Since late 2012, I have been tracking and analyzing Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) performance versus its management's plan (the "Plan") to improve cash flow and shareholder returns. As part of a series of Seeking Alpha articles, I offer a 2013 third quarter update.
The 2012-2015 Plan
Shell management had previously announced an ambitious, 2012-to-2015 financial growth plan. Four cornerstones were articulated:
- Improve operating cash flows between 30 and 50 percent versus the previous four-year period; the target is OCF of $175 to $200 billion over the period;
- Invest $120 to $130 billion net capital expenditures over the period, emphasizing integrated natural gas opportunities, deepwater production, and "tight" hydrocarbon / shale resource plays
- Maintain a strong balance sheet;
- Link the cash dividend to the results
The goals and objectives are premised upon $80 to $100/bbl oil prices. If oil prices stay towards the upper end of the range, Shell management states the spending and results will follow along the upper Plan target ranges, too.
Here's the original slide from the 2012 fourth quarter conference call outlining the Plan components:
2013 Third Quarter Update and Analysis
Is the Underlying Crude Oil Premise Intact?
The Plan goals and objectives were premised upon $80 to $100 crude oil prices.
Oil prices have co-operated during the first seven quarters of the period. Benchmark Brent crude has been at or above the top of the range.
Brent Crude Oil Spot Price data by YCharts
Shell senior management continues to emphasize that its plans are not predicated upon quarter-by-quarter milestones. Theirs is a long view. Nonetheless, quarterly reports do provide investors sufficient information to re-calibrate current trends versus anticipated Plan results.
In 2012, Shell kicked off the Plan by generating Operating Cash Flows (OCF) of $46 billion. That was a strong start. Through the first nine months of 2013, the company has booked another $34.4 billion. This compares somewhat unfavorably with the year-over-year nine month period, as operating cash eased $1.8 billion this year versus last year. Third quarter cash was $10.4 billion, or about $2 billion less than the linked 2Q.
While not yet a major problem, a decline in year-over-year 2013 OCF will begin to make achieving the upper end of the plan considerably more difficult. I premised Shell could generate OCF of $200 billion via the following annual totals:
Matching the 2012 total in 2013 was a key component of the projection. In the fourth quarter 2012, Shell generated cash flow of approximately $9.8 billion. In order for the company to meet last years' total, it will need to generate $11.6 billion this year. I believe this is unlikely. There are not enough new projects producing strong returns to reasonably indicate such a jump. My view is fiscal year 2013 will see Shell book operating cash flow between $42 and $44 billion.
Revised Operating Cash Flows may look more like this:
Assuming OCF slips to $43 billion this year, extra-ordinary returns will be required in 2014 to make the top end of the Plan. Looking back to July, CFO Simon Henry delivered the following remark during the second quarter conference call Q&A session:
And we're talking about the five projects, so five out of 17, and the overall project growth is expected to deliver, we've said before, $9 billion of cash flow growth 2015 versus 2012 ...
Mr. Henry was referring to expected incremental cash flow with respect to five of seventeen major capital projects; the first five ready to go online over the next few quarters. If an additional $9 billion is added to the 2012 total, cash flow of approximately $55 billion may be expected in 2015. Therefore, by deduction, Royal Dutch Shell would need to make $55 billion in 2014 to make the $200 billion mark.
Bottom Line: Barring blowout fourth quarter, the probability is low that Shell will meet the top end of the four-year Plan. However, a four-year target of $190 to $195 billion remains within sight. This is no small achievement, and would provide sound shareholder returns.
Shell has stated its intent to spend $130 billion net capital over the four-year Plan period. Through the third quarter this year, net capex has reached $28.5 billion. Furthermore, CFO Simon Henry indicated that Shell was going to ramp up 2013 net capital expenditures to $45 billion. This is well above previous guidance. Mr. Henry added that investors would see a significantly lower capital spend in 2014. From the third quarter earnings conference call:
2013 will clearly be a peak year for net investment. As we work through those $10 billion of acquisition and this year's lower rates of divestments, the divestments will step up significantly in 2014-15. We're not providing a split of '14 and '15 spending today or any of the moving part, something we might come back to next year. But to help with the simpler [recluse] net investment last year $30 billion, net investment this year $45 billion, net investment over four years 130 [million dollars] is a pretty good indicator of significant divestment activity and capital choices to come.
