Royal Dutch Shell Breakup: 3 Scenarios

Summary

• Daniel Loeb's Third Point recently took a stake in Royal Dutch Shell and is pushing for a breakup of the company into a fossil fuel and a renewables company.
• Valuation of Shell has been lagging during the last couple of years, but it is questionable whether a breakup would erase the value lag.
• In this article, I will explore three different valuation scenarios of a potential breakup of Royal Dutch Shell.

acilo/E+ via Getty Images

Just before the company published its Q3 results, big news about Royal Dutch Shell (RDS.A) (RDS.B) hit the presses. Third Point, headed by Daniel Loeb, announced that it purchased a stake of more than $500 million in Shell and urges the company to split into a "legacy" fossil fuel company and a renewables company.

In this article, I will try to assess whether a breakup could unlock major shareholder value.

Shell has underperformed

During the last couple of years, Royal Dutch Shell has seriously underperformed compared with some of its peers. If we look at the following graph, which depicts the forward price-to-earnings ratio, we can clearly see that the forward P/E ratio of Exxon Mobil (XOM) and Chevron (CVX) has been more than a third higher than Shell's.

Data by YCharts

Forward P/E ratios of Royal Dutch Shell and some of its peers (Source: YCharts)

It is not uncommon for European companies to have lower P/E ratios than their American peers. We can also see that the ratio of Shell is slightly higher than the one of fellow Europeans BP (BP) and Total (TTE). The interesting part here is that in today's market environment, companies that engage in renewable energy and related industries usually command a higher premium than their "grey" counterparts. This makes it noteworthy that Shell still has a lower P/E than Exxon or Chevron, which have undertaken little steps in the renewable energy business, while Shell has been quite active on this front.

Valuation of renewable energy companies

When we compare Royal Dutch Shell with some renewable energy companies, it becomes clear that investors are willing to pay a hefty premium for renewable businesses. Please take a look at the following graph as an illustration of this.

Data by YCharts

Forward P/E ratios of Royal Dutch Shell, NextEra Energy (NEE), and First Solar (FSLR) (Source: YCharts)

If we want to find a large European sustainable energy company, Ørsted (OTCPK:DNNGY) comes to mind, which is probably the closest peer we can find if you want to compare the renewable energy division of Shell with another company. Ørsted currently has a forward P/E ratio of almost 23, which is not as high as the American sustainable energy businesses, but still much more than the mere 9.4 of Royal Dutch Shell.

If Shell would break up, as Daniel Loeb of Third Point proposes, what would be the expected value that could be unlocked?

Shell Renewables & Energy Solutions

The department inside Shell which deals with renewable energy is Shell Renewables & Energy Solutions. The services that this group offers are summed up on their website:

Shell provides more and more renewable and low-carbon power helping customers to switch to these options through energy solutions and decarbonisation services. Our offer includes renewable power such as wind and solar, electric vehicle charging, hydrogen and electricity for homes, companies and businesses. Find out more about the offer and our business.

But how large is the renewable energy business of Shell exactly? This is information that is not easy to find since many sustainable endeavors of the company are integrated and intertwined quite well in the company. As an example, Shell invests heavily in the hydrogen economy which it views as an important pillar of the future sustainable economy. Nowadays, most hydrogen is produced using natural gas.

In its financial results, Shell includes its renewable portfolio as a part of the Integrated Gas segment.

The Integrated Gas segment manages liquefied natural gas (LNG) activities and the conversion of natural gas into gas-to-liquids (GTL) fuels and other products, as well as the New Energies portfolio.

(Note that New Energies is the old name of what is currently Shell Renewables & Energy Solutions.)

All of this makes the actual size of Shell's renewable business difficult to estimate, and any guess which I would make is very likely to be completely wrong. But this doesn't stop me from creating some scenarios.

3 Scenarios

In all of my different scenarios, I will try to calculate the expected value of the "grey" Shell added with the value of the "green" Shell. The current market capitalization of Shell is $177.6B, so we should compare any calculated value with this original number. I will also take the current valuation of Shell as a given, which means that I am agnostic about whether the current P/E of 9.4 is likely to rise or to drop.

