Shell-shocked by the first dividend cut since World War 2, investors in Royal Dutch Shell (RDS.B)(RDS.A) have been selling off, causing the stock to tank over 10%. It came as a total surprise to most investors and puts a big hole into the pockets of many loyal dividend investors. The dividend was the primary reason for me to invest in the company as not only did it appear safe from a financial perspective but also enjoyed strong commitment by management.
Both conditions are now gone as Shell’s earnings call was even worse than the fact that the dividend was cut. Not surprisingly, 90% of the exchange with analysts was centered on that historic dividend cut and the messages Shell’s management delivered represent another blow to investors.
In a previous article I outlined that I had been wrong on Shell in the respect that I expected it to continue to pay the dividend after having reaffirmed it in February or at least come up with a temporary suspension to be reviewed every quarter. None of that happens and the earnings call explains why. Here are my key takeaways from it that I believe every investor in Shell should know about.
Key Message #1: Shell considers the dividend to be “meaningful” after a 66% cut
Not only did Shell drastically and surprisingly cut the dividend by a massive 66% but it also portrayed the new dividend to still be meaningful.
But it will be a level that, in our mind, going forward, in a very wide range of potential and very uncertain futures is affordable, but it’s also meaningful also.
Investors buying into the stock today can lock in an around 4% YoC which could indeed be considered meaningful, certainly not shabby, in times of a zero interest rate environment which is likely to stay for years. However, for many investors like myself, our existing position in Shell was likely built at much higher prices given that Shell dropped over 50% since the outbreak of the corona crisis and has been hovering between $40 and $70 for most of the time over the last 5 years. As such, we are now sitting on a YoC anywhere between 1.8% and 3.2%. On its own, I already do not consider this meaningful but given that the previously juicy dividend also compensated investors for years of stagnating stock prices, this patience no longer pays off.
Thus, calling it “meaningful” without qualifying whether Shell is addressing existing or new investors is not going to help to build trust. Many investors and retirees have been banking on Shell’s dividend to fund expenses and are now confronted with a big income hole.
This is not to say that the dividend cut itself is unreasonable or unwarranted but rather that the communication of that cut has been a disaster in my view. This is a company with a decade-long decorated dividend history and thus such a dividend cut warrants better communication or more contextualization.
It should be noticed that Shell has not been saying that it intends to keep the dividend at that level forever but the call surely failed to induce any confidence that it will be a priority going forward once the business improves (more on that in message #2).
It’s also, therefore, a level which I hope we can start building back from, first of all, building balance sheet strength, but also building back with further shareholder distributions going forward.
Key Message #2: The new dividend appears here to stay for a long time regardless of macro conditions
Shell’s official argument for cutting the dividend is stated as follows:
And considering the risks of a prolonged period of economic uncertainty, including the weaker demand in our products, lower and the less stable commodity prices, we do not consider that maintaining current level of shareholder distributions is in the best interest of the company and its shareholders
We do not expect a recovery of oil prices or demand for our products in the medium-term, both will recover over time.
Source: Royal Dutch Shell Q1/2020 Earnings Call
First of all, I can’t argue with the facts that there is a high degree of uncertainty and that oil prices and demand may require more than a few months to recover.
Secondly, Shell is undertaking this massive dividend cut in order to bolster its financial resilience and improve its balance sheet. Alternatively, it could have waited, say another quarter, and review things afterwards and meanwhile funding the dividend with even more debt – its gearing ratio is already firmly above its target corridor between 15% and 25% – or dilute shareholders by offering a scrip dividend like it did during the big oil glut in 2015/16 or depleting its cash pile which currently sits at some $20B with an additional $22B available in revolving credit facilities, which together is almost 50% above last year’s free cash flow.
Source: Shell Q1/2020 Earnings Slides
While that would have prevented a big income hole among Shell’s investors, I also think it is prudent not to do it and instead prioritize balance sheet strength and resilience over shareholder distributions.
What strikes me though is the fact that Shell is, on the one hand, referring to prolonged economic uncertainty and on the other hand, explicitly stating that it is evaluating its outlook for 2021 and 2022 in “a reasonably calm fashion, not jump to conclusions.” However, on the other hand, given that the situation is so uncertain and could easily swing into both directions (look at all the states which have been reopening in the U.S. and all the countries in Europe slowly opening up as well), I don’t see how you can be so sure that the reset dividend will be the new normal for such a long time. One analyst also asked that question whether Shell is not expecting much more visibility in three months’ time at the end of July to talk about how conditions have changed and what that means for its business.
Still, Shell’s CEO said that he does not think that “by Q2 we will have more visibility.” In my view, that is a premature statement given the exact high level of uncertainty he mentioned to rationalize the dividend cut. How can you be sure that you don’t have more visibility when everything is uncertain?
As such, while I understand and actually applaud that Shell is focusing on balance sheet strength now by cutting capex, operational costs and dividends, I am wondering why it hasn’t simply suspended the dividend which would have underlined all that uncertainty and should have been accompanied by a strong statement on reviewing the dividend at the end of next quarter. That would have helped to retain and regain balance sheet strength instead of cutting the dividend by a seemingly arbitrary number.
