition, if they secure $43,000, they can short 10 contracts and the account will receive $370.00. That shows how the investment immediately returns 0.86%.
Moreover, the breakeven price is lower at just $42.63 (i.e., $43.00-0.37), or 10.6% below today's price. This shows that the investor has plenty of safety at this strike price, and it provides good additional income. As a result it makes for a long investor in DVN stock to short these OTM puts as a way to both increase income and potentially automatically average down into the stock.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
