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The market has misunderstood Shell’s turnaround potential

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By Deborah Hyde | 07:47:24 | 18 March 2010

Oil major Royal Dutch Shell’s management says the group’s transformation over the next couple of years will be significant and it can begin to lift its dividend again from next year.

CEO Peter Voser said: ‘These are exciting times for Shell. We are poised to deliver a new wave of financial and production growth.’

He said the group is making substantial investments in new projects to drive Shell’s financial performance going forward.

‘Shell should be in a surplus cash flow position in 2012, after capital investment and dividend payments, assuming $60 oil prices and a more normal environment for natural gas prices and downstream.’

That is a big promise from the group which has traditionally been more dependent on higher oil prices than many of its peers.

Shell has underperformed in recent years (up only 13.5% versus 22.5% at BP over two years) as BP began its transformation much earlier and has been able to grow its dividend despite lower oil prices.

Speaking at a strategy meeting this week, Shell’s management made a convincing case that it can do what it takes to turn its business around, prompting Soc Gen analysts to lift their price target to £22.30 and even the less optimistic UBS team lifted its target to £19.

With analysts pretty evenly split between those advising investors to buy the shares and those who remain more cautious, the key now is whether Voser and his team can deliver on these ambitious plans.

‘The underlying story for Royal Dutch Shell from 2012 is compelling,’ said Richard Griffith analyst at Evolution Securities.

But he has a ‘reduce’ recommendation on the shares since the recovery means Shell needs to complete a number of key projects in order to turn its finances around.

‘In other words Shell is dependent on a positive macroeconomic environment to keep short term gearing under control before the underlying performance can assert itself in 2012 and beyond,’ said Griffith.

Given the erosion of dividends on the FTSE 100, income investors will also be cheered by the group’s plan to lift its dividend – in dollar terms at least – from next year.

But Lucy Haskins at Barclays Capital and Alistair Syme at Nomura remain worried by the fact that in the near-term at least Shell will continue to finance the dividend from debt.

Syme said he doesn’t think Shell is mis-priced based on its own profitability outlook and doesn’t see any reason why investors should take the risk on a business that has:

  • potentially more near-term execution risk on new projects and
  • more limited financial capacity over the next two years (RDS is borrowing money to pay its dividend).

Haskins believes Shell is being overly optimistic about the outlook for refining margins and that a mistake here could see the cashflow come in below Shell’s guidance.

But even she is lifting her price target to £20.50 to reflect the higher cash generation forecasts.

And the top rated analysts – based on the accuracy of their forecasts – at Citigroup and Goldman Sachs are much more upbeat. Both Mark A Fletcher and Michele della Vigna have ‘buy’ views on the shares. They see good upside potential of 13.3% and 42% respectively.

Vigna said Shell’s presentation included a very detailed plan on how the group expects to achieve 11% production growth and 50% cash flow growth by 2012 even if the oil price remains at current levels.

At $80 per barrel, cash flow would climb to $43 billion from $24 billion in 2009, Shell said.

‘This would be the strongest cash flow growth story amongst big oils (excluding the emerging market names), with a clear path to delivery, as all the major projects underpinning this growth appear to be within 12 months of completion,’ said Vigna, adding that would bring Shell from sub-sector to sector leading profitability.

‘This is likely to be a driver of re-rating over the coming 12-months, as the market becomes more confident over the delivery of these projects,’ Vigna said.

Given Vigna’s estimates for Shell earnings are 25% above consensus for 2011, he believes positive earnings revisions will be another important performance driver for Shell.

Fletcher’s optimism also reflects Shell’s plan to lift production by 2-3% per annum and the planned reserve replacement rate of more than 200% which he said is more than adequate to fuel growth.

Like Vigna he believes the market has misunderstood the potential at Shell.

‘Visibility on the trajectory of growth, capex and cash flow remains low, but we believe that it will improve over the next 12 months as project delivery provides the impetus to unlock material upside.’ he said.

He said the underlying story that emerges should be a powerful mix of growth, declining capital expenditure and free cash accretion.

‘We believe that the market is not pricing-in this potential, with the current share price discounting an inconsistent combination of declining volumes, but persistently high capex,’ he said.

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