From the Q3 unaudited results of Shell, the following numbers can be distilled (all numbers except the percentages in billions of dollars):

Results for the first three quarters of 2021	Integrated gas	Shell as a whole company	Percentage of Integrated gas
Adjusted earnings	4,705	12,898	36,5%
Adjusted EBITDA	10,339	38,656	26,7%
Cash flow from operations	11,926	36,935	32,3%

Click to enlarge

Source: 2021 Q3 results of Royal Dutch Shell

It is not 100% clear how Third Point would split up the business of Shell, but this is what we know:

Third Point, which is led by Daniel Loeb, urged Shell to split itself into "multiple standalone companies", including a "legacy" arm focused on oil and gas that could "slow capex beyond what it has already promised". (Source)

Scenario 1: The entire Integrated Gas part of Shell will be split up and valued as a US renewable energy business

Even though Third Point suggests that the gas part of Shell should be part of the "grey" part, I will first construct a scenario which considers the most optimistic case: Shell will split off its entire Integrated Gas arm and this will be valued at a P/E ratio comparable with a US renewable energy business.

As we can see in the numbers which I put in the table from the Q3 results of Shell, the Integrated Gas part of Shell represents on average about 32% of the company, based on earnings, EBITDA, and cash flow.

For this scenario, I will assume that the new, green Shell will be valued at a P/E which is comparable with pure-play renewable energy companies from the US, like NextEra Energy or First Solar. These companies have a P/E of around 30, so I will take 30 as the expected P/E value of the green Shell.

Scenario 1	Old P/E	Market cap	New P/E	Market cap
Grey	9.4	$120.7B	9.4	$120,7B
Green	9.4	$56.8B	30.0	$181,3B
Total				$302,1B

Click to enlarge

Source: author's own calculations

Scenario 2: The renewable energy business of Shell will be valued as a European renewable energy business, the rest of the company will be valued comparable with its European peers

This scenario means that "grey" Shell will likely become a bit cheaper since the P/E of Shell is currently 9.4 and those of its European peers BP and Total are around 8. I will value the "green" Shell at the forward P/E of Ørsted, which is 23.

For this scenario, we need to estimate how big the renewable energy business of Shell is. I already wrote that this is a very difficult estimate, and I will likely be very wrong in my estimate, but let us take a relatively optimistic position that about 50% of the Integrated Gas business is renewables.

Scenario 2	Old P/E	Market cap	New P/E	Market cap
Grey	9.4	$149.2	8.0	$127.0B
Green	9.4	$28.4B	23.0	$69.5B
Total				$196,5B

Click to enlarge

Source: author's own calculations

Scenario 3: Like scenario 2, but with Shell Renewables estimated at 30% of its Integrated Gas business

For this scenario, I will use scenario 2, but now estimate the size of Shell Renewables at 30% of its Integrated Gas portfolio. Valuations will again be a P/E of 8 for the grey Shell and 23 for the green Shell.

Scenario 3	Old P/E	Market cap	New P/E	Market cap
Grey	9.4	$160.6B	8.0	$136,6B
Green	9.4	$17,0B	23.0	$41,7B
Total				$178,4B

Click to enlarge

Source: author's own calculations

I chose the 30% for a reason. As you can see, the resulting total market capitalization is about the same as the current market cap of Royal Dutch Shell. This means that, if Shell's renewables business is smaller than 30% of its Integrated Gas business, it will lead to a lower market capitalization than it currently commands.

Takeaway

When we look at the three different scenarios which I sketched, we can compare the results of these scenarios on the expected valuation of the different components of Royal Dutch Shell:

	Grey	Green	Total
Current situation			$177.6B
Scenario 1	$120,7B	$181,3B	$302,1B
Scenario 2	$127.0B	$69.5B	$196,5B
Scenario 3	$136,6B	$41,7B	$178,4B

Click to enlarge

Source: author's own calculations

Only scenario 1 will lead to large value creation by splitting up the company. But we should keep in mind that scenario 1 uses the very unlikely presumption that the whole Integrated Gas part of Shell would be split off and valued as a US renewable energy business. This does not seem very likely to happen, since even Third Point suggested that the gas part would be put under the umbrella of Shell's legacy business.

I view scenarios 2 and 3 as much more realistic, with the large uncertainty that I have no clue how large Shell's renewable business exactly is. We do know that it needs to be bigger than 30% of the Integrated Gas business in order to make a breakup worth it. In scenario 3 the resulting total market capitalization is almost the same as the current valuation.

These three scenarios, combined with the expected costs and difficulties in splitting up a huge company like Shell, make it unlikely that a breakup would unlock significant shareholder value. I expect that Shell can unlock more value by speeding up its sustainability efforts and discontinuing its more polluting business instead of a breakup.

Thank you for reading! Please let me know in the comment section what you think about Royal Dutch Shell and whether the company should be split into two!

Analyst’s Disclosure: I/we have a beneficial long position in the shares of DNNGY, NEE either through stock ownership, options, or other derivatives. 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.

Comments

[the new generation]

this company is going to grow big in the next few montes big by when its steel cheap!
its got great grades and its season is coming winter! (Those who got it, got it)

[mfergu4018]

1,100 shares to vote no on the breakup of shell.

