Royal Dutch Shell (RDSB) shares rose nearly 4% on Tuesday as the oil giant restored its full-year cash dividend at its annual management day. The decision came earlier than Morningstar equity analysts expected, but is not entirely surprising. Shell has generated sufficient free cash flow during the past four quarters to cover a full cash dividend, while oil has averaged $52 a barrel. The company is scrapping its scrip dividend scheme, where investors receive dividends in shares or cash, a measure put in place during the years when oil prices slumped.
Along with the dividend announcement, Shell investors were cheered by news that it had increased its annual organic free cash flow target by $5 billion to $25 billion-$30 billion for 2019-21 and reiterated its plans to repurchase $25 billion of shares during the next three years. The increase in free cash flow guidance is a function of greater confidence around its cost-cutting efforts, reduced operating cost base and strong project delivery.
The increase in free cash flow and safety of the dividend relative to its yield were among the key tenets of our thesis on Shell. While the market has begun to recognise this potential, we still see shares trading at a discount. Our fair value estimate of £27.50 – against a current price of just over £24 a share – is unchanged. The fair value estimate was increased from £25.35 to £27.50 at the beginning of November. Shell has a four-star Morningstar rating, which means analysts consider it to be trading at a discount.
Outside of the dividend announcement and updated guidance, the update largely served as a reminder of Shell’s strategy, which is unchanged. More mature businesses including refining and marketing, integrated gas, and conventional production will serve as the cash engines to fund dividends. Deepwater and chemicals will provide growth, with the former eventually becoming a cash engine, and with new energies and unconventional eventually serving as growth drivers post-2020.
Higher Oil Prices Needed for Better Returns
In our view, Royal Dutch Shell does not earn an economic moat – or defendible competitive advantage – because its asset base is not capable of delivering sustainable excess returns at our long-term oil price assumption of $60 per barrel. Based on an evaluation of its oil- and gas-producing assets using our exploration and production moat framework, Shell’s upstream portfolio rates feature some of the highest costs among its peer group, based on production and finding and developing costs.
Its upstream returns on capital employed amounted to only 11% during the past five years, which is below average compared with other integrated firms. We think the addition of BG Group and its lower-cost asset base should improve Shell’s competitive position and lead to improved performance. However, considering the price paid and the increase in capital employed, it’s unlikely to result in sustained excess returns without higher oil prices or better-than-expected cost improvement.
Similar to ExxonMobil, Shell’s downstream segment consists of a large refining footprint that is integrated with chemical manufacturing. However, Shell has more exposure to Europe, where refining margins are likely to remain under pressure, and less in North America, where there is a feedstock cost advantage. Its level of chemical integration is also well below Exxon’s. During the past five years, its downstream return on capital employed has averaged 9%, less than half that of Exxon.
