Seeking Alpha

Royal Dutch Shell: 10 Reasons To Be Long On The Greatest Energy Stock In The Market While It Returns $125B To Shareholders

|
About: Royal Dutch Shell plc (RDS.A), RDS.B, Includes: BP, CVX, TOT, XLE, XOM
by: Nikolaos Sismanis
Nikolaos Sismanis
Long only, Growth, growth at reasonable price, long-term horizon
Summary

Royal Dutch Shell is ready to accommodate the increased demand for energy.

The company's free cash flow is enormous, even after returning billions to shareholders.

Investments in new energies will position Shell favorably in the future.

Below, I list 10 reasons why I believe Shell is a fantastic stock to be holding.

My love for Royal Dutch Shell (RDS.A) (RDS.B) is no secret. The stock was my first pick for my "Grandpa's Retirement Portfolio" a couple of months since, in my opinion, it is one of the most fabulous retirement stocks in the market. The point of this article is to explore 10 reasons why I believe Royal Dutch Shell is currently the best energy stock in the market, in-depth.

My thesis

Headwinds from slowing global economic growth are manifesting in weak oil and gas pricing benchmarks, presenting an obstacle to Shell's near-term performance. However, management has maintained 2020 share-buyback and deleveraging objectives. Attainability appears healthy and is likely to go smooth on the evolution of the macroeconomic landscape. Still, in the longer term, Shell has the most-compelling strategy among integrated oil majors, in my view, holding the most extensive LNG portfolio. That makes it best-placed to exploit projected global undersupply by mid-next decade. The largest five listed oil and gas companies - Chevron (CVX), BP (BP), Royal Dutch Shell, Exxon (XOM), and Total (TOT) have all been attractive to me. However, Shell remains the most balanced of all. The company is a compelling buy for several reasons. Below, I am listing 10 of those, for which I remain confident that Shell is a long-term juggernaut to hold in your portfolio.

1) Upstream cash flow is robust

Following a tough Q3, with Shell's upstream earnings below expectations due to lower oil and gas realizations and well-performance issues, a reduction in the segment's 2019 consensus adjusted earnings from $7 billion is anticipated. However, upstream adjusted operating cash flow remains on track to exceed $20 billion this year, we believe. Shell has a robust project pipeline, with 250,000 barrels a day of peak-production capacity coming online in 2019-20, and volume will climb through year-end. With oil prices being favorable, even without any increase in volumes, RDS can generate superior profitability, as you can see below.

The upstream unit is expected to generate almost half of Shell's organic free cash in 2019-21.

Source: Bloomberg Intelligence

2) Solid production even under a macro-headwind climate

Over the past few months, if not years, there has been a lot of speculation regarding whether we face the end of an economic cycle, which could cause macroeconomic headwinds. When it comes to Shell, I believe that the company will be able to withstand such struggles. Not only has oil been in high demand, but also Shell has all the means to accommodate it. Moreover, it generates an enormous stream of cash flow to fund operations, under any economic climate. As you can see below, Shell was able to maintain and deliver continuous net earnings, even under the 2015-2016 time frame that the oil stocks had to go through. Regardless, LNG sales volumes have seen a steady upward trend, with no justification for a potential slow down.

Shell's integrated-gas unit's $9 billion adjusted earnings consensus for 2019 will likely be revised down after Q3 earnings and cash flow were weakened by lower gas and LNG spot pricing, isolated production impacts, and a one-time tax provision. Still, Shell's largest unit by adjusted earnings is showing excellent operational delivery. It should reach record-high liquefaction and sales volume by year-end with the startup of Prelude, a 3.6 million-tons-per-annum (mtpa) floating LNG project, and the resumption of Idku LNG in Egypt. New LNG capacity coming online in the U.S., Russia, and Australia supports an oversupplied global scenario, which is likely to persist through 2021 at least.

Shell's downstream weakness in 2Q, amid a volatile macroeconomic environment, may extend into 2H before gradually easing with rising availability. While the $8 billion consensuses for 2019 downstream adjusted earnings appear high, the $6-7 billion organic free cash flow guidance still looks achievable. The oil-product business remains a highlight, expected to grow 6% annually, and add $2.5 billion to earnings by 2025 vs. 2015.

Shell's downstream comprises marketing, refining, and trading, and chemicals. The unit refines 2.6 million barrels a day, weighted to the Gulf of Mexico and western Europe.

3) Targets on track - A potential $125B to be returned to shareholders

Shell's financial framework is stable and in good condition after a three-year effort to deleverage following its $53 billion BG acquisition in 2016. The $25 billion buyback program remains on pace, and 2020 average organic free cash flow guidance of $28-33 billion is achievable, despite a weak 1H.