This echoes one of the comments I read on Shell’s earnings call:
Secondly, van Beurden’s utterly defeated pessimism gives no confidence in the company’s prospects in the near and long term. Despite so much evidence to the contrary, and despite the awareness that he should possess about the impact of his words on investor confidence, van Beurden is acting like it will take years for the world to overcome the coronavirus. He speaks gloomily of how awful prices may yet be for Shell products and commodity prices as far out as 2022, as if it is possible or responsible to try and predict either when there are so many variables at play.
Source: Seeking Alpha
Key Message #3: Shell is going all-in on carbon emission reduction and likely using proceeds from the reset dividend to invest into renewables
Just few weeks before the dividend cut, Shell hosted its remote “Responsible Investment Annual Briefing” on April 16, 2020, where Shell basically doubled down on its climate ambition goals citing “society’s expectations have shifted quickly in the debate around climate change” which means reducing its net carbon footprint of the energy products it sells by 30% by 2035 and by 65% (up from around 50%) by 2050.
Although Shell’s CEO did not explicitly mention it, he did make a link between lowering the dividend now and that 2050 vision of net zero emissions, as he was saying that in light of the uncertainty mentioned above, Shell needs to preserve financial resilience and flexibility in order to grow these new lower carbon businesses.
But of course, at the same time we also want to have resiliency and the flexibility to still flex our strategic muscle, so to speak, in areas where we have to.
Source: Royal Dutch Shell Q1/2020 Earnings Call
Already announced prior to its earnings release, Shell cut FY2020 capex by around $5B and during that call it became apparent where the priorities now lie. Around 45% of that reduction will originate from Shell’s upstream segment, i.e. oil and gas, 30% from downstream and the remaining quarter will be split between integrated gas and new energy. Assuming a 50/50 allocation at the latter, this would mean that Shell’s renewable business would only face marginal capex cuts, if any, given that things could change during the year.
Generally, the perception is that the new lower carbon businesses also generate less cash flow than Shell’s conventional oil and gas portfolio and while the final jury on this one is still out, I think one needs to differentiate. Investments in, for instance, hydrogen power could generate very healthy returns as, for instance, pure renewables play Brookfield Renewable Partners (BEP) is able to grow its FFO at a double-digit clip. However, Shell is no pure-play on renewables on any dimension and as such, investors looking for that sort of business model can certainly find better investments such as BEP.
The other aspect to point out is that the majority of Shell’s emissions originates from the energy intensity of the products it sells as opposed to the resources it develops.
So indeed, the product mix that we sell and of course, you have to bear in mind that we sell 6 times as much oil products, if you like, then we produce oil out of the ground
And that means Shell needs to massively change that energy mix rather than simply investing in lower carbon energy production in order to reach its 2030 and 2050 targets.
That will obviously require a lot of investments over the next years and decades and listening to the call it sounded as if this new “meaningful” dividend is what Shell will be able to afford, well, forever. It could be just a communication misunderstanding or the new reality investors need to cope with that Shell’s dividend will remain low in order to afford all these investments even once the fallout from the current crisis has ended.
Out of all the oil majors, except Norwegian Equinor (EQNR), Shell is the only one not to keep the dividend and instead cut it whereas TOTAL (TOT), Chevron (CVX), BP (BP), Exxon Mobil (XOM) and ConocoPhillips (COP) all kept their dividend for at least one more quarter. I think it is prudent for Shell to reduce its cash outflows but Shell has not given strong contextualization as to why it cut it 66%, which seems like an arbitrary number to me.
On top of that, the entire communication around the dividend cut has been a disaster in my view, not so much because Shell raised hopes in February that the dividend will be maintained, but rather how management still sees it as meaningful when at the same time a 66% cut creates big income holes for many investors.
We can argue whether adjusting the dividend now is premature or wise (we will only know in hindsight anyway) but at least the communication needs to be spot on. It does not help if the CEO is touting economic uncertainty and at the time expecting oil prices and demand to remain depressed for years. It is not possible to predict this at this stage.
I remain a shareholder because I believe that prioritizing balance sheet strength over dividends, as painful as this is in the short term right now, is the right choice but I am lacking a strong commitment to the dividend as well as a regular review of Shell’s capital allocation going forward. Personally, I believe that the dire outlook Shell gave will not necessarily match reality. The aviation sector which is a big customer is very likely to see depressed demand for a long time but other industries and sectors could come back much quicker. For instance, Marathon Petroleum (NYSE:MPC) mentioned that it is already seeing signs of recovery in demand for gasoline.
The entire oil industry is highly volatile and uncertain right now and I believe only suitable for long-term and risk-tolerant investors. Within the oil industry there are better investments to be found than Shell right now, following its dividend disaster.
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Disclosure: I am/we are long RDS.B, XOM, BP. 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.
Additional disclosure: I am not offering financial advice but only my personal opinion. Investors may take further aspects and their own due diligence into consideration before making a decision.