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Royal Dutch Shell: An Unsustainable Dividend

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Jesse Moore: Sept 15, 2016

Summary

  • Shell is funding its dividend and capital expense programs through a combination of debt and asset sales.
  • Those assets are operating, economic assets that provide long-term value to the company under its assumptions.
  • Shell has one year of leeway at current prices to fund its dividend after that rising debt will put too much pressure on the companies balance sheet.
  • Since I have a negative outlook on prices till at least 2018, I expect a Shell dividend cut in the first half of 2017.
  • Adding to the long list of resource companies with debt-funded dividends, we have Royal Dutch Shell (RDS.A, RDS.B). With a current yield of nearly 8%, and assuming you knew nothing about oil and gas, you could reasonably conclude this company is in peak operating condition. Unfortunately for investors, that story would be far from true.

Capital Expense – Free Cash Gap Growing

Many Shell investors focus on the stability of the dividend as a hallmark of the stock. Those investors are seemingly immune to what the balance sheet, cash flow statement tell us. As the company has pushed towards gas and is being pushed by its investors towards renewables, the capital expense bills have piled up. Throughout the oil downturn, Shell has hardly reduced capital expense in line with free cash flow – a result of long-term project planning that cannot be reined in.

Shell is representative of a common thread seen across the oil and gas industry. Historically low, or negative, free cash flow on the back of exorbitant capital expenditure in relation to the cash generation ability of the business has turned out poorly.

Long Term Cash Burn

Shell has a so-called “multiple time horizon” strategy that involves several areas of cash flow generation. None of these will generate free cash flow this year as prices remain depressed, and the money sink that is deep water is a poor strategic decision in the face of declining unconventional onshore costs.

Paying The Bills

How is Shell paying the bills in the face of declining free cash flow? With low-interest rates, Shell has turned to debt and asset sales for funding investors’ appetite for dividends and expensive capital projects. Over the next three years, Shell will sell close to $30 bn in operating and economic projects – in case you’re wondering, this is almost exactly the value of expected dividend payments over that time.

Value Creation

A discussion about dividends for a company such as Shell inevitably brings me to a discussion on value creation. If the purpose of the corporation is to maximize value, is the dividend the best method of doing this? Let’s use Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) as an example.

By never paying a dividend, and re-investing profits, Berkshire can maximize investors capital. Buffet has a hierarchy of free cash flow uses that follow something along the lines of:

  1. Can we re-invest earnings to make our subsidiaries more efficient
  2. Can we expand our business through acquisitions or capital expenditure
  3. Can we widen the moat of our businesses

The most applicable here is item number two. Which also brings about the industry touted Return On Average Capital Employed (ROACE). If Shell is projecting ROACE to rise to 10% over the next few years, then there are a plethora of projects around the world (and that Shell is itself selling) that would represent an ROACE of that level in the event oil prices recover. This says that Shell values the status quo (i.e., the dividend) over the long term profitability of the business.

Asset Sales

Over the next three years, as stated above, Shell is going to be selling assets to fund the dividend. While some may argue these are underperforming assets, they are quite valuable. If they weren’t, they would struggle to find even a single buyer. Included in the asset sales are its stake in Woodside Petroleum (OTCPK:WOPEY) at a cyclical low, its midstream infrastructure at a cyclical low, U.S. shale assets, and downstream refineries. The list is anything but “underperforming.” Woodside has been one of the most resilient Australian companies in the face of an LNG bust and poses significant upside. Specifically, if you are of the belief that oil prices are going to recover (which Shell management apparently is).

So why would you sell these assets to fund the dividend? Broken incentives.

Sustainability Of The Dividend

Shell has a relatively low gearing ratio compared to a typical company after a price crash. However, management has made it clear they do not wish to elevate gearing much above 30%. To do that, they will need to halt the rise of its debt and decline of its share price. As a dividend cut would almost certainly lead to a collapse of the share price, management must sustain the dividend. How long can they do that? About one year.

To maintain capital expense in the $30bn/year range, while paying a dividend of roughly $10bn/year, the company needs to $40bn per year. The three methods of managing the gap between free cash flow coming in (negative in the most recent quarter), and the $40bn required by management is via share price elevation, equity raising, or asset sales. With the share price in a multi-year downtrend, and an equity raising looking like a leper, asset sales are the only way.

As we already covered, asset sales of $30 bn don’t even cover one year of the funding gap. As asset sales continue to fall short of cash demand, the company could be forced to hasten sales and receive even less money. Debt will be the primary funding source for Shell as prices remain low through the end of the decade. Therefore, I expect a dividend cut in early 2017 once other options have been exhausted, and it becomes clear that oil prices aren’t rising this year. The crazy part is that investors should have encouraged it earlier.

While I have no economic interest in Shell after several reviews, the investors owning it do. Many have invested in the idea that oil prices will recover. If they do, the ROACE of the average project will skyrocket, and assets sold today will be looked upon with regret. I see a company that refuses to accept a chance of market circumstances and refuses to adapt its strategy to that reality.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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