The message is that Shell plans to accelerate net capital spending this year, with the expectation that capex spend will moderate and divestitures will go up in 2014 and 2015. Overall net capital will stay within plan limits. This is an acceptable path forward; however, I harbor some concerns that future divestitures will not only offset capital spend, but erode cash generation. To "move the needle," Shell must sell assets valuable enough to attract good bids. Such assets may reduce Shell's own cash flows in 2014 and 2015.
Bottom Line: Shell has accelerated 2013 net capital spending. In order to stay within Plan parameters, future spending will ease and divestitures increase. The company is quite capable of doing this. However, this action raises questions about asset divestitures hampering associated forward cash flows. This becomes especially relevant whereas meeting high-end OCF targets appears less likely.
A keystone of the Plan is maintaining a strong balance sheet. One important metric is what EU management calls "gearing," or the debt-to-capital employed ratio. In Shell's case, a stated Plan objective is limiting gearing to between 10 and 30 percent.
At the end of the second quarter, gearing was 11.2%, up from 9.1% in year-earlier quarter. These figures are within boundaries.
Shell has an outstanding balance sheet by most common measures: liquidity, debt, and equity metrics are excellent.
Bottom Line: Continued maintenance of a strong balance sheet is not at issue. Nonetheless, investors should anticipate 2013 net capex and dividend payments exceed operating cash flow. This will require additional borrowing, thereby increasing leverage into next year.
Royal Dutch Shell management has promised to link the cash dividend to results. To date, they have delivered.
An expected 5% hike in the third quarter payout is forthcoming. The ex-dividend date is November 13. Based upon the recent share price, the annualized dividend yield will be 5.6 percent. Very strong.
Meanwhile, Standard & Poor's offers Shell a "AA" credit rating.
The dividend has been increased for at least twenty years.
Bottom Line: Management has fulfilled its promise to link the dividend with results. The 5% dividend increase is aligned with improved operating cash flow. The payout is safe and amongst the highest in the Energy sector.
As the four-year Plan unfolds, investors find strength mixed with weakness. While prospects of operating cash flow meeting the high end of the target range appear reduced, period-over-period cash flow improvement of "only" 40% instead of 50% requires no apologies.
Meanwhile, Shell remains well in control of its capital expenditure and divestment plans. In 2013, investors may expect free cash (operating cash less net capital) to be negative before dividend payments: thereby requiring assumption of additional debt. However, the corporate balance sheet is so strong that this action poses no real threat to the business, its credit rating, or the dividend. Indeed, as a positive signal to investors, the third quarter cash dividend was increased 5%, providing a strong and secure 5.4% yield.
I remain bothered by other parts of the story line. Shell reported a third quarter earnings miss on the heels of a poor second quarter report. In its third quarter prepared statements and conference call, the company cited weaker industry refining conditions globally, headwinds from low refining margins, and continued challenges from the Nigerian operating environment.
Indeed, Nigeria is a loser. Shell is attempting to largely extricate itself from that part of the world. Future investment success in the Arctic, after sustaining serious losses already, is no better than a question mark. Meanwhile, Shell has begun to take impairments and writedown North American shale assets: too late to the party and finding slim pickings. Divestiture activity has been focused upon the refining side of the house: the very business that Shell states are facing stiff margin headwinds. Selling assets in a down market is often less than opportunistic.
Mr. Ben van Beurden will become the new Royal Dutch Shell Chief Executive on January 1. I do not expect any major changes to the corporate strategy, philosophies, or the Plan.
Long-term investors may appreciate Royal Dutch Shell for its safety, deliberate management, and high dividend yield. The company may yet surprise investors to the upside via strong future upstream project returns resulting in meaningful cash dividend increases.
Such action could improve the P/E ratio by as much as a full multiple point.
Please do your own due diligence before entering into any investment. Good luck with all your 2013 investments.