For This Oil-And-Gas Name, A Focus On Dividends Comes At A Cost For Shareholders

| About: Royal Dutch (RDS.A)
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Shell recently announced a minor asset sale in the Gulf of Mexico in order to reduce debt.

The company has committed to much larger divestitures in order to stabilize debt, as low sale prices result in real dilution for equity holders.

Financial engineering allows for the current dividend to be maintained, but the creativity results in long-term dilution for equity holders at a big cost.

Royal Dutch Shell (RDS.A) announced a minor divestiture in its goal to step up asset sales in order to reduce its huge debt load, following the British Gas deal as well as continuation of steep dividends during this downturn.

This particular sale of some assets in the Gulf of Mexico has little impact on both the production and debt profile of Shell, which is looking to divest $30 billion worth of assets in a 3-year time window. These sales are much needed, however, to contain leverage following the aggressive build-up in debt. Deleveraging potentially allows Shell to maintain its high dividend policy in the coming years.

While I understand the need to cater to investors with such a yield, Shell has reinstated the script dividend to alleviate some cash flow pressure. I do not like such a strategy, however, as it essentially means issuing equity at historically low prices in order to finance dividends. What is also worrying is that this $30 billion divestiture program has to take place at a time when valuations are depressed in the energy sector. These sales at low valuation, in combination with the full price paid for British Gas, might actually end up destroying quite a bit of shareholder value.

Given the inconsistent nature of some of these huge strategic decisions, I am not attracted to the shares, even as I understand that many investors like the yield in this rate environment.

Just A Minor Sale

Shell recently announced the sale of its Brutus/Glider assets, located in the Gulf of Mexico. EnVen Energy will buy these assets in a $425 million cash deal.

The deal encompasses production facilities and related infrastructure, as total production currently comes in at 25,000 barrels of oil-equivalent per day. The company failed to specify the reserves of the activities, as the deal tag values each barrel of oil-equivalent produced per day at $17,000. Note that these assets being sold make up just 0.7% of companywide production.

Applying a similar $17,000 multiple to the 3.5 million barrels of oil-equivalent being produced each day yields a valuation of merely $60 billion for Shell's production assets. This suggests that the sales price and its multiples are on the low side. Drilling at sea is a more expensive form of production and not in great demand at a time when producers focus on quality, low-cost production fields.

For acreages in certain lucrative US onshore basins, the current M&A market is reasonably hot. Many players often pay multiples of +$100,000 for each barrel of oil-equivalent produced per day.

Second-Quarter Performance

Shell's earnings are highly complicated. A large business like Shell occasionally reports special charges related to divestments, while changes in oil and gas prices impact inventory valuations as well.

Shell did report second-quarter earnings of $239 million on a constant cost basis, although this number did include one-time charges of roughly $800 million. Adjusted for this, profits came in around $1 billion at a time when WTI crude prices averaged roughly $45 per barrel for the quarter. Earnings fell from $1.5 billion on an adjusted basis in the first quarter of 2016, and adjusted earnings of nearly $3.8 billion in the second quarter of 2015.

Important to recognize is that all of the modest second quarter profits resulted from solid results of the downstream and chemical business of Shell, while upstream is actually losing money. Given the adjusted earnings of a billion, interest bill of $800 million for the quarter and $6.1 billion in depreciation charges, EBITDA comes in around $8 billion for the quarter. Once annualized, Shell generates little over $30 billion in EBITDA at the moment.

Cash Flows And & Debt

As seen above, Shell is actually profitable, although earnings are sufficient to cover the fat dividend to which management has committed itself. Worse, Shell issued a lot of shares in order to finance the BG deal, as the outstanding share base has now surpassed the 8 billion mark. The $0.47 quarterly dividend costs the business $3.8 billion a quarter, or nearly $15 billion a year. Given the very modest profitability at the moment, this actually suggests that debt keeps increasing as earnings do not cover the dividend.

Shell ended the quarter with $15.2 billion in cash while debt has risen to $90.3 billion. Net debt of $75 billion is equivalent to roughly 2.3 times the EBITDA number calculated above at $32 billion. The trouble is that this leverage ratio excludes other liabilities which certainly involve cash outflows in the coming years. Net pension liabilities have risen to nearly $14 billion by now, as decommission obligations have doubled over the past 5 years to little over $30 billion.