Shell can fund its share-buyback program, begun in mid-2018. With $9.25 billion completed by mid-2019, the company remains on pace to achieve its $25 billion targets by year-end 2020, with the quarterly run rate increased to $2.75 billion per tranche. Lean 2019 spending, at the low end of $24-$29 billion, and estimated annual cash-dividend costs of about $16 billion, will be comfortably covered by operating cash flow.

The adjusted operating cash flow was $22.6 billion in 1H. The company estimates that for every $10-a-barrel change in the price of Brent crude, annual operating cash flow moves by $6 billion.

As of mid-2019, Shell had repurchased $9.25 billion of stock. With the next tranche of $2.75 billion initiated in July, the company ended Q3 with 2.3 billion, slightly lower. In their presentation, management made it clear that they expect to complete $25 of repurchases by the end of 2020. They also seek to address the scrip-driven share dilution - about 3% annually - that was sustained through the oil-market downturn. Shell previously suspended buybacks in February 2015.

At Shell's average repurchase price, its $25 billion buyback target corresponds to about 800 million shares or 10% of the total outstanding when the program began.

A highlight of Shell's 2021-2025 strategy outlook was the confirmation that it remains firmly on track to achieve its 2020 targets, an explicit endorsement of the company's strategic delivery. We can expect a steady annual organic free cash flow of at least $25 billion (assuming oil at $60/barrel) as comfortably achievable by 2020, while discipline continues to hold CAPEX near the low end of its $25-30 billion range. Debt reduction is also consistent with Shell's goals at approximately 20% gearing (under IAS 17).

In my view, Shell's rising organic free cash flow outlook through 2025 supports its announcement for the $125 billion of shareholder distributions (including dividends and buybacks) over the five years ending 2025, representing a strong signal. The objective includes the implication that dividends would rise from 2021 onwards, after completion of its current $25 billion share buyback program by the end of 2020. Note that management didn't clarify how the $125 billion would be split between share buybacks and dividends, though we can expect the breakdown will remain biased toward buybacks, given the flexibility offered relative to a permanent dividend hike.

The $125 billion compares with an estimated $90 billion returned to shareholders via dividends and share buybacks from 2016-2020, and $52 billion from 2011-2015.

Source: Bloomberg Intelligence

4) Debt reduction and a well-fortified balance sheet

Shell has cut its debt by almost $19 billion since reaching a critical balance-sheet inflection point in late 2016. A flurry of noncore asset disposals, alongside free-cash-flow growth, helped reduce net debt-to-capital employed to 23% as of 2Q (IAS-17) from a peak of 29.2% in 3Q16. Management targets 20% (IAS-17) or 25% (IFRS-16), and the balance sheet remains, in my view, in a comfortable window. Management's objective to repurchase $25 billion of shares by year-end 2020 is a piece of evidence to balance-sheet progress made since the blockbuster BG acquisition.

5) Organic free cash flow is king

Everyone loves free cash flow. The market is currently at all-time highs, and while driven by strong earnings, valuations aren't exactly cheap. In my opinion, companies that generate significant free cash flow will be more comfortable should the market take the wrong turn anytime soon. When it comes to cash flow, Shell knows it can generate some of the best C/F statements in the energy sector. Over the past 12 months, Shell has generated over $27 billion in free cash flow, even after all dividends and buybacks.

Source: Bloomberg

The company's free-cash profile is a function of its 2012-14 capital-intensive period, which is yielding a wave of project startups in the cash engines of conventional oil and integrated gas. In 2020, Shell expects $5 billion in operating cash flow, exclusively from new projects being brought online. Organic free cash flow in 1H was $9.6 billion.

Shell models its outlook at a Brent oil price of $60 a barrel. As I mentioned, a $10 change corresponds to about $6 billion in annual operating cash flow.

Shell's rising organic free cash flow outlook, targeting $35 billion by 2025, assuming $60 oil, (vs. about $30 billion in 2018 with oil averaging $71), will accompany marginally higher annual CAPEX and dividends, still leaving excess free cash for debt reduction or inorganic growth. Given management has broadly achieved its balance sheet deleveraging objective of about 20% gearing; I anticipate a growing appetite for M&A for Shell in the coming years. Most likely, it is to be focused on cash engines or growth priorities such as the Permian, deepwater, and its emerging power segment.

Note that Shell's two most significant European peers (BP and Total) have made multi-billion-dollar scale upstream-focused acquisitions within the last year, (BHP Billiton Permian and Anadarko Africa).

