Royal Dutch Shell: I Was Wrong As Shell Rewrites Its Dividend History With A 66% Cut
Summary
- Shell's relatively strong Q1/2020 results were overshadowed by a 66% historic dividend cut.
- A prolonged period of economic uncertainty, weaker commodity prices, higher volatility and an uncertain demand outlook left Shell no other option.
- The dividend cut has slashed Shell's dividend yield from around 10% to around 4%.
- As painful and disappointing as such a cut can be, it ultimately is a prudent move and should help Shell overcome this storm without any further drastic moves.
Following up on my birthday on April 28 where Wirecard (OTC:WRCDF) shocked markets with a disappointing and devastating special KPMG report that has seen the stock drop by almost 1/3, it was only two days after that Royal Dutch Shell (RDS.A) (RDS.B) delivered another heavy blow to my portfolio.
Following unprecedented market conditions in Q1/2020 and in April, Shell did the previously unthinkable and slashed its dividend by 66%. Out of all the dividend cuts and suspensions this pandemic has already brought to my portfolio, this one comes as a shock as obviously pinpoints that I was wrong when I declared that "Shell will do whatever it takes to maintain the dividend in the short term." The dividend cut marks the first time since World War II and easily overshadowed Shell's Q1/2020 earnings and its outlook.
Source: Edie.net - all image courtesy remains
For years Shell has been active in portraying the stock as a world-class investment case, and while it was able to weather the 2015/2016 oil glut, this pandemic which sank crude oil prices firmly into negative territory is unprecedented and the result of dual black swan. As such while I am obviously disappointed that the dividend was cut that early, here are my thoughts on what matters now.
What is going on at Royal Dutch Shell?
Apart from declaring its first-quarter 2020 interim dividend, Shell also released earnings for Q1/2020. Unsurprisingly profits tanked with earnings down 46% and income from Shell's Upstream segment collapsing from $1.5B to $0.3B.
A historic collapse in oil prices in Q1, although the real carnage happened in April actually, is accompanied by a high degree of uncertainty around macro economic recovery. While stock markets have been rallying tremendously since hitting their low in mid-March, the real economy paints a completely different picture. Unemployment claims have reached over 30M in the U.S., GDP is contracting around 5% in Q1 and the road to recovery is basically unknown in terms of duration and potential changes in consumer behavior.
Source: Shell Q1/2020 Earnings Slides
Shell was giving these indicators as part of its earnings call, but what becomes apparent is that although it expects oil prices and oil demand to recover, it does not look very realistic that oil prices will sustainably reach their $60/bbl level anytime soon (=within a year).
We need to put these figures into reference. For Q1/2020 the average Brent price was $50/bbl (it is currently roughly 50% lower!) and already Shell's profits tanked by almost 50%. With the current oil price being roughly 50% lower than the average in Q1/2020, the real damage will only happen and show in Q2.
In Q1 Shell's cash generation was actually surprisingly strong at first glance with operating cash flow hitting $7.4B and free cash flow eclipsing $12B with the latter covering the dividend by more than 3 times for the quarter. However, that illustrious FCF figure includes $7.4B in favorable working capital adjustments. Excluding those, FCF would have reached around $4.7B, resulting in a FCF dividend payout ratio of around 75%.
Source: Shell Q1/2020 Earnings Slides
Prior to announcing that Shell temporarily suspends its share buyback program, the company had already "wasted" a precious $1.5B at much higher prices.
Assessing the historic dividend cut
In my view, Shell has not been really transparent about its unexpected and massive dividend cut. Back on March 23, 2020, just a month ago, Shell made several moves to strengthen its financial fortress and reinforce business resilience, such as:
- Cutting FY2020 Capex by around $5 billion to $20 billion
- Launching divestment program of more than $10 billion in assets
- Suspending share buyback program
- Reducing operational costs by $3-4 billion p.a. over the next 12 months
Following this announcement, the stock was rallying from the low $20 to the mid $30s on hopes and expectations that Shell will be able to maintain its dividend.
What is important though to remember is that back then Shell already did not mention its dividend and now in hindsight it was probably already in intense discussions about that even though management couldn't have known that oil prices will crash into negative territory in April.
Still, it is a shock that Shell is cutting the dividend and especially that it already cuts it that early whereas rivals like Exxon Mobil (XOM), Chevron (CVX) and BP (BP) kept their dividend in place, at least for now.
In my view that shows that Q2 is turning into an absolute nightmare, and given Shell's elevated gearing ratio in the high 20s, although it improved it by 1pp in Q1, taking on debt to pay the dividend could have possibly resulted in further rating downgrades which would be another serious problem.