The one bit of ¨luck¨ which Shell has is that some investors elect for scrip dividend instead of cash payments. The company therefore issued 50 million shares during the second quarter with a value of roughly $1 billion. This suggests that actual dividend payouts of $15 billion only involve roughly $11 billion in actual cash outflows, with the remaining $4 billion in dividends resulting in dilution of the equity base.

In essence, just 70-75% of the dividend is paid in cash with the rest being paid through dilution. In other words, the dividend has already been effectively lowered from $0.47 per share to $0.35 per share after management introduced the option to elect for stock. While investors receive a +7% yield, they see dilution of 2-3% per annum as well.

Balancing Cash Flows

At $45 per share, Shell is pretty much posting profits of $5 billion per annum on the back of the current results including depressed production profits and solid downstream results. Adding $4.5 billion in pre-tax synergies from the BG deal, while allowing for further cost cuts, I believe that the company could post after-tax profits of $10 billion per annum in such an environment going forward.

Dividends come in at $15 billion per annum but only result in cash outflows of $11 billion per year. They do result in 2-3% dilution per year at the current rate, by those investors electing for share dividends instead of cash. That actually suggests that earnings should be able to largely cover the cash dividend payments in the coming period.

Capital spending is seen at a total of $90 billion in the period 2016-2018, offset by planned $30 billion in divestments. These net investments of $60 billion will be offset by an anticipated $60-$75 billion in deprecation charges, suggesting that Shell will be able to operate in a cash neutral way in the coming years. Even if oil prices do not recover, cost savings, modest dilution and divestitures should stabilize the net debt load of the business.

While this pretty much guarantees that the company will survive the crisis, investors have some concerns. Ongoing dilution of the shareholder base is one issue. The other concern is the fact that realizations from divestitures might disappoint, implying that Shell has to sell a lot of assets at low prices in order to meet its target, reducing the earnings power of the business along the way. The recent sale in the Gulf of Mexico is a prime example of that.

Final Thoughts

Shell managed to post earnings of $20-$30 billion a year during years in which oil traded at around $100. Every $1 drop in realizations should hurt pre-tax earnings by $1.2 billion in theory with production running at 3.5 million barrels of oil-equivalent per day. High taxes on oil profits, as well as the fact that NGL and natural gas realizations on a per barrel basis are much lower compared to crude, result in a much lower sensitivity of net profits on the back of changes in oil prices.

An after-tax profit swing of $500 million per year on the back of a $1 swing in oil prices looks much more realistic. This seems to fit reality as well as Shell posted profits of $20-$30 billion a year when oil was at $100 per barrel, while it currently breaks even with oil around $50 per barrel. While cost savings and synergies could allow for better margins even if oil prices do not recover, lower marginal costs reduce the potential upswing in oil prices in all likelihood as well.

Of course, the potential for investors ultimately depends on a potential recovery in oil prices, the timing of such a recovery and the level at which prices find their new equilibrium. If $25-$30 billion in earnings marks peak profits for Shell, and profits nowadays break even, average earnings are seen somewhere in between.

Including synergies and costs savings, I am generously believing that earnings might average at $15-20 billion per year throughout the cycle. With over 8 billion shares outstanding, that yields a $2.00-$2.50 earnings per share number, for roughly a 10 times earnings multiple.

I would be very cautious to award Shell a higher multiple than this given the challenged outlook for the sector with regard to environmental treaties, a $75 billion net debt load and large other liabilities being present on the balance sheet. At best investors can look forward to a current unsustainable dividend yield of +7%, as long as they realize that this will be paid for by reduced prospects for the common stock. At this rate, dilution takes place at a rate of 2-3% per year, while divestments will result in a shrinking asset base on top of this dilution.

I personally do not think that the company is a very desirable investment opportunity but recognize the appeal of a 7-8% yield in a world in which interest rates are negative. Investors should recognize, however, that I believe that markets will increasingly view many of the company's assets as terminal projects, rather than value them on an ongoing basis. This could have a huge impact on valuation multiples being applied to production and reserve multiples.

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

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.