6) Prudent spending

Capital-spending reduction has been Shell's principal and most immediately useful tool for managing its financial framework, with its annual spending floor down more than 40% from a combined Shell-BG peak of $45 billion in 2014. Spending came in below the $25 billion level in 2018, and Shell has guided to $24-$29 billion until 2021. I expect the lower end of the range this year. Capex cuts have been weighted toward exploration, project deferrals, and structural-service cost deflation.

The investment will be underpinned by conventional oil and gas, integrated-gas segments, and deepwater growth, accounting for about two-thirds of capital. Cash CAPEX in 1H comprised $10.9 billion.

7) New energies on the rise

Shell highlighted a new strategic theme of "Emerging Power" in its 2021-2025 strategy, outlining plans to integrate across the electricity value chain from generation, distribution, trading, and customer products, reflecting its peer-leading efforts to safeguard its portfolio for the energy transition. Shell expects to spend as much as $3 billion annually on new energies from 2021 to 2025, up from about $1.5 billion now. By 2030, we can expect Shell's new energy spending to roughly quadruple from current levels to 20% of CAPEX. Massive electrification is anticipated to occur in the global energy system in the coming decades. It will be needed to achieve Paris climate goals, while Shell's head of new energies said earlier this year, the company would strive to be the world's largest power producer by the 2030s.

Rising budgetary allocations to new-energy units can reflect awareness among integrated oil companies of the long-term risks to future oil demand from internal combustion engine efficiency gains and electrification of the transport sector. Currently, accounting for a nominal 2-5% of capital budgets, we can expect the sector's green investment to increase further in the coming years, facilitated by a recovery in free cash flow and the improving cost efficiency of renewable technologies. Early indications from select management teams suggest up to 20% of annual investment could be green by 2030.

Source: Bloomberg Intelligence

8) Growing LNG Demand

The rationale for a final investment decision on LNG Canada is framed by emerging strong fundamentals in the global LNG market. Anchored by Asia, steady and robust LNG demand growth projected through 2030 comes amid a shortage of investment in global liquefaction capacity and project FIDs since 2015, generating an undersupply scenario early next decade. Bloomberg New Energy Finance expects global LNG demand to rise from 284 MMtpa in 2017 to 450 MMtpa by 2030. Asia is expected to be the core driver, buying an additional 14 MMtpa, comprising 86% of global LNG demand growth.

9) Transition to EV-charging deals

Shell's early-2019 acquisition for an undisclosed consideration of Greenlots, a North America-based EV-charging and energy-management software company, reflects a clear and growing trend among integrated oil companies toward EV and electricity deals, in our view. I see EV charging as a pragmatic and relatively low-risk entry point that rounds out existing service-station infrastructure and also potentially provides a natural hedge against declining gasoline and diesel demand. Nevertheless, EV-charging networks are unlikely to make a material contribution to the companies' revenue or earnings anytime soon, despite sharply rising plug-in-vehicle sales.

Shell's Greenlots deal followed its $31 million investment in Ample in 2018, and NewMotion in 2017 (value not disclosed), both EV charging companies.

10) Energy storage disruption opportunity

Battery-storage integration is a key growth area in renewables, along with offshore wind and solar, which are now all targeted by oil major Shell. A deal to acquire battery storage supplier Sonnen gives Shell exposure to fast-growing home battery-storage demand in key markets such as Germany, Australia, and the U.S., and allows it to compete for new grid service sales. The sonnenBatterie network in Europe has a capacity of 300 megawatt-hours, with Sonnen's virtual battery plant now providing grid-balancing services in Germany. A shift to the electrification of heating and transport also adds Shell some synergies with Sonnen, as it allows for both home electric-heating and EV-charging products.

Any expansion of Sonnen's footprint, particularly in the U.S. and Australia, could drive new demand for its core battery supplier Sony. Below, the graph depicts new additions to the residential energy storage space by country. (in MWh)

Source: Bloomberg Intelligence

Conclusion

Royal Dutch Shell is, in my opinion, the most significant energy stock in the market right now. Its cash flow is tremendous, and even under macroeconomic headwinds, the company is well-positioned to accommodate the increasing demand for energy. The shareholder return program is terrific, and management seems to be on track on delivering ~ $125 billion to shareholders, as promised.

On top of that, RDS is making considerable investments in the renewables sector and is planning accordingly for higher demand in both sustainable energies and EV-charging stations. In my opinion, RDS is a fantastic holding for any portfolio, whether it is retirement oriented or not. The stock is a cash-flow machine that could outpace the market, should the indexes take the wrong turn.

Disclosure: I am/we are long RDS.A, 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.