Income investors are attracted to Royal Dutch Shell (NYSE:RDS.A) because of the very attractive yield of 6%+. Nevertheless, as income investors we need to do more fundamental work on our underlyings instead of just looking at dividend payouts. In my opinion, Shell's yield is not backed up by the fundamentals presently. We don't necessarily need huge capital gains in our underlyings (as we manage an income portfolio), but protecting the downside is always our priority.
Let's take a look at Shell and I'll explain why, in my opinion, there are better opportunities in the energy space -- such as Chevron (NYSE:CVX) -- at the moment, irrespective of the high yield Shell is currently paying out. To start, we have to look at Shell's track record. Why? Because the company is promising a $15 billion all cash dividend in addition to the repurchase of $25 billion of stock between 2017 and 2020.
Obviously, statements like these attract investors in hoards. But can the company make good on these promises? I cannot stress enough the importance of protecting the downside when investing in dividend stocks. This stock is trading at multi-year lows, so accurate due diligence is required. Below are three reasons why I believe Shell shouldn't be in an income-derived portfolio.
First, Shell has lost a huge amount of money in its shale bets in North America to the tune of $900 million alone in 2014. As a result, Shell is cutting spending by 20% to lower its North American shale exposure to try and keep losses at a minimum. This means that 700,000 acres of shale assets will be sold off and the headcount in this division will also be cut by 30%. Furthermore, this is upsetting for the company as its valuable shale gas assets in the U.S. (Mercellus shale in Pennsylvania, Texas, Colorado, and Kansas) will attract buyers as assets go on the cheap.
What dividend investors need to take into account here is that the selling of assets is never good for a company in the long run. It is estimated that the company will have to sell in the region of $30 billion of its assets in order to make good on its promises mentioned above. Here is where Shell leaves itself open, in my opinion. If the price of oil were to drop to $20-$30 a barrel, Shell would receive very few proceeds from the sale of its North American assets. This would mean that the 20% would probably turn into 30% in order to make good on the above-mentioned agreements. If this were to happen, it would definitely have negative connotations for the share price. If production slides noticeably in the big oil majors, it almost always is reflected in the share price -- no matter how profitable the respective production may be at the time.
Second, Shell is too overexposed in its refining operations in Europe. The company currently has six refineries in Europe (which is too many) as supply outweighs demand by a great deal. Cheaper diesel from Russia and the Middle East are definitely hurting European refiners. Furthermore, petrol is not being used as much in Europe as diesel as motorists switch to cars that consume less fuel. I live in Spain and it is quite evident that many Shell petrol stations have shut down over the last few years. The ones that remain can't compete in terms of price with other petrol stations (where the fuel is probably being imported). I can only see closures in this division of Shell's business, which, again, will result in lower output.
The company needs to restructure in order to stay competitive. If I were the CEO of this company, I would be selling assets in order to invest in more profitable ventures. However, because of the company's share buyback and dividend above-mentioned promises, its investment budget might lag over the next decade. While that might be OK in the short term, it's definitely not OK in the long term.
Finally, I wanted to compare Shell with Chevron as Chevron is in our income portfolio. The temptation here for income investors is to invest in Shell solely because of the high dividend. Furthermore, the stock looks cheap when you see the price-to-sales ratio of 0.49 and price-to-book ratio of 1.18. However, its debt levels have been rising and this is illustrated by its debt-to-equity ratio, which has also been rising since 2013 (as the chart below shows).
Compare this with our underlying Chevron, which pays a lower 4%+ yield but whose debt-to-equity ratio is substantially lower at 0.18.
Chevron has a long history of increasing its dividends. Even though Shell currently pays a higher yield (partially due to its recent share price fall), Chevron seems a safer play right now. I believe my thesis will play out in the coming weeks when Chevron continues to raise its dividend, while Shell will probably reduce its dividend -- or, at best, keep it at current levels, which is $0.94 per share.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.