One cannot but admire CEO Ben van Beurden for his courage…

August 4, 2015

Summary

• Royal Dutch Shell is dead serious about protecting future dividend payments. CEO Van Beurden committed himself to paying attractive dividends in the next two years.
• Although I am impressed by Shell’s massive cost reduction plans and the slash in investments, I believe the dividends are still not fully covered by future cash flows.
• However, Shell’s strong balance sheet and the expected sale of non-core assets provide ample room for the company to keep distributing juicy dividends in the (near) future.

One cannot but admire CEO Ben van Beurden for his courage. Amidst the biggest oil crisis since the early seventies, the CEO is very clear about Shell’s (RDS.A, RDS.B) dividend intentions.

In a short clip on the company’s website, Van Beurden states that Shell is “committed to its dividend policy.” In an interview with Bloomberg, the CEO even calls dividends an “iconic aspect in Shell’s proposition to investors.”

Those are not just empty words. To my knowledge, the company did something that it has never done before: given a strong guidance for the next seven quarterly dividend payments. Despite the “challenging market conditions,” Shell intends to pay a total dividend of $1.88 per share this year ($3.76 per share for the ADR). The company even expects to distribute at least $1.88 per share next year.

At the current share price of €26.15 (ADR price $57.60), this dividend payment gives the share a yield in excess of 6.5 percent.

Like it or not, but when the dividend yield on a stock is significantly above the yield on a government bond, an investor runs the risk that the dividends are not sustainable. What is the likelihood that Van Beurden cannot keep his dividend promise?

The facts changed

“When the facts change, I change my mind. What do you do, sir?” is one of my favorite quotes by British economist John Maynard Keynes.

In this article I wrote in January, I argued that Shell’s operating cash flow would drop from $42 billion in 2015 to $26.2 billion in full-year 2015, if oil prices remained low. The conclusion of the article was that if the low oil price was more permanent than most investors believed it to be, Shell’s royal dividends and share buybacks were at risk if the company did not reduce operating expenses and investments.

During the second-quarter results presentation on Thursday, Shell announced that the company is preparing for a “prolonged downturn” in oil prices by cutting thousands of jobs and slashing billion of dollars in investments in the next two years.

The facts have changed. How should investors who are worried about the sustainability of dividends and share buybacks deal with this new piece of information?

Low oil destroys Shell’s cash flows

Shell’s second-quarter cash flow statement shows the devastating impact of low oil prices. The company’s operating cash flow shrank from $22.6 billion in the first half of 2014 to $13.2 billion for the first six months of this year.

If one assumes oil prices remain low in the second half of this year, it seems fair to assume an operating cash flow of $26.4 billion (FY 2015). This is simply twice the semiannual cash flow of $13.2 billion.

You do not have to be a brain surgeon to see that $26.4 billion is not enough for Shell to cover all the expenses it made last year. Capital expenditures alone lay at $32 billion, significantly above this estimated cash flow. And there’s no wiggle room for dividends or share buybacks (almost $13 billion last year).

CEO Van Beurden seems to be fully aware of this new reality, and has taken drastic steps to secure dividend payments in the future.

Two billion spared

Despite several restructurings and job cuts in the last decade, Shell’s operating cost level is still higher than that of most competitors.

Therefore, I was pleased to hear the company announce that it wants to reduce costs by 10 percent. Part of the cost savings program is the elimination of 6,500 jobs. Job losses are found in every corner of the world. Shell employs 94,000 people in more than 70 countries.

What will be the impact of this measure on operating cash flows? The company expects a reduction in operating costs of $4 billion for full-year 2014. The interim results show that Shell is well on track: half of the cost reductions have already been realized. The so-called production and manufacturing expenses dropped from $15 billion to $13.2 billion (see page 8).

I expect the other $2 billion of cost reductions will be visible in results of the second half of this year.

Lower investments

Shell also lowers its investment level. Many (large) projects have been canceled or delayed, as they are not/barely profitable at the current oil price level.

In April, Shell lowered its capital expenditure outlook for this year by $2 billion. But now, the company intends to slash investments by more than a fifth. This implies CFO Simon Henry spends about $7 billion less cash on capital expenditures compared to last year.

After adjusting figures in my spreadsheet model to take into account the new information, I come up with the following cash flow statement estimates for full-year 2015:

Cash Flow Statement: Shell still needs to borrow if it wants to return cash

*In billion dollars. 2014 figures are taken from the cash flow statement in 2014. 2015 figures are my estimates, based on targets from the management board.

Even after CEO Van Beurden’s harsh measures, I expect to see a drop in free cash flow from $13.1 billion in 2014 to $2.9 billion this year (operating cash flow minus investments). This means that Shell’s full-year 2015 free cash flow will be way too low to cover the dividend payments of $9.9 billion and buybacks of $3.3 billion of last year.

In my opinion, the dividend is safe, but I believe Shell will be extremely careful with share buybacks in the near future. The company indicates that it remains committed to buy back shares for $25 billion between 2017 and 2020. However, it is less clear about the amount of purchases between today and 2017.

I would like to note that CEO Ben van Beurden is very clear about his priorities regarding the use of cash:

“First, debt service, then dividends and then a balance between buybacks and capital investment“.

I infer a massive reduction, if not stop, in buybacks in the coming two years. In my view, the first sign of such a measure is already reflected in the half-year figures. In the first six months of this year, Shell bought back $400 million worth of shares. In the same period last year, the figure was four times higher, at $1.6 billion.

Dividend secured

Don’t get me wrong. Even after Van Beurden’s drastic operational measures and a potential stop in buybacks, it seems very likely to me that Shell’s cash flow statement will appear to be a mess in the coming years. The company must deal with a “dividend funding gap” if the price of oil stays low – the free cash flow will not cover dividends.

However – and I want to emphasize this – this does not mean that Shell will lower or suspend its dividend somewhere in the near future. Van Beurden’s bold dividend commitment to shareholders has everything to do with the company’s robust balance sheet. The company’s gearing ratio – net debt as a percentage of capital – was 12.7 percent at the end of the second quarter (end of June last year 13.4 percent). Shell has one of the strongest balance sheets in the sector.

French Total (NYSE:TOT), Italian ENI (NYSE:E) and Spanish Repsol (OTCQX:REPYY) have ratios of respectively 22.2 percent, 24.4 percent and 17.7 percent, respectively (end of 2014). In my opinion Shell can easily stretch the gearing ratio to 20 percent. This means the oil giant can borrow an additional $20 billion to pay dividends.

As mentioned before, I expect a dividend funding deficit of $6.6 billion in 2015 (do note, I set buybacks at zero!). Therefore, I believe the $20 billion additional debt buffer is adequate to secure dividend payments for the next three years, at least. Note that Ben van Beurden clearly stated that Shell strives to further reduce costs and investment in 2016 if oil prices remain low, emphasizing that management is working with, as he called it, a dynamic decision-based process. I also like to note that Shell intends to sell about $30 billion worth of assets between 2016 and 2018, right after the finalization of the BG Group (OTCQX:BRGYY) acquisition next year.

Scrip dividends effect

CFO Simon Henry also noted that the company reintroduced the scrip dividend in March of this year. Shareholders who use this program receive dividends in shares instead of cash. This move was also made by other oil companies to limit dividend cash outflows. “This gives us more short-term flexibility and ultimately helps to protect the dividend,” CFO Simon Henry said.

It is difficult to predict how many investors will opt for the scrip dividend, but it seems fair to assume the dividend cash outflow in 2015 will be lower than that in 2014 ($9.9 billion).

The BG Group deal

I cannot leave the biggest acquisition of Shell in the last 15 years – the $55 billion British BG Group deal – unmentioned. I believe the takeover will weigh on Shell’s balance sheet, but the impact should not be exaggerated, as the acquisition is largely paid in shares.

More important, Shell said that although higher oil prices are more than welcome, the deal will also enhance its free cash flow and add value if the price for oil remains low for some time.

Van Beurden said in the Financial Times: “I want to be very clear we are acting with determination. We are not waiting for the 90 dollar cavalry to arrive when we deal with today’s challenges.” While Shell’s management reacted a little late, in my opinion, I believe the company is taking the right measures now.

I want to stress that there are no free lunches in this world. Lower investments and huge divestments will have a negative impact on Shell’s production capacity.

This is already visible in the financial figures: the second-quarter production was 2.7 million barrels of oil a day, compared to 3.08 million barrels in the same period a year ago.

SOURCE

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