Earlier today, Royal Dutch Shell (RDSB) announced that it would cut its distribution for the first time in over seventy years. Not since 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 16¢ per share instead of the previous 47¢ per share. For holders of the ADRs trading in New York, the comparable figures are 32¢ per share and 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.
In terms of the numbers, Shell sees cash capital spending in the $20b region this year. The old dividend cost it around $15b per year, so it was on the hook for $35b including CapEx. Moreover, it has around $15b worth of debt maturing this year that needs paying off. That added up to a total bill of around $50b over the next year.
Historically, two features helped the majors in previous crises. Firstly, diversified operations. Plunging commodity prices are not a new thing, but downstream operations – refining and so on – offered a profit source not directly linked to energy prices in the way that upstream operations are. Secondly, scale. That not only 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.
This time looks different. For one, 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 terms of numbers, the company reported overall profit of $2.9b in its 1Q20 results. That was some $2.4b 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 $7.4b in cash from operations last quarter (excluding changes in working capital). With cash capital expenditure coming in at just under $5b, that only left around $2.4b to cover its dividend. The previous level of quarterly distributions – 47¢ per share – consumed around $3.75b 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 $74b, 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 $47b last year (excluding working capital movements) under fairly benign operating conditions – its level of indebtedness is actually not unreasonable. Even after factoring in a circa $38b combined CapEx and dividend bill, the business generated surplus cash to deal with debt last year:
Our organic free cash flow was more than $20 billion, but that includes a negative working capital impact of around $5 billion, and that’s all at an average Brent price of $64 per barrel through 2019, and very importantly, below average historical downstream conditions.
(Source: CEO Ben van Beurden)
Because the economic climate remains so volatile, it is hard to say how much cash the company ends up generating this year. I reckon the figure comes in at around the $30b mark assuming Brent averages in the $40 per barrel region overall. 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. Its debt is rated as Aa2/AA- by the agencies at the moment, albeit with a ‘negative’ outlook attached to both. In the past, Shell spoke about maintaining a circa 20% average gearing rate across the cycle. That is the level it sees as commensurate with its current credit rating. Gearing stood at 29% at the end of 1Q20, and that 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 1,285p each, down 11% on yesterday’s closing price. I have the current dividend yield at 4% based on the new rate of quarterly payouts. 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 $10b per year, even if spends $25b 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 2,500p 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.
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