Earlier today, Royal Dutch Shell (RDS) announced that it would cut its distribution for the first time in over seventy years. Not since the days of WWII has the company felt the need to push the nuclear button with respect to its dividend. From now on, shareholders will receive a quarterly distribution of $0.16 per share instead of the previous $0.47 per share. For holders of the ADRs trading in New York, the comparable figures are $0.32 per share and $0.94 per share respectively.
Given the sacrosanct nature of its dividend, the fact that the company deemed this move necessary tells you all you need to know. In truth, I had expected Shell to soldier on a bit longer. BP and Exxon Mobil have so far resisted cuts, though those two will need to revisit that decision in the next couple of quarters. I can see California-based Chevron going longer; with its balance sheet in better health going into the crisis it looks in stronger shape than the other majors.
Historically, two features helped the majors in previous crises. Firstly, diversified operations. Plunging commodity prices are not a new thing, and Shell has faced plenty of downturns in the past seventy-five years. Downstream operations – refining and so on – offered a profit source not directly linked to energy prices in the way that upstream operations are.
The second feature is, well, scale. Obviously that means typically low cost production, thereby remaining profitable down to very low prices, but also in terms of their balance sheets. The likes of Shell could easily smooth out the cycle as far as shareholder dividends were concerned. It would see leverage rise during downturns, and then make cash hand over fist once conditions improved again. The balance sheet would then improve as retained earnings swelled up again.
This time looks different. Demand for end products has been totally annihilated due to the precise nature of this downturn. That means downstream operations look just as ugly as upstream right now. In its 1Q20 results, the company reported overall profit of $2,900m. That came in some $2,400m lower than the equivalent period last year. Moreover, this was before operating conditions completely fell off a cliff. Brent crude oil averaged $50 per barrel last quarter, around double its current level of $25 per barrel.
Turning to cashflow, and Shell generated $7,400m in cash from operations last quarter (excluding changes in working capital). With cash capital expenditure coming in at just under $5,000m, that only left $2,400m or so to cover its dividend. The previous level of quarterly distributions – $0.47 per share – consumed around $3,750m of cash every three months. That means the company was already looking at turning to alternative sources of cash, even before the worst of the downturn arrived.
That brings us to the other issue: the net debt load. At circa $74,000m, the figure looks absolutely gargantuan. It is, but Shell is also a titan in its own right. Relative to the amount of cash that the business generates, around $50,000m last year under fairly benign operating conditions, its debt level is not unreasonable.
In terms of this year, Shell sees cash capital spending in the $20,000m region. The old dividend cost it around $15,000m per year, so it was on the hook for $35,000m including capital expenditure. Moreover, it has around $15,000m worth of debt maturing this year that needs paying off. That adds up to a total bill of around $50,000m over the next year, assuming it carried on with its previous level of dividend spending.
Because the economic climate remains so volatile, it is hard to say how much cash the company ends up generating this year. Should Brent average in the $40 per barrel region overall, I reckon the figure comes in at around the $30,000m mark. That would not have been too bad, though conditions are currently much worse than that guide price.
Anyway, maintaining its current credit rating is also important to the company. At the moment, its debt is rated as AA-/Aa2 by the agencies, albeit with a ‘negative’ outlook attached on both ratings. In the past, Shell spoke about maintaining a circa 20% average gearing rate across the cycle. That’s the level it sees as commensurate with its current credit rating. Gearing stood at 29% at the end of the last quarter, which may explain why management felt compelled to act.
Unsurprisingly, the stock got absolutely hammered in trading after the announcement. The shares ended the day at around £12.85 apiece, down 11% on yesterday’s closing price. Based on the new rate of quarterly payouts, I have the current dividend yield at 4%. I think that represents a good deal, though it wouldn’t surprise me to see the stock fall a bit more.
Here’s the thing. Under reasonable mid-cycle conditions, Shell can cover its old dividend with a big chunk of change left over. I’m talking north of $10,000m per year, even if spends $25,000m or more on capital expenditure. If it commands a valuation of 10x free cash flow at that point, then we are taking a trip back to the £25 per share area in the next couple of years. Despite the historic dividend cut, the maths would suggest that the stock is a bargain at the moment.