[R_Mitchell]

Don't know how many more quarters like this can BVB still afford to have.. and once he's gone, the road for the break-up will be open.

[Violence is Golden]

Best thing Shell management could do is to apply for an internship position in Total Energies so they could learn how one adds renewables to an Oil&Gas company the profitable way

[fortbrepoels]

SHELL will no split for the moment whit raison , SHELL go closed GRONINGEN and have now the STREAM2 for gas in the future .
Wind and sun go change the olie industry , that take time and many money .
For the moment we have change whit the olie price and every shareholder will see a good dividend and not payé for a green dream .
The green man in the street have no RDS shares A or B

[Old Professor]

Maybe, it would be better just to "break off" Shell from its fickle and feckless management team, and go from there.

[kamendc]

For a P/E ratio to have any meaning, you need to have earnings, which stands for the E in the formula.
There is no way Shell's earnings from renewables are 50% or even 30% of the Integrated Gas segment earnings. If they had any material earnings, they would have broken out this segment separately in their reporting, at least to boast about it (not even talking about providing benefits to investors in terms of visibility, which I believe is part of their fiduciary duty).
For all we know, it may have negative earnings - how will you apply a P/E ratio then?
Otherwise I am onboard with Mr. Loeb, let Shell spin the wind, solar, charging stations and similar stuff to a separate entity - it does not have to be financed with oil&gas earnings, there are many many funds with an ESG mandate who will be happy to finance it (not saying they will necessarily earn a good return out of it, though).

[martyr1777]

@kamendc Keep seeing this ignorant argument.

You know the one that completely ignores all the very profitable renewable pure plays in the market. BEPC comes to mind.

But opening with the 'lagging value, P/E' is misleading. Because over the last 5 years XOM has lost 23% of its value, RDS only 13%. So who's underperforming?

[Giesbers Investment Strategy]

@kamendc, thanks for your interesting comment. I have been wondering myself as well why Shell would not list the earnings of their renewable portfolio separately. You are right that if they are negative, calculating expected market caps is meaningless and my whole article is only a pure hypothetical practice (which it probably still is because the breakup is likely not going to happen). A more practical reason for not reporting their renewable earnings separately might be that they are so interconnected in the company that it is difficult to pinpoint which is renewable and which is not (for example: using natural gas to produce hydrogen).

[Giesbers Investment Strategy]

@martyr1777, well, it depends on what is the subject. XOM has a higher P/E than Shell, so Shell's stock is underperforming. As a company, XOM might be underperforming since they made their E in the P/E equation comparatively lower.

[TheOldHand]

Transition to green is going to be slow and expensive (and filled with various investment opportunities). I believe that Hydrogen will be a major branch of "green", but -- other than "heavy moving" nitches (fuel cell busses, over the road tractors, locomotives) -- will be slower and even more expensive. Time will pass and as it does petroleum will be burned.

[Giesbers Investment Strategy]

@TheOldHand, Hydrogen has the large benefit (for Shell at least) that it is currently mostly produced using natural gas, which they view as an important transition fuel. (Never mind that this actually creates more emissions than when you would use the gas for heating). But in the long term, of course, Shell also wants to produce hydrogen sustainably. You are very right that this will be very slow and expensive, but hydrogen would be a true solution for vehicles that are difficult to power using only batteries, like ships and airplanes.

[HK_Phooey]

In looking a PE ratios in your chart, one could argue that there is a negative correlation between commitment to net zero / transition and stock performance for traditional energy companies. Suggesting to me that the market doesn't believe... yet. While a break up may give a short term value bump sufficient for fund managers to take their gains and move on, it will leave long-term investors and progress toward cleaner energy production high and dry.

[martyr1777]

@HK_Phooey "one could argue that there is a negative correlation between commitment to net zero / transition and stock performance"

No it actually doesn't because looking at the PE for the YTD ignores the fact that XOM has lost more value in the last 5-10 years then all the European majors.

[Giesbers Investment Strategy]

@martyr1777, XOM might have lost more value during the last decade than European majors, but it is still valued at a higher forward P/E

[captaindividend]

Hasn't this already been dismissed by Shell's largest shareholder as impractical.
The only way to build green is via continuing oil income. The third point proposal seems misjudged as best.

[Giesbers Investment Strategy]

@captaindividend, yes it has, but Loeb said he is playing the long game. I still do not think it is going to happen.

[vooch]

Sorry My Friend, This Dan Loeb character is simply a grifting film flam man. His plan is bogus. Already the biggest shareholders of RDS have said no to Loeb's value destroying plan.

[Giesbers Investment Strategy]

@vooch, thanks for your comment, I agree