Royal Dutch Shell (RDS.A, RDS.B) has a sizeable debt wall ahead of them. With nearly $20 billion in debt due over the next five years, this company is going to have to be firing on all cylinders in order to not just meet these principal repayments, but to generate enough cash flow to fund the sizeable dividend, boost capital expenditure per the company's Q3 2016 guidance, and still remain in positive free cash flow territory. It's important that investors take a tough look at the debt due this year and understand the company's current liquidity position.
The Debt Wall Has Been Built
I've been quite positive on Royal Dutch Shell over the past couple of months, ever since I first looked at their liquidity situation, projected proceeds from divestments, and the level of cash inflows with respect to their primary budget items like capital expenditure. What we have below is not a pretty picture, unfortunately. Royal Dutch Shell has a tough few years ahead of them, having principals repayments of over $4 billion each year for the next five years. Not only does that tax this company, but it's going to continue to leave an interest expense burden that continues to mitigate the bottom line.
Now, there's an important note that needs to be made. Royal Dutch Shell has a crude oil sensitivity (using the Brent) that for every $10 change, operating cash flow changes by roughly $5 billion. Think about it this way, should crude oil trade around $60 by the end of 2017, then the company will have generated enough residual cash flow to pay down debt obligations. That's definitely achievable and one of the reasons that this sizeable debt stack doesn't worry me. Additionally, the company still is planning on divesting $22-24 billion worth of assets over the next twenty-four months, which will help set the company up with a liquidity position that will be able to cover the oncoming debt fully and then some.
Of the debt due this year, there's quite the mix of denominations. The May 2017 4.625% issuance has the largest amount outstanding at 1.5 billion denominated in euros, which places its USD burden around $1.59 billion. There's also the BG assumed debt of $500 million due at the end of the year which carries a hefty interest rate of 5.125% and is denominated in British pounds. The rest of the debt is denominated in USD. I will note that I would've liked to see the company make progress on the principal repayments in the past couple of years; however, the debt burden through the down cycle was heavy as well, so there was little room to direct cash flows towards these maturities.
One thing to note here is that the maturities are spread throughout the year, allowing time for the company to generate a higher level of cash flow to fund these repayments. If all the debt was stacked in a single month or even a single quarter, we'd have a large problem on our hands.
Will Debt Impact Performance?
That depends. At least from a retail perspective, equity holders don't always think about the maturity lineup of large majors because they're fixated on the massive size of the company, the consistent dividend yield, and the global footprint. It's quite the compelling investment thesis at face value. Shoot, had you only looked at those things over the past year you would've been very lucky as the performance of this stock has been quite impressive for a major O&G company. In the last twelve months, it's traded up from $35 to nearly $60, for gains of just shy of 70%. However, it's important to recognize the significant risks present with the company.
While I don't believe debt will hinder equity performance, it may very well hinder company performance. I'll give you an example. Take a look at their most recent income statement and head to the interest expense line. In Q3, Royal Dutch Shell paid out almost $1 billion in interest, which is a ridiculous burden to have. That's not inclusive of funds dedicated towards principal repayments either, naturally. Considering that Royal Dutch Shell only made (relatively) $1.4 billion in net income during the quarter, that $1 billion interest expense is a direct cause of lower profitability.
Now, the quarterly results were met with much optimism, but this company would be in a much better financial state if they hadn't burdened themselves with debt a few years ago. However, hindsight is 20/20, so we'll refrain from analyzing the past. Should Royal Dutch Shell be able to alleviate portions of some of their maturities then they're going to be able to really increase the bottom line and provide a greater return to shareholders.
With all of that being said, I will say that the company is focused on properly directing its cash flows towards dividend sustainability, debt repayment, and keeping capital expenditure at a level that allows for a significant amount of free cash flow to be developed. I'd say the heaviest focus of this company, especially over the next twelve months, is to stay positive in terms of free cash flow and to maintain the dividend, which currently sports a yield of 6.43%.
Source: Investor Presentation
I remain bullish on Royal Dutch Shell. The company clearly has the right direction and has cut back expenses considerably - both capital and SG&A related - that they can afford to progress in line with current guidance. The yield, too, is an excellent source of current income representing a payout that is unparalleled by peers. This is going to be a tough year for the company, but should they be able to pay down all of their debt with minimal backlash from analysts or the investing community, then the stock should put up considerable gains at a premium to commodity prices.
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.