- Shell announced solid Q1 results that were better than expected.
- Shell nevertheless cut its dividend in order to prepare for a Q2 that will be weaker.
- Shell looks like a solid long-term investment.
- Several other oil majors look like they may be forced to cut their dividends as well.
- This idea was discussed in more depth with members of my private investing community, Cash Flow Kingdom. Get started today »
Royal Dutch Shell (RDS.A) (RDS.B) cut its dividend by two-thirds a couple of days ago, which shocked many investors. The surprising move, the first dividend reduction in more than 70 years for the supermajor, does not mean that Shell is a bad investment, though. The dividend reduction will allow the company to preserve liquidity in order to weather the current crisis more easily.
Shell's dividend cut also brings up the question of who might be next to cut the payout, with several other major oil companies being in a position where they might be forced to cut their dividends as well.
Source: Seeking Alpha's image bank
Shell's First Quarter Results Were Not Too Bad, But Things Will Be Worse During Q2
Shell announced its first-quarter results a week ago, reporting revenues of $60 billion, which was down 28% year over year. Despite the massive revenue drop, Shell still managed to generate profits of $2.8 billion during the quarter, despite oil prices slumping during the quarter.
Shell also managed to generate massive free cash flows of $12.1 billion, although that was impacted by one-time items such as a decline in Shell's working capital. Adjusted for that, Shell still managed to generate free cash flows of $4.7 billion, or close to $20 billion annualized.
For a company that is heavily impacted by a double black swan event of lower oil consumption (due to COVID) and lower oil prices (Russia-Saudi oil price war), generating free cash flows of that magnitude is not a bad result at all.
This brings up the question of why Shell has cut its dividend, as the dividend was still covered during the first quarter thanks to the company's strong cash generation. The explanation is that the second quarter will, in all likelihood, be worse than Q1. Global oil demand dropped even further, and on top of that, oil prices took out new lows during April:
Oil prices during Q1 remained in the $40+ region for about two-thirds of the quarter, whereas they have not been this high during any day of the current quarter. It can thus be expected that Shell's results during Q2 will be substantially worse than those that the company reported for the first quarter. The same will hold true for all of its peers.
Dividend Cut Prepares The Company To Weather The Storm
Shell had repeatedly touted its great dividend track record, there had not been a single dividend cut since World War II. This changed, however, when the company decided to cut the payout by 66%, to $0.32 per ADR going forward. This results in total dividend obligations of $1.25 billion per quarter, based on a share count of 3.91 billion.
Shell thus will pay out roughly $5 billion a year in dividends going forward, instead of almost $15 billion annually at the previous level. The dividend cut will thus allow Shell to save $10 billion a year on a go-forward basis, or $7.5 billion during the remainder of this year, as one payment at the pre-cut level has already been made during the first quarter.
The dividend cut has not been foreseen by us or a meaningful number of analysts, most investors were very surprised to see the company break the decades-long dividend record. Management succinctly explains its reasoning, however:
The pace and scale of the societal impact of COVID19 and the resulting deterioration in the macroeconomic and commodity price outlook is unprecedented. The duration of these impacts remains unclear with the expectation that the weaker conditions will likely extend beyond 2020. In response, Shell (OTC:SHLLQ) has taken decisive actions to reduce our spending and position our businesses to compete in the current lower commodity price environment and uncertain demand outlook. The Board of Royal Dutch Shell has taken the decision to reset its dividend to provide financial resilience and further flexibility to manage the uncertainty. Shell is taking the steps necessary to ensure that we are well-positioned for the eventual economic recovery. [Emphasis by author]
The current crisis was indeed a surprise to everyone, and businesses around the globe were not prepared for the massive economic and societal changes this crisis brought. Shell's management is not sure about what the demand picture for oil will look like in the near term and how long the recovery will take, and in order to be prepared for the worst and to remain flexible, management was proactive and cut the dividend. One could thus argue that management preferred to cut the dividend now, freely, rather than being forced to cut the dividend at a later point in time and unnecessarily damaging the balance sheet in the meantime.
Shell has substantial debt on its balance sheet, but there should not be any liquidity or solvency concerns for the company. First, Shell holds an AA2 credit rating, giving it one of the healthiest balance sheets in its industry. Second, the company is well-diversified both geographically as well as when it comes to business units, with refining, trading, LNG, chemicals, etc. providing meaningful profit streams in times of low oil prices. Third, the dividend cut means that Shell will save $10 billion a year going forward, which eases the need for cash. Last but not least, as a Europe-based company, Shell profits from the ECB's bond-buying that allows for access to low-interest-rate debt -- at one point in the past, the yield on Shell's bonds actually dropped below zero.
The fact that Shell's management decided to cut the dividend despite the fact that this destroyed its dividend record, despite the strong balance sheet and the still-solid cash generation during Q1, brings up the question of whether its peers will follow Shell and cut their payouts, too.
Who Might Be Next In Cutting The Dividend?
In order to determine which other major oil companies may cut their dividends in the next couple of months, we can look at the balance sheet strength and cash flow generation relative to that of Shell, to see which peers are in a better position, and which peers may be in more trouble.
Balance Sheet Strength
We see that Shell had the most debt on its balance sheet on a net basis (adjusted for cash holdings), at $48 billion. Peers BP (BP) and Exxon Mobil (XOM) hold debt that is almost as high, whereas Total (TOT), Chevron (CVX), and especially ConocoPhillips (COP) hold significantly less debt.
On an absolute basis, net debt does not say too much, thus it makes sense to put this relative to assets and/or EBITDA.
|Company||Net debt to EBITDA (2019)||Net debt to Assets||Better or Worse than Shell?|
Source: Author's calculation, data from YCharts
On a balance sheet strength basis, Exxon Mobil and BP look somewhat weaker than Shell, whereas Total, Chevron, and ConocoPhillips have stronger balance sheets.
Cash Flows And Dividend Coverage
We don't know what cash flows during 2020 will look like, but we can look at analysts' estimates for EBITDA as a proxy for operating cash flows, and then calculate an EBITDA payout ratio for 2020 assuming dividends remain unchanged.
|Company||2020 EBITDA forecast||Dividends annual (pre-cut)||Payout ratio||Better or Worse than Shell?|
|Shell||$32 billion||$15.2 billion||48%||-|
|XOM||$15 billion||$14.7 billion||98%||Worse|
|CVX||$15 billion||$9.0 billion||60%||Worse|
|BP||$19 billion||$6.9 billion||36%||Better|
|TOT||$21 billion||$6.6 billion||31%||Better|
|COP||$3 billion||$1.5 billion||50%||Equal|
Source: Author's calculation, data from YCharts
We see that Exxon has the highest payout ratio by far, while Chevron's payout ratio also is elevated. ConocoPhillips' payout ratio is relatively on par with that of Shell on a pre-cut level (i.e. assuming that Shell would have continued to pay its dividend at the Q1 level). Both BP and Total have a lower payout ratio.
We believe that balance sheet strength may be a better predictor of a possible dividend cut, as the payout ratio estimate depends a lot on the analyst estimates for the EBITDA these companies will generate.
Based on what we see in the above tables, there are two companies with an elevated risk of also cutting the dividend in the near term, Exxon Mobil and BP. Both have weaker balance sheets than Shell, and Exxon Mobil also pays a very high dividend relative to the quite modest expected EBITDA. Granted, it has a strong credit rating, but the risk of a dividend cut still seems higher compared to Chevron and Total. The rather high risk of a dividend cut by BP and Exxon Mobil is reflected in their above-average dividend yields of 11% and 8%, respectively. Chevron has a much lower dividend yield of below 6%, which shows that the market is not pricing in a cut here.
ConocoPhillips is somewhat of a more complicated guess, as it is not a well-diversified major, unlike the others. It has, however, a very clean balance sheet, and its dividend is costing the company just $1.5 billion a year. The market is not pricing in a dividend cut here, as the yield is rather low, at just 4.3%. We tend to agree that the risk of a dividend cut is lower than at BP or Exxon Mobil, however, one can never be sure in these times.
Shell cut its dividend in a move that surprised almost everyone, despite a very solid first quarter. Management wants to prepare the company for even harsher times, however, which is a prudent and conservative goal, although some income investors may feel burned by the company.
Source: Stock Rover; Note: Margin of Safety is the difference between current price and Stock Rovers proprietary discounted cash flow analysis algorithm.
Despite the dividend cut, Shell looks like a solid value pick that has a good chance of performing well in the long run, mainly due to a very inexpensive valuation.
Source: Stock Rover
In the long run, oil prices and demand should recover, and Shell has the balance sheet to weather the current crisis until that point is reached. We believe that there is considerable total return potential in Shell over a time frame of a couple of years.
Since Shell has cut its dividend, it makes sense to ask what other companies may be forced to do the same, and we believe that BP and Exxon Mobil are the most likely candidates in the peer group. No dividend cut is guaranteed, however, and a dividend cut can also not be ruled out for Chevron, Total, and ConocoPhillips.
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Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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This article was written by
Jonathan Weber holds an engineering degree and has been active in the stock market and as a freelance analyst for many years. He has been sharing his research on Seeking Alpha since 2014. Jonathan’s primary focus is on value and income stocks but he covers growth occasionally.
He is a contributing author for the investing group Cash Flow Club where along with Darren McCammon, they focus on company cash flows and their access to capital. Core features include: access to the leader’s personal income portfolio targeting 6%+ yield, community chat, the “Best Opportunities” List, coverage of energy midstream, commercial mREITs, BDCs, and shipping sectors,, and transparency on performance. Learn More.
Analyst’s Disclosure: I am/we are long RDS.A. 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.
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