Royal Dutch Shell: 4Q19 Review

by The Compound Investor

On Thursday morning Royal Dutch Shell (RDS) released financial results covering Q4 2019. I think it is fair to say the market reaction has not been overly positive. The stock is down circa 3.4% in New York, which follows similar trading earlier on in both London and Amsterdam. Now, the last time I covered Shell on The Compound Investor was last summer. Brent crude traded for around $62.30 apiece at the time, while it currently languishes in the $58.40 per barrel area. Perhaps unsurprisingly, Shell ADSs have lost around 14% of their value over the same period.

Here are some of the headline financial numbers. CCS earnings excluding identified items (basically Shell lingo for normalized net income) clocked in at $2.9b in Q4 and $16.5b over 2019 as a whole. On a per-ADS basis, and remember that one ADS represents two underlying ordinary shares, Shell reported CCS earnings excluding identified items of $0.74 in Q4 2019 and $4.08 for the year as a whole.

Dividend Cover

Usually when it comes to Shell, most folks want to hear about one thing and one thing only: the dividend. Alongside its quarterly results announcement the oil & gas giant declared a static $0.94 per ADS quarterly cash dividend. Readers will no doubt notice that quarterly net profit came in lower than its dividend commitment in the fourth quarter. Over the year as a whole, the $4.08 per ADS that Shell made in net income just about covers its dividend obligation with a tiny amount of change left over.

The cashflow picture looks a bit better. Shell generated around $47b last year from all of its business lines (excluding $5b in negative working capital movements). After spending just under $24b on cash capital expenditures, the company retained around $18b in surplus cash. The annual dividend took up just over $15b of that. The company also spent a further $10b on stock buybacks last year as part of its wider $25b buyback plan.

When you process all of those numbers, you should arrive at the conclusion that Shell cannot afford to self fund its current rate of dividend spending and large scale share repurchases. It can do one or the other in the current macro environment. Obviously this excludes taking on more debt, or even including receipts from the sale of assets. Shell expects to raise $10b from the latter by the end of 2020.

The Buyback Program

I’ve mentioned this previously, but the $25b buyback program that Shell announced in 2018 makes financial sense for two reasons. (It also plans to return circa $125b via additional buybacks and dividend repayments in the 2021-2025 period). Firstly, Shell diluted its shareholders when it completed the BG Group deal back in 2016. That is because it paid part of the purchase price with freshly minted Shell stock. Secondly, the company cancelled its scrip dividend program at the end of 2017. (That is the process of paying dividends with new shares in lieu of cash). As a result of both of these points, the annual cash dividend bill has gone through the roof in recent years.

At its current stock price, every $1b spent on share repurchases reduces the annual dividend bill by circa $70m. That saved cash then represents a recurring source of retained profit for Shell to use as it sees fit. It could even decide to increase the per-share dividend via buybacks, thereby growing the income stream without actually spending more cash.

Unfortunately, this relies on commodity prices and trading conditions playing ball. Shell realized a liquids price of $57.76 per barrel last year, down around 10% on the $63.85 per barrel it realized over the course of 2018. (Bear in mind that many of its gas sales contracts are also linked to the price of oil). Furthermore, its Downstream operations haven’t picked up the slack, primarily due to poor macro conditions. Shell made $15.2b last year through refining, chemicals and so on. That was around $2.4b lower compared to 2018.

So far, I calculate that Shell has spent around 60% of the $25b earmarked for the stock buyback program. If the company is to complete it on schedule, then that means spending another $10b on share repurchases in 2020. Add that to $15b annual dividend bill, and we would potentially be looking at another $25b in total 2020 shareholder returns. That represents over 10% of the company’s current market capitalization, just to provide some context.

Now, Shell also plans to spend around $24b on CapEx this year according to management guidance. If it is to self-fund its shareholder return plan, it would need to generate almost $50b in cash from operations in fiscal 2020. Bear in mind that it will also raise some money from the sale of non-core assets. Given macro conditions and Shell’s level of gearing, it would not surprise me to see the buyback program delayed somewhat, but let’s see.

Valuation

Shell ADSs trade for just under $54.50 apiece as I type. That puts the stock at 13x last year’s profit and a prospective dividend yield of 6.9% – with that figure based on a $3.76 annual distribution. Call me crazy but I think that is a fair deal. I mean, in the current oil price environment the dividend is pretty secure. In a $60-plus oil environment, the stock starts to throw off significant levels of excess cash again. If you share my view that $65/bbl represents a reasonable long-term oil price estimate then it seems more than possible for Shell to deliver at least high single-digit annual shareholder returns.

Note

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