From a financial perspective, while Shell could have managed to pay the dividend for another quarter by drawing on its cash reserves or credit facilities, it is probably a prudent step to cut the dividend once and deep and align it with the unprecedented changes happening in the world economies.
As much as I am disappointed to lose a lot of dividend income, at least temporarily, I actually think it is the right decision management took. I am sure it was not an easy one, but this will now release it from the "dividend has never been cut since WW2 mantra" - which I personally also took for granted for too long - and hopefully allow Shell to overcome this crisis, pay down debt and make it a financially more resilient company.
Focus on energy transition
One of the biggest uncertainties the COVID-19 crisis carries is what changes it will have on the future. Will people travel less? Will people increasingly work from home? Will malls, restaurants and stadiums be populated with people like in the good old times again? Will massive stimulus measures and economic aid be increasingly directed towards building up a nation's economy for the future by investing in critical infrastructure areas that could accelerate the energy transition from fossil fuels to renewables?
Obviously, the latter question is the most relevant for Shell as many politicians are already debating how huge fiscal aid packages should be structured so that the economy will move forward and not simply reset back to its pre-COVID-19 structures. For Shell this means that it will increasingly focus on the energy transition which also became apparent during its call where this topic was taking a very prominent stage.
By 2050 or sooner Shell aims to have transformed its business into a net-zero emissions energy business. Recently Shell intensified its carbon reduction plans citing "society's expectations have shifted quickly in the debate around climate change" which means reducing its net carbon footprint of the energy products it sells by 30% by 2035 and by 65% (up from around 50%) by 2050.
Source: Shell Q1/2020 Earnings Slides
Investor Takeaway
Following the initial shock of a historic dividend cut that has seen the stock price tank 13%, I am certainly not jubilant on Shell anymore in terms of it being a world-class investment case. However, while it is hard to accept the new reality we are facing right now in a world where oil demand is presumably remaining depressed for an elongated period, I do think it is the right move to cut once and to cut deep. It should protect and improve the resilience of Shell, sustain and grow the value and ultimately also enable future growth and shareholder distributions when market conditions allow to do so.
One can argue whether it is a statement of strength that Shell opted for this step that early when its peers have kept dividends steady for now, or a sign of weakness, namely that Shell's capital allocation in the past has already been not prudent and was stretching the company's balance sheet.
The truth is probably somewhere in between. I do like the fact that Shell is looking forward and not clamoring to history just for the sake of its "never cut since WW2 mantra". The big question is obviously how long it will take the company to get back to the $0.94 dividend when market conditions have improved.
I am holding my shares for now, but also don't plan on adding to my position as long as all that uncertainty persists.
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This article was written by
Analyst’s Disclosure: I am/we are long BP, RDS.B, XOM. 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.
I am not offering financial advice but only my personal opinion. Investors may take further aspects and their own due diligence into consideration before making a decision.
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Comments (386)
Shell was correct to cut the dividend. They probably took advantage of the circumstances to cut it more than they really had to, but they will take the opportunity to redirect that cash normally paid out as dividends into debt reduction. It's a good move. They can reduce debt quickly and substantially and get it over with, so to speak. Another reason to be cautious is that although natural gas is not going away any time soon, recent indications are that the transition to renewables may be larger than expected and thus the transition to natural gas will not be as large as hoped. So they have to take that into consideration also. If the oil and especially gas business bounces back strong in a couple of years, I think there is every possibility that Shell will restore a dividend on a scale that it had before. If they have that kind of cash flow, they will restore a generous dividend. If the oil and esp gas business doesn't bounce back as they hope, then Shell will instead increase the dividend gradually and use cash flow to ensure the business is evolving properly over future years. That will probably not be particularly lucrative but it could be. And it's better to take an unexciting transition and be happy with that than see the bottom fall out with nowhere to go. A strong factor on their side is that the Russians and Saudis are absolutely getting crushed by low prices now. IT cvan't last. The stability, the very future, of those significant countries is at stake. There's no way ultra low prices are going to persist for too long. That will help Shell and other oil and gas companies.
"I was wrong when I declared that "Shell will do whatever it takes to maintain the dividend in the short term."@Rida Morwa @PendragonY
RDS.B - crap
Lloyds - crap
Standard General - crap
BAE - sort of crap
Reckitt - sort of crap now and less diversified
NGG - crap, stealth dividend cut not long ago
All the grocers and retailers like Morrison - crap
RBS- crapCan't think of one single company that is invest-able in the UK. They are all kind of brain-damaged entities. Maybe IR, but has dividend withholding. Ideas?
Taken by an incompetent CEO/Board who have lost in just one precipitated move all the massive credibility capital they had gathered throughout the years. It is so absurd that I wonder wether there isn't something criminal going on !