Credit analyst takes wait and see approach to Devon, wants debt reduction

By Ronda Fears

Nashville, Tenn., March 22- Adopting a wait and see attitude toward Devon Energy, credit analyst Carol Levenson of Gimme Credit said there needs to be a material reduction in the oil and gas producer's debtload before she would recommend the paper.

"We continue to maintain a wait and see attitude toward this suddenly financially aggressive independent oil and gas producer, which recently completed the second of two major acquisitions. The first of these to be announced, the purchase of Mitchell Energy, was to be financed with a balanced amount of debt and equity," Levenson said in a report Friday.

"But when the second, all-cash purchase of Anderson Exploration was announced, we noted we would only perceive value at weak BBB levels. We don't believe Devon's subsequent bond deals have reflected this level of credit risk in their pricing."

Devon Energy (Baa2/BBB) sold $1 billion of bonds Thursday. Levenson said considering where the deal was priced, "we wouldn't have knocked ourselves out trying to buy this paper." The $1 billion of 7.95% notes due 2032 sold at 99.481 to yield 7.995%. Devon has a little over $1billion of convertibles outstanding, 4.95% and 4.9% issues that exchange into ChevronTexaco stock, and a 0% convertible due 2020.

Whether Devon was brilliant or lucky, Levenson noted the company fortunately chose not to rely on the commercial paper market or short-term bridge financing for initial funding of its $6 billion in acquisition debt. The $3 billion amortizing term loan has minimal maturities before 2005, and the company is paying an incredibly low 3% to borrow these funds.

The new bonds refinanced a good deal of the acquisition debt into longer maturities, the analyst said, and Devon still expects to reap net proceeds of $1 billion from asset sales this year with the cash earmarked for debt reduction.

Moreover, bondholders could benefit from the single financial covenant governing Devon's bank lines, Levenson said. Leverage, adjusted to exclude the ChevronTexaco exchangeables as well as any non-cash asset writedowns, can't go above 70% through June 2002, or above 65% thereafter.

"While this should deter Devon from voluntarily increasing its leverage, which stands at 60% under this measure, until its bank loans are paid off, the covenant naturally could cut the other way if Devon should experience a cash flow shortfall and needed to borrow more," Levenson said in the report.

The company's fourth quarter earnings were hurt by falling oil and gas prices, dropping some 90%, even excluding the $900 million pretax non-cash charge caused by a ceiling test of its reserve values.

Falling earnings and cash flow coupled with a much higher debt load and interest expense burden is not a winning combination, but the analyst noted that Devon has hedged nearly half of this year's oil and gas production to produce more predictable results during these financially stressful times.

While Devon claims its 2002 capital spending budget of $1.5 billion will be funded internally, the analyst said she thinks the company may have to cut back on spending to make this happen.

"Even at breakeven free cash flow, and assuming the $1 billion in asset sales materialize, we project restoration of debt protection measures will be a painfully slow process without more radical action, such as additional equity issuance or more major asset sales," Levenson said in the report.

"This is where our wait and see approach comes in. Considering management has no track record with cash-funded acquisitions of this magnitude, we would prefer to see some material debt reduction actions take place before recommending this name."

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