Dividends On A Knife-Edge: Royal Dutch Shell And BG Group

| About: Royal Dutch (RDS.B)

Summary

RDS acquired BG Group on February 15, 2016.

The BG shares have been delisted.

RDS/BG now yields over 7.5%.

$60B is required Annually to cover Capex, Debt, Dividend and other Cash Commitments.

Its Cashflow from Operations is only $30B.

Background

Royal Dutch Shell completed its acquisition of BG Group on Feb 15th 2016. The full year 2015 results for both companies have been released in recent weeks. I wanted to review the full years earnings reports and assess the dividend safety for the combined entity.

Since May 2015, I have made a total of five investments into Royal Dutch Shell B shares (NYSE:RDS.B) on the LSE. The average price I have paid for my shares is £17.45GBP per share. I estimate the dividend per share to be £1.23, which results in an overall yield of 7%.

As of 16th Feb 2016, the RDS.B share price stood at £15.90 and yielded 7.7%.

From here on in, I will be looking at figures in USD$B.

How do the cashflows look for both companies?

For 2015, RDS and BG reported the following statements of cashflow:

RDS

BG

Combined

Operating Cashflows

29.8

4.3

34.1

Cash Commitments

Capex

26.1

5.6

31.7

Dividends

9.5

1

10.5

Buybacks

0.4

0

0.4

Debt Reduction

6

0

6

JV Commitments

1

0.8

1.8

Interest

1.7

0.6

2.3

Total Commitments

44.7

8

52.7

Cash Deficit

-14.9

-3.7

-18.6

New Debt Issued

21.5

0

21.5

Other Proceeds

0.39

0.39

Asset Sales

4.7

5.2

9.9

26.2

5.59

31.79

FX Gain/(Loss)

-1.1

-1.1

Cash to Balance Sheet

10.2

1.89

12.09

Click to enlarge

I am not confident that the 2015 cashflow performance will be repeated. I will make a number of adjustments to better estimate what will happen to cashflows in 2016:

  1. RDS paid for BG in shares and cash. A material one-off cash outgoing will occur in 2016. What is this figure?
  2. The new shares that will be issued to BG shareholders come with a handsome dividend that must be accounted for.
  3. Given the ongoing doubts about over supply in the oil market, it makes sense to annualize the Q4 2015 results for 2016.
  4. And then there are the proposed synergies, but I feel these will be cancelled out by the increased debt load RDS has to take on to fund the BG deal, which in turn will drive up debt reduction and debt maintenance cash commitments.

What is RDS paying for BG?

RDS paid the following for each BG share:

  • £3.83 hard cash + 0.4454 RDS shares

The deal closed officially on 15th Feb 2016. Assuming this was the actual date when RDS shares were used to purchase BG shares then the price per RDS share on 15th Feb was about £15.50.

Therefore RDS paid each BG shareholder the following value in cash and shares:

£3.83 + (0.4454 * £15.50) = £10.72 per share

Google Finance is showing BG has 3.42B shares outstanding. Assuming this data point is correct, then RDS appears to have paid around £37B for BG (or $53B USD).

But RDS is paying the lion's share in its own shares and about 35% in cold hard cash. RDS needs $19B in hard cash now to cover the cash part of the BG acquisition.

What is the impact on the RDS dividend?

RDS will issue about 1.52B new shares to the BG shareholders taking our figures above (0.4454*3.42 BG shares).

The current dividend is running at £1.23 per share so total dividend payments will be increased by £1.87B ($2.7B).

So going forward in 2016, RDS will pay out what it paid out in 2015 ($9.5B) plus $2.7B (for the newly issued shares) -- around $12.2B.

The impact of annualizing Q4 2015 to estimate 2016

If we take Q4 2015 is a more accurate proxy for what will occur in 2016 then the following cashflow picture emerges

Operating Cashflow

$28B

Capex

$35.2

Dividends

$12.2B

Debt reduction

$7.3

Interest payments

$3B

Other JV commitments

$1B

Total Annual Commitments

$58.7B

2016 Deficit after commitments

-$30.7B

Click to enlarge

And don't forget that RDS requires a big one-off $19B in cash to pay the cash element of BG.

