- Management's updated strategy plan will improve free cash flow profile.
- 7%+ annual dividend growth and cumulative $7.5B share buyback through 2016 is achievable.
- Current share price only reflects 4-5% dividend growth potential.
- Valuation gap to global oil majors should shrink if capital return can be improved.
Share price of Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has risen by 18% over the past 12 months. Management has recently updated the company's long-term growth strategy. In my view, the implication would mean better free cash flow prospects and likely improved dividend growth down the road. Based on the current stock valuation, I recommend income investors seeking exposure to global oil majors to consider buying the shares now.
In March, management elaborated on an updated long-term strategy plan, which is aimed to improve RDS' poor free cash flow and return on equity performance as a result of excessive capital spending and disappointed volume growth in recent years. Management has set out a target to increase operating cash flow (OCF) to approximately $50B and achieve 12% return on common equity by 2015/2016. To meet the target, the company will 1) conduct operational restructuring in both Upstream and Downstream divisions; 2) dispose about $15B non-core assets in 2014 and 2015; and 3) maintain annual capital spending at around $35B over the next few years. Given RDS' free cash flow generation and capital return performance have been lagging global oil majors, this revised strategy should be a good news as it will improve the stock's relative valuation if the company can demonstrate positive progress. Further, RDS has a solid pipeline of new projects coming online in 2014 and 2015 with many of them focusing on deep water in Gulf of Mexico, which is a promising area. The company also has a leading exposure to LNG among global oil majors. In 2013, LNG businesses accounted for 30% of RDS' total operating cash flow. As the growth for LNG sector is expected to exceed industry average over a long run, RDS' strong presence in this area should bolster its overall financial performance.
I have performed cash flow projections to gauge RDS' free cash flow profile over the next few years and its impact on dividend growth and share repurchase. My analysis started with consensus revenue estimates which predict the top line to reach $423.9B by 2016. The forecast incorporates certain level of management's $15B disposal plan and represents a -2.1% CAGR from 2013. Over the past 5 years, RDS' OCF margin improved from 7.7% in 2009 to 9.0% in 2013. My model assumes a 9.0% OCF margin in 2014 and a 1% annual margin expansion through 2016. I believe the OCF margin expansion is achievable given management's target to drive higher capital return, divest OCF-diluted projects as well as the start-up of many lucrative new projects. It should be noted that my operating cash flow forecast of $46.6B for 2016 is 7% below management's $50B target. I then assumed capital expenditure to remain flat at $37B through 2016, which is also more conservative than management's target of $35B per annum. In terms of asset disposal, I assumed some delays in the $15B disposal plan and therefore only modeled $13B in 2014 and 2015 and the remaining $2B in 2016. Based on these conservative assumptions (relative to management's), RDS can still have sufficient free cash flows to sustain a 7.5% annual dividend growth and an cumulative dividend repurchase of approximately $7.5B through 2016 (see chart below).
In terms of valuation, I believe RDS is now trading at an attractive level. Based on Gordon growth dividend discount model, a 9% cost of equity (the cost of equity would be lower if using CAPM model given RDS' low 5-year beta of 0.51), and current annualized dividend per share of $3.60, the share prices of RDS.A ($75.7) and RDS.B ($80.8) imply a perpetual dividend growth rate in a range between 4.0% and 4.5%, which is below my dividend growth expectation of 7.0%+, suggesting that the current valuation should pick up if management is able to deliver better than 4-5% dividend growth (see chart below).
From a relative perspective, the valuation also seems compelling. The stock now trades at 4.6x (RDS.B at 4.8x) consensus estimated 2015 EBITDA and 10.3x (RDS.B at 11.0x) consensus estimated 2015 EPS, both of which are at 8-11% discount to the average levels from global oil majors. It should be noted that RDS has a higher consensus long-term EPS growth estimate than peer average, making the valuation even more attractive on PEG basis. Its dividend yield is also much higher than peer average. Capital returns (i.e. return on capital and return on equity) are the primary drag on valuation as the gap remains notable. Given the improvement of these metrics are management's top focus, I would expect the gap to shrink over time, which would be a main driver for valuation multiple expansion.
In conclusion, RDS should see improved free cash flows and dividend growth over the next few years if management is able to execute the revised strategy (the improvement is still possible even with some misses). A buy rating is thus warranted as the stock still trades at solid discount to its peers and only reflects 4-5% dividend growth potential.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified