Share price of Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has risen by 28% over the past 12 months, outperforming a 21% gain for S&P 500 Index. In my view, despite the strong price appreciation, the stock has not yet achieved its full valuation given the company's promising outlook, meaning that the current price uptrend would not stop from here.
Given RDS' attractive dividend yield at 4.6%, the most attractive aspect of the investment would be the company's strong free cash flow growth prospects, which I believe will provide solid margin of safety on the company's dividend commitment. I have performed cash flow projections from 2014 to 2016 to illustrate the growth potential. My analysis is based on consensus revenue estimates which predict the sales to grow by decline by 1% CAGR from $448.5B in 2014 to $439.7B in 2016. RDS' operating cash flow margin expanded from 7.7% in 2009 to 9.0% in 2013. Looking forward, I expect the cash margin to continue rising from 9.0% in 2014 to 11.0% in 2016. My expectation is based on current consensus view that EBITDA margin will likely expand by 200 bps over the next 3 years. In addition, a few start-up projects are expected to come online over the next few years. Management's plan to drive up cash flow from Downstream business by $2.5B per year also supports my view. For capex, I assumed the spending to rise slightly from $35.5B in 2014 to $36.5B in 2016. It is noted that my projection for 2014 is more conservative than management's guidance of $35.0B. Given management's plan to dispose $15B worth of assets in the next 2 years and that many start-up projects are approaching their final stage, I expect that capital spending trend to be flat or even go down over a medium term. For conservatism, I modeled a slight spending increase in 2015 and 2016. Based on the conservative assumptions, free cash flow was projected to rise by 56% CAGR from $4.9B in 2014 to $11.9B in 2016 (see chart below).
As RDS has achieved $11B disposals in 2014, I modeled total divestiture proceeds of $12B for the year. I then assumed $3B in 2015 such that the total disposal value in 2014 and 2015 will match management's guidance. In 2016, I assumed another $1B sale. For cash acquisition, I only used the $4.1B that was reported in Q1 2014. As a result, total distributable free cash flow in 2014 is estimated to be $16.9B and the figure is expected to stay at above $10B over the next 2 years (see chart above). RDS is projected to spend $10B in dividend in 2014. Assuming a 4.5% annual growth in dividend spending over time (which is in line with RDS' current dividend growth pace), my projected distributable free cash flow can well cover the payment from 2014 to 2016. The fact that RDS' consensus long-term EPS growth estimate of 7.3% and my free cash flow CAGR forecast both exceed the current dividend growth rate would suggest that investor may see dividend growth accelerate in the next few years.
Based on current annualized dividend of $3.76 per share and 9% cost of equity, the Gordon Growth Dividend Discount Model suggests that current share price of ~$82 (~$87 for RDS.B) has priced in a dividend growth range of 4.0%-4.5%, which has not full reflected the higher dividend growth potential (see chart below).
Despite the strong price appreciation in the past 12 months, RDS.A and RDS.B trade at 10.6x and 11.4x forward 2015 EPS estimate, respectively, which are at notable discount to the same multiple of S&P 500 Index at15.4x though RDS' long-term EPS growth potential (7.3%) is not significantly lower than S&P 500's estimate of 9.0%. Moreover, RDS also trades at favorable valuation relative to its global integrated oil peers. Both RDS' forward P/E and EV/EBITDA multiples are at slight discount to peer averages, even though RDS has above-average long-term EPS growth potential and dividend yield. The primary reason could be due to RDS' lower profitability as measured by metrics such as EBITDA margin and return on capital. However, as management continues to work on its plan to improve capital efficiency, I expect profitability to improve notably over the next few years. As a note, current consensus views expect EBITDA margin to reach 15.4% by 2016, which represents a significant improvement from its historical level (see chart below).
In conclusion, I believe RDS' free cash flow and dividend growth potential are being underestimated. As share valuation remains inexpensive, a buy rating is warranted.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: The author is long RDS.A. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.