So it seems to me that RDS must source about $50B via new debt issues and assets sales to finance the purchase of BG and its ongoing commitments just for 2016. Cashflows from Operations will just about cover Capex.

RDS is indicating it plans to sell $30B of assets over the next few years but will need to still issue plenty of debt. The annual interest and debt principal reduction payment will thus rise considerably and likely cancel any benefits from synergies.

In May, Shell announced it would issue $20B in new debt to finance the BG deal.

RDS and BG together had over $40B cash on their balance sheets at the end of 2015, but about $67B in total debt.

The market cap of RDS-BG is around $190B.

Is the RDS dividend safe for 2016 and beyond?

Overall RDS will have a cash deficit of $50B in 2016.

The $50B deficit will be funded by:

  1. $20B new debt
  2. $10B of proposed asset sales in 2016
  3. $5B indicated capex and synergy savings*
  4. $15B cash will thus have to come off the balance sheet

* Please note I have not accounted for the debt and interest repayments on the $20B and hence this part of my analysis is on the optimistic side of the fence.

I just about believe that RDS will pay its dividend in 2016, but I predict RDS will do a lot of damage to the balance sheet to maintain its dividend. Given the current oil price environment, it could well deplete the cash on its balance sheet from $40B to $20B over the course of 2016.

The combined commitments (after capex) of dividends, debt reduction and other various commitments will probably run in the $25B-$30B range for years to come.

RDS/BG needs to increase revenues to generate more free cashflow.

And I don't see a share buyback happening any time soon despite what management might say.

Revenue = Price X Quantity

At the moment, oil prices seem to offer little sanctuary as a means to increase revenue.

Can Shell/BG deliver material volume growth so that it can generate the free cashflow required to meet its dividend and debt commitments?

In 2015, RDS produced around 3M BOE/day. BG produced around 0.7M BOE/day.

In its recent earnings report, Shell claims it can deliver another 600k BOE/day by 2020 and that this excludes the potential of BG.

For the sake of argument, let us assume Shell/BG can increase production from 3.7M BOE/day to 5M BOE/day by 2020. That's a 25%-30% increase in volume.

In today's price environment this would probably increase Cashflow from Operations to an estimated $35B-$40B. This would enable the new entity to cover its capex and its debt commitments, but nothing would be left over to cover the $12B in dividends. So I conclude that increased output by itself is not enough.

Shell/BG requires a sizable movement in oil prices to make the model work for its investors. The combined entity needs to get to about $60B in operating cashflows per year to handle all its commitments. I estimate that $60-$70 Brent oil is required to make the deal work for investors at a minimum.

I summarize my thought process on cashflow from operations as follows:

2016 forecast for CFO X Volume growth of 25% X 50% price growth

= $28B X 1.25 X 1.5

= $52.5B

But annual cash commitments for capex, dividends, debt reduction/maintenance and JV commitments comes to nearly $60B.

Finally, I don't see $100 oil in the short to medium term. The US shale rigs that have been shut down will quickly come online as soon as prices come into range. ARAMCO is also starting to promote an IPO. Privatization of all or part of this state controlled energy behemoth will no doubt lead to production efficiencies. Other state controlled oil organizations may well fellow suit to maximize their production volumes and protect their income streams for the future.

Conclusion

Shell/BG is not quite adding up for me.

In the short term, it has zero Free Cashflow. It must issue debt or sell assets to pay a dividend and to pay down its debt commitments.

In the longer term, I am not confident the Free Cashflows will cover the substantial dividend and debt commitments of the business.

As such I sold off half my RDS Shell this morning at £16 per share.

I will consider re-entering the position in the event of a substantial price collapse or perhaps look at other oil stocks that have no M&A risk. Several beaten-up industrials like Emerson (NYSE:EMR), Boeing (NYSE:BA) and Eaton Corp (NYSE:ETN) offer compelling values with decent Free Cashflows that can cover strong dividend yields alongside good buyback policies.

I believe Shell is a risky investment for income investors.

Disclosure: I am/we are long RDS.B.

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.