Royal Dutch Shell: A Look At Profitability

| About: Royal Dutch (RDS.A)

I have been analyzing big oil stocks that offer a good return on investment for a value investor. My analysis here is based on the profitability ratios in the financial statements of Royal Dutch Shell (NYSE:RDS.A) over the last five years.

When a firm has strong profitability ratios, it portrays to an investor that it provides a good return on his or her investment. The profitability numbers that I came across for Royal Dutch Shell weren't the best. Keep in mind, however, that this is just one of the many ways to analyze a stock.

Royal Dutch Shell's dividend yield is roughly double that of industry giants Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX). But the trouble that Shell is having is finding new reserves. Shell's proved reserves were 13.6B barrels of oil equivalent in 2012, down from 14.25B in 2011.

A profitability analysis of a company involves looking at a class of financial metrics to determine a firm's capacity to generate profitable sales from the resources it has. Typically, higher ratio numbers translate to a higher investment value for the firm.

Source: Royal Dutch Shell annual reports.

Operating income divided by net sales is the calculation used to obtain the operating profit margin. The operating profit margin has been much lower than the industry over the past five years. The declining operating profit margin is rather concerning and energy investors will most likely prefer Chevron or Exxon as they have stronger numbers in this regard.

Net income divided by net sales gives you the net profit margin. The net profit margin has also stayed below the industry average in the last five years.

The Return on Investment ratios are also not as impressive as the rest of the industry, but Shell's closest rivals like BP Plc (NYSE:BP) and TOTAL S.A. (NYSE:TOT) have similar values. I must mention here that Chevron and Exxon are far ahead in this avenue too.

The Return on Equity [ROE] ratio is arrived at by dividing the net income by the shareholders' equity. The ROE has gone up from 2010 to 2011, but then declined from 2011 to 2012. All the major integrated oil companies have not been able to replicate the impressive 2008 levels.

As for the Return on Assets [ROA], it is obtained by dividing the net income by the total assets. Even the ROA has been generally lower than the industry average over the last five years.

Income Statement:

Shell has an impressive income statement, as is shown in the table below. The income statement numbers are far superior to Chevron. The sales numbers are similar to Exxon, but the income before interest and income tax expense and net income figures are much lower.

Note: U.S. dollar in millions.

Balance Sheet:

Shell has a fairly strong balance sheet. The numbers used to arrive at the profitability ratios listed in the 'Return on Investment' table are shown in the table below.

It can be seen from the balance sheet that total assets and shareholders' equity in oil and gas companies have continued to grow. Shell's total assets and shareholders' equity numbers are comparable to Exxon's and this is a good thing.

Note: U.S. dollar in millions.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

Free cash flow is a measure of financial performance that must be taken into account. It is calculated as operating cash flow minus capital expenditures. Free cash flow [FCF] represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

Over the past five years, Shell's free cash flow has largely remained positive with the exception of 2009. Still, it must be noted that negative free cash flow is not necessarily a bad thing. When the free cash flow is negative, it could be an indication that a firm is making large investments. This could work out very well for a company in the future if these investments earn a high return.

In the case of Shell, the energy company has made a massive commitment to natural gas production across the globe. Although, natural gas prices are currently low, they should increase in the long term as the more environmentally friendly natural gas will be more viable than coal.

Note: U.S. dollar in millions.

The positive cash flow that Shell has is growing and this is an indication that the energy company has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

11. Cash Flow Margin = Cash Flow from Operating Activities / Total Sales

A high cash flow margin can indicate that a company is efficient at converting sales to cash, and may also be an indication of high earnings quality.

On the other hand, a low or negative cash flow margin means that a firm will have to borrow money or require a large influx of outside capital in order to keep on operating.

As Shell's cash flow margin is reasonably high, it can continue operating without any foreseeable cash problems. Still, the cash flow margin has been lower than the cash flow margins for Chevron and Exxon over the past five years.

Note: U.S. dollar in millions.

Conclusion: Be cautious with RDS.A

RDS.A is currently trading at $65.00 and it has had some depressed price action as of late. Furthermore, the profitability ratios don't match up to the largest oil and gas companies.

In the short to mid-term horizon, Shell is a short idea. All investments come with an element of risk and Shell could very well turn out to be an energy play in the long term. This will depend on the success of its riskier and more expansive projects to find new sources of oil and gas.

The increased expense of funding these projects will hurt profitability and this is an industry wide phenomena as seen by the slowly declining industry averages.

All material is sourced from Morningstar and MSN Money.

Disclosure: I am short RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.