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Shell Is Nothing Short Of Exemplary

Earnings Forecast Focus: Sep. 5, 2017 6:49 PM ET

Summary

  • Shell CEO Ben van Beurden’s “lower forever” quote was aimed at operating costs and overall company culture. It does not reflect the CEO’s oil price outlook.
  • The company’s operational excellence has been nothing short of exemplary.
  • Scrip dividend will be removed when gearing is down to 20% from the current 25%.
  • At the current rate, it should take no more than twelve months to reduce the gearing to 20%.
  • Obviously, the dividend is safe. More importantly, this is an opportunity to buy a company with excellent leadership.

Royal Dutch Shell’s (RDS.A) (RDS.B) transformation under CEO Ben van Beurden has been truly remarkable. The relatively new CEO has put his mark on the company. He has shown that Shell, under his leadership, has the ability to navigate the downturn with relative ease. Not only that, he has shown the ability to transform a company when most other companies are busy trying to survive. While I won’t be spending much time on the dividend safety, as that has been made clear over and over again, it is safe to say that the 6.6% yield is beyond safe. Investors now have the opportunity to purchase a 6.6% yield with additional capital appreciation should oil rebound.

The mindset

The CEO’s infamous quote “lower forever” caused a minor media firestorm, presumably because such a statement from such a high profile oil executive would certainly add to the clicks received. The lower forever mantra does not reflect the company’s oil price forecast. Rather, it embodies the culture that the CEO has created. It is a statement to remind themselves that they shouldn’t bank on higher oil prices just around the corner to improve cash flows and the balance sheet. The statement is to remind that the company wants to keep operating costs lower “forever” and that capital spending most be prudent and based on a conservative outlook.

In terms of actual oil forecasts, the CEO said: “To be perfectly honest, I do think we will have quite a bit of movement in the oil price going forward and there is a better than 50-50 chance that we will see oil prices trend up, as the fundamentals of supply and demand reassert themselves over the longer period of time.” This mindset, while definitely good for media ad revenue, is even better for Shell investors.

Operational excellence

When we take a look at what management has done to reduce costs, we can call it nothing short of exemplary. Operational excellence at Shell is more than just a buzzword. The company has managed to reduce operating expense from $40 billion to $38 billion on a rolling basis. My No. 1 concern when oil companies talk about operating cost reduction is that most of these reductions are actually a result of service cost deflation. As such, as the industry trends up, the operational costs will inflate again.

In other words, my number one concern is that these costs aren’t sustainable. At Shell, this has been different. They have copied a practice from the shipping industry. The company has retrained its employees so that they can do the maintenance themselves. This saves the company money since they are less reliant on outside contractors. In fact, the company has reduced the number of outside contractors by half since 2014. This has reduced the cost by 35% while at the same time allowing for increased availability of the assets.

Just to really drive home what operational excellence has done for the company, we should consider the cash flow from operations, which came in at $38 billion excluding working capital. The last time the company brought in a comparable level of operating cash flows was when oil was selling for $100 per barrel. Management isn’t satisfied as yet and is still continuing the “lower forever” push. Management expects to create $4.5 billion in synergies as it continues to digest the BG merger this year of which $0.5 billion has already been realized.

Here’s one last quote that embodies Shell’s “lower (operational costs) for longer” mantra: “Put simply, we’re now operating BG and Shell combined with lower costs and fewer employees than it took to operate Shell alone before the combination.”

The other levers

Amid the downturn, the company had to find ways to survive. As a response, the company identified four powerful levers it could pull divestment, capital investment, operation costs and new projects. As I’ve talked about operating costs above, I’d like to focus on the other three levers. The company identified $30 billion worth of divestments as early as the start of 2016. Selling $30 billion of oil related assets in an oil downturn cannot be considered a small feat. Especially since the reason for choosing these specific assets was that they underperformed. Now, in mid-2017, the company has managed to actually sell $25 billion of that $30 billion, $10 billion of which are still pending. So far, the company has received $15 billion of which $11.5 billion was received in cash.

The proceeds will not be used to pay the dividends (around $9.7 billion) as the company already produces $16 billion in organic free cash flow. Rather, it will be used to help reduce the gearing, or leverage, to 20% from 25%. This has an important implication which I will return to shortly. First, we need to discuss the other two levers. Luckily, they go hand in hand.

Capital investments and new projects are instrumental to Shell’s business. Many fear that all the cost cutting will cause the business to shrink. While this is typically an effect to watch out for, it is not the case with Shell. The company’s capital program will not only sustain the business, but it will actually deliver growth. This seems rather counterintuitive, but the key factor making all this possible is again operational excellence.

What Shell could previously achieve with $32 billion can now be achieved with $25 billion, according to the CFO. In the upstream business, management is only sanctioning projects with breakeven prices of $40 or lower. In the downstream and chemicals businesses, the projects are delivering between 15% and 20% return on invested capital. On a consolidated basis, the company’s return on invested capital is 4.2%, which clearly shows the drag that the upstream business has on the business. Nonetheless, the company continues to invest in much higher quality products than it did before the downturn.

Scrip dividend

Now, previously I talked about reducing the gearing to 20% and suggested that it has an implication. Currently, management’s priority center around reducing debt, maintaining dividend and replacing the scrip dividend with cash. In effect, what we’re seeing here is debt holders competing with shareholders. Management has chosen to appease the debt holders and market sentiment first before making life better for equity holders. To that extent, the scrip dividend will not be removed until the company reaches a gearing of 20%. This has been stated very clearly by the CFO:

In terms of the scrip and our cash priorities, as I mentioned before, they haven’t changed. Our priorities are debt repayment first, followed by dividend, scrip removal and then finding the right balance between repurchases and capital investment. We made a clear commitment to the market in terms of getting our financial framework in the right place, and we did the BG acquisition, took on the debt. We’re working through that. We’ve made tremendous progress over the last year achieving a gearing of 25% for the quarter, paying down some $3.8 billion of debt in this quarter alone.

At this rate, the scrip dividend will be removed within a year. This becomes even clearer if we factor in the additional proceeds from divestments of around $15 billion (assuming proceeds are all cash). In short, it is highly likely that the scrip dividend will be removed within 12 months from now, which will stop the dilution.

Conclusion

The company continues to make exemplary progress in reducing its costs while maintaining capex at a level needed for growth. The scrip dividend shouldn’t last another 12 months, and the dividend is safe as organic free cash flow of $16 billion covers the $9.7 billion in payments. In short, I will be looking to add Shell to my portfolio shortly.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RDS.A over 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.

SOURCE

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