Royal Dutch Shell Changes Rules, So Now What? (Part 2)

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 |  About: Royal Dutch Shell plc (RDS.A), RDS.B, Includes: MSFT, PSX, SDRL, XEL
by: Mike Nadel

Summary

Shell reshaped its dividend payment plan, so we reassessed its place in our portfolio.

The company offers an attractive dividend but appears overvalued.

After taking a closer look at Shell, we sold most shares and bought other companies.

We still have some decisions to make regarding our last batch of Shell.

Two weeks ago, Royal Dutch Shell (NYSE:RDS.A)(NYSE:RDS.B) changed the rules for shareholders who reinvest dividends. As I said in Part 1, "I wasn't exactly thrilled." Now that a little time has passed, however, I realize this "Shell game" actually was a good thing because it made me thoroughly examine whether the company belonged in our portfolio.

Before I detail our moves regarding the RDS.A my wife and I have held in our Roth IRAs, here is a recap of Shell's May 25 announcement:

Royal Dutch Shell plc ("Shell") announces the cancellation of its Scrip Dividend Programme ("the Programme") with effect from the second-quarter 2014 Interim Dividend onwards. The cancellation means that the second-quarter 2014 Interim Dividend and future dividends will be settled entirely in cash, rather than offering a share-based alternative. This decision will allow for a more efficient share buy-back programme.

Simply stated, those who hold RDS.A in tax-advantaged accounts such as IRAs no longer will be allowed to receive additional shares in lieu of cash dividends. To avoid the 15% Dutch withholding tax, owners must sell before the next ex-dividend date in August, buy B shares and take dividends in cash. RDS.B owners who have been receiving dividends in RDS.A shares also must switch to cash payouts.

Investors who own RDS.A in taxable accounts already have been paying the Dutch government (and hopefully have been recouping the money as a credit at tax-filing time). If they like the status quo, they need not change a thing. The same is true for RDS.B shareholders already receiving cash dividends.

OK, now to the question each investor should ask himself or herself: Do I want to own Royal Dutch Shell at all?

Shell Versus Peers

Let's compare RDS.B with Big Oil peers BP (NYSE:BP), ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM). (Note: Had I used RDS.A in this table, the results would have been nearly identical.)

RDS.B BP COP CVX XOM
Price (6/5/14) $82.35 $50.44 $80.05 $123.52 $100.55
M* Fair Value $72.00 $57.00 $75.00 $132.00 $109.00
Over/Under FV? 14% OV 12% UV 7% OV 6% UV 8% UV
P/E - ttm 20.5 15.7 12.3 11.9 13.7
P/E - fwd 17.0 3.8 12.0 10.1 12.9
Dividend Yield 4.5% 4.6% 3.5% 3.5% 2.7%
5YR DGrwth 2.1% -6.1% 13.3% 9.0% 9.7%
#Yr of DG 3 3 13 27 32
Click to enlarge

As the table shows, Shell is easily the most expensive by both today's price/earnings ratio and next year's estimated P/E. Although Morningstar's "Fair Value" is subjective, the analysts there use the same metrics to compare all companies, and they found RDS.B significantly overvalued.

While Shell's yield compares favorably to BP's, its dividend growth lags behind that of COP, XOM and CVX. Exxon Mobil and Chevron are Dividend Aristocrats, having increased annual payments to shareholders for more than a quarter-century; Shell, on the other hand, froze its dividend from May 2009 through February 2012.

There are plenty of investors willing to overlook some less-than-ideal metrics to capture Shell's yield. Additionally, many no doubt trust Shell's management to follow through on its promise to enhance shareholder value in the wake of scrapping the Scrip Dividend Programme.

My wife and I are moving in a different direction; we already have sold two batches of the stock.

Dumping Shell, Adding Others

At the time of Shell's announcement, we had 291 shares of RDS.A in our Roth IRAs. The stake was worth approximately $23,000 and was primed to generate about $1,094 in annual dividends.

After selling 125 shares, we picked up Ensco (NYSE:ESV), a deepwater driller I had been eyeing for some time. It has a P/E of 8.8, its price is 16% below Morningstar's FV and its dividend yield is 5.8%. We bought 140 shares, good for $420 in annual dividends. Ensco could turn out to be a nice growth play as well as a fine income generator.

Yeah, but isn't ESV riskier than Shell? Probably, and like Shell, it's no Dividend Aristocrat, either. I had all that in mind when we sold another 92 shares of RDS.A and purchased Avista (NYSE:AVA), the rock-solid utility from Washington state. With a 15.9 P/E, it is fully valued, but it benefits from a friendly regulatory environment, has a 4% yield and has been growing divvies for 13 years. We bought 315 shares, which will produce $400 in annual dividends.

Although I am not obsessed with replacing every "Divvy Dollar" we give up in selling Shell, we have done well so far - losing $816 in annual RDS.A dividends while gaining a combined $820 from ESV and AVA.

Future Moves

The transactions leave us with 74 shares of RDS.A, roughly $5,850 worth. On June 26, we will receive about 3.5 more shares as part of the final Scrip Dividend Programme payout.

The plan is to sell all of it and use the proceeds to either top off current holdings (most likely ESV, AVA, CVX, XOM and/or COP) or initiate a new position. Top candidates for the latter scenario include utility Xcel (NYSE:XEL), deepwater driller Seadrill (NYSE:SDRL), oil refiner Phillips 66 (NYSE:PSX) and software giant Microsoft (NASDAQ:MSFT).

One other possibility: holding on to some Shell by buying RDS.B.

The dollar value of our remaining Shell stake represents almost the exact profit we have realized since opening the position in 2012. So if we buy RDS.B after selling the remaining A shares, we'll be "playing with house money."

Then again, no matter what we buy with the RDS.A proceeds, it will be purchased with that same money. So we'll need a better reason to stay invested in Shell. Do we like its potential and its place in our portfolio enough to keep it? Right now, I'd say that's a long shot.

Meanwhile, although I'm willing to let the price drift up and down a bit while awaiting the next dividend, I'm not willing to watch serious money go down the drain. So I have placed a stop sell order at $76.79, which is 5% below the stock's post-recession high.

Conclusion

Had Shell not scrapped Scrip, I probably would have paid it no mind and been content to keep it in our portfolio. When a company we own changes the rules, however, it provides a perfect opportunity to fully examine our reasons for owning it.

And upon close examination of Royal Dutch Shell, I'm confident we can do better.

Disclosure: I am long RDS.A, XOM, CVX, COP, AVA, ESV. 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.

Additional disclosure: I might buy shares in any company mentioned in this article at any time.