Royal Dutch Shell: Boom, Or Bust?

| About: Royal Dutch (RDS.A)
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Depending on your point of view Royal Dutch Shell (NYSE:RDS.A) is either a well-managed company with a nice dividend and a long-term growth strategy that is being unfairly punished by Wall Street, or it's a company with low profit margins, a risky venture in Alaska, and a lack of new sources of energy.

Despite a strong balance sheet and steady overall profits, Europe's largest oil company has watched its stock price fall 8% in the last year. It is trading around $65 a share, with a price-to-earnings ratio around 8.


When it reported its quarterly and year-end earnings on January 31, Shell's investors and analysts sounded disappointed. The stock fell despite the company increasing quarterly net income by 15% to $5.6 billion. Wall Street expected earnings of about $6.3 billion. Shell blamed prolonged price deflation in natural gas for most of the shortfall.

Shell's earnings release contained several bits of disappointing news. First, its upstream operations had lower quarterly earnings from the year before, from $5.1 billion to $4.4 billion. Second, its U.S. exploration and production business reported a loss of $69 million, which it blamed on the low price of natural gas. And the company estimated that it replaced only 44 percent of the oil and gas reserves it produced in 2012, meaning it's not finding adequate new sources in which to drill.

Prior to its financial reports, Shell delivered bad news when its Kulluk drill ship run aground in the arctic waters off Alaska during a storm. That rig, along with another, need repairs done before the company can begin drilling in the region.


Shell has been focused on Alaska's Arctic coast as a frontier for energy exploration. It paid around $2.2 billion for licenses to drill in 2008 and has spent around $2.8 billion for operations over the past six years. But the investment has yielded nothing; no wells nor any new deposit discoveries.

Industry watchers are questioning the Arctic strategy as easier-to-recover sources in the lower 48 states give companies a much cheaper option.

Shell's plans also include increasing exploration drilling activity over the next two years. It expects to drill over 40 high-potential wells in 18 conventional basins, and test 10 key resources plays for tight gas and liquids-rich shales.


On the bright side, the company generated cash flow from operations of $46 billion in 2012, an increase of $10 billion from the year before and above its pre-financial crisis level. In the fourth quarter alone, cash flow from operating activities increased more than 50% to nearly $10 billion.

Helping cash flow are start-up operations from the previous three years that brought in $6 billion of cash flow, according to the company. Shell ended the year with $18.8 billion in cash and equivalents on its books, up from $11.3 billion the year before.

The company also claims to be better managing its portfolio. It exited non-core positions worth $7 billion in 2012 and $21 over the last three years. During the same period, it spent $5 billion and $17 billion, respectively, on key acquisitions.

Shell's growth agenda, which the company confirmed in a special statement in late January, aims to deliver $175-$200 billion of total cash flow from operations for 2012-2015, a net capital spending program of $120-$130 billion, and a competitive dividend for shareholders. Shell has 30 new projects under construction, which it says should unlock 7 billion barrels of resources, and drive continued financial and production growth. Upstream start-ups in 2010-15 are expected to add $15 billion of cash flow in 2015, in a $100 oil price scenario. Shell forecasts that 50% of its 2013 capital investment will contribute to cash flow by 2015.

Even with all its capital investments, Shell is paying one of the most generous dividends in the oil industry with a yield of 4.86%. And with a fairly low payout ratio of 36%, the dividend percentage is in little danger of being lowered. In fact, the company said that it is likely to increase its dividend in the first quarter of 2013 to 45 cents a share, a 4.7 percent increase over the first quarter of 2012.

Also, the company's production, manufacturing and administrative expenses have been held generally flat since 2008, demonstrating good expense management. That has allowed management to increase capital investment 10% to $33 billion this year. About $18 billion of that investment will be earmarked to new project development, while another $12 billion will be allocated to growing its mature businesses.

Shell's major weakness is its profit margin. Its trailing 12-month gross margin was 16%, much less than the industry average of 26.7%. Likewise, Shell trails in the industry in five-year average gross margin, 17.5% to 27%. Its return on assets and return on investments also trail industry averages.

The stock price is not only down from last year, it's essentially flat when compared to its price five year ago. However, the company has added value, as indicated by an increasing net book value. NBV is the value of the company's assets minus the value of its liabilities and intangible assets. It's also known as shareholders' equity, or what the company would be worth if it paid off its debts and liquidated itself.

Shell's net book value has increased each of the last five years, from $19.59 a share in 2008 to $28.65 at the end of the third quarter in 2012. Plus, Shell has relatively low debt and a healthy return on equity of about 19%.

Boom, Or Bust?

As one stock watcher summarized, the discrepancy comes down this: Shell's management is trying to execute a four-year plan in which it's currently on track to do after completing the first year. Wall Street lives on a quarterly basis and wants results now.

In the end there may be no right or wrong, just a matter of perspective.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.