Royal Dutch Shell: Cheap

by The U.K. Income Investor

Royal Dutch Shell (RDS) has struggled since I last covered it back in April. At the time, the energy giant had just inflicted its first dividend cut on stockholders since the Second World War. The shares traded at around the 1,285 pence mark back then, which was some 10% higher than the current price of 1,170 pence per share.

On that basis, it would not surprise me if investors were mightily sick of this one. Stock markets have done well over the past few months given the grim state of the pandemic-hit global economy. Not only that, but the price of oil has improved substantially over that period too. Brent crude oil traded for around $25 per barrel back at the end of April, while it closed last week at around the $45 per barrel mark.

Anyway, the firm released financial results at the back end of last month. The company generated $6.5B in operating cash flow (excluding $4B in negative working capital movements) on the back of an average realised liquids price of just $24.30 per barrel. For 1H20 as a whole, the firm generated just under $14B in cash from operations versus $22.5B generated at the same point last year. Its 1H20 realised liquids price of circa $34.75 per barrel represented a drop of around 40% year-on-year.

The Dividend

The dividend cut is probably still a sore point for many investors out there. Prior to that, this was seen as one of the stodgiest income names in the world. Whether that came via directly holding the company’s stock, or indirectly owning it through pension plans, an awful lot of people had exposure to this. For that reason I don’t think we can talk about Shell without first talking about the dividend.

Now, the attraction of a lower dividend in terms of corporate financial health is clear. The 62¢ per share saved thus far in FY20 from the reduced dividend works out to a massive $4.8B in cash terms. Call it almost $10B on an annualised basis, with these figures based on 7.8B shares outstanding. The new 16¢ per share quarterly payout only costs the firm around $5B on an annualised basis, which should be easy enough to cover in most operating environments.

A quick look at the balance sheet shows why this is important. With net debt currently over $77B, the firm’s gearing level is now comfortably over the 30% mark following its $17B post-tax asset impairment charge. Allowing that ratio to balloon higher would not be commensurate with its current Aa2/AA- credit rating. It goes without saying, but debt reduction becomes a much easier proposition with an extra $10B in retained earnings each year.

Valuation

The shares remain cheap in my view. Despite slashing $10B from its annual dividend bill, the stock still offers a current dividend yield of over 4%. That is a measure of just how beaten-down it is. Anyway, and as always with cyclical businesses, we should probably look ahead to more normal operating conditions. On that basis, if Shell returns to making north of $40B in annual operating cash flow, then the current price is a steal.

The above would mean the business could cover a combined capital spending and dividend bill of $30B, while still throwing off circa $10B in surplus annual free cash flow. That latter figure works out to around 100 pence per share, and a very attractive proposition at the current 1,170 pence share price.

Moreover, it would not need particularly high energy prices in order to realise this. Cash from operating activities clocked in at $47B last year after excluding working capital movements. It achieved that at a realised liquids price of $57.75 per barrel – not a particularly high number in the grand scheme of things. If the company sees those prices in the next few years, then the stock will produce good returns from here.

Note

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