Shell Stock: Raising The Dividend (NYSE:SHEL)

Article Thesis

Shell (NYSE:SHEL) reported its third-quarter earnings results on Thursday morning. The company recorded strong profits and cash flows and announced new shareholder returns. This includes a new tranche of buybacks, but importantly, Shell also signaled that it would increase its dividend by 15% pretty soon. That will lift its dividend yield to a more attractive level, and it could be the first step in bringing up its dividend closer to pre-pandemic levels over time. With a beneficial macro environment and a low valuation, Shell has significant potential.

What Happened?

Shell reported its third-quarter earnings results, with the headline numbers looking like this:

Revenue growth, unsurprisingly, was strong on the back of higher oil prices and massive LNG demand in Europe, while higher demand for refined products following the recovery from the pandemic also played a role. $1.30 in earnings per share sounds good, as it annualized to $5.20. But that does not yet account for the fact that US-based investors mostly invest in ADRs (‘SHEL’) — each of which is equal to two shares. Earnings per ADR are thus twice as high, at $2.60 for the quarter or more than $10 on an annualized basis.

Strong Underlying Results

Delving into the details, there are several important things to consider. Looking at production levels, Shell has not been able to grow its output. Instead, company-wide production, measured in barrels of oil equivalent per day, was down 2% year over year. While one could assume that this is due to Shell’s lower investments in new hydrocarbon production in recent years, Shell’s management explains that production sharing contract effects were the main cause of that, with strikes at Prelude FLNG having an adverse impact on production levels as well. Since those strikes came to an end at the end of the quarter, it is likely that the headwind will not exist during the current quarter, Shell’s Q4. Production being down slightly isn’t great, of course, but it’s not a disaster, either. In fact, the price movements in oil and natural gas are way more impactful than the volume movements, as commodity prices do oftentimes change by way more than 2% over a year. In the current environment, where energy markets are tight and where prices for oil and gas are high, Shell is more than able to offset some small volume headwinds via higher prices, which explains why sales were up so much despite slightly smaller production volumes. I believe that there is a good chance that global energy markets will remain tight for the foreseeable future, which makes it likely that energy commodity prices will remain elevated, which should help offset any potential volume headwinds going forward.

Let’s next look at Shell’s cash generation, which is all-important when it comes to investments in new hydrocarbon assets and green energy assets, but which also is key for debt reduction, dividends, and share repurchases. During the third quarter, Shell’s operating cash flow totaled $12.5 billion. That included significant working capital movements due to higher natural gas inventories in Europe, for example, thus in order to account for that, it makes sense to look at the Q1-Q3 total as that leads to a less distorted picture. During the first nine months of the year, operating cash flow totaled $46 billion, or more than $15 billion per quarter (which would have been true for Q3 as well at constant working capital levels). Shell has spent $18 billion on capital expenditures so far this year, which includes both its hydrocarbon business and its “green” investments. That has resulted in free cash flows of $28 billion so far this year, or $37 billion on an annualized basis. Since considerable positive working capital effects can be expected for Q4, when high European natural gas inventories are monetarized, and since energy prices, overall, remain elevated, I believe that those $37 billion in free cash are very achievable in the current year. Shell is currently trading with a market capitalization of $198 billion, based on a share count of 3.56 billion, Shell is thus currently trading with a free cash flow yield of 19% — which is pretty attractive, I believe.

While many investors see Shell as a company that has entirely moved away from its old hydrocarbon business, that is not true. In fact, Shell continues to invest way more money in its “old” businesses compared to its green ventures. Of the $18 billion that Shell invested so far this year, Shell spent $2.4 billion in its “Renewables and Energy Solutions” unit, or around 15%. More than $15 billion have been spent in Shell’s upstream, integrated gas, chemicals, and marketing business units. While Shell has been talking a lot about making the leap towards green energy, its investment focus remains with the hydrocarbon business for now, which is a good thing in the current price environment for oil and natural gas.

But as the company has ample cash left over after investing in its operations, Shell has to spend money on additional items. In general, free cash flows can be used for the following things: Acquisitions, debt reduction, dividends, and share repurchases. Shell is spending some of its vast cash flows on all of these things. In August, Shell acquired Sprng Energy, an India-based renewable energy business. Shell also has been reducing its debt levels quite successfully over the last year, with net debt coming down by $9 billion over that time frame. Shell still has a considerable net debt position of $48 billion as of the end of the third quarter, but relative to the company’s earnings, cash flows, and asset base, that does not look outrageously high at all. In fact, Shell is expected to generate EBITDA of $84 billion this year, thus its net debt to EBITDA ratio stands at just 0.57. Shell’s gearing (net debt versus total capital), its preferred way of gauging its indebtedness, stands at 20.3% as of the end of the third quarter, which is not high at all, especially when we consider that Shell’s average interest rate is pretty low due to its EU exposure. I believe that Shell’s net debt will continue to trend down over time going forward, but debt reduction will likely not be what management focuses on — due to an already very solid balance sheet, there is no need to prioritize the reduction of debt levels over other items.

When it comes to shareholder returns, Shell has focused on share repurchases in the recent past. Considering the very low valuation shares trade at, that makes a lot of sense — when Shell is buying back its own shares while they trade with a 19% free cash flow yield, that can be seen as a 19%-yielding cash on cash investment, with no risk of project delays or other potential execution risks, arguably making buybacks a better choice compared to aggressive growth investments. Shell spent $6 billion of its Q2 earnings on buybacks and announced a new $4 billion buyback program for the earnings it generated during Q3. Those will be spent before the company reports its Q4 results in early 2023, thus it is another 3-month program. With Shell spending $4 billion to $6 billion on buybacks per quarter, the company can reduce its share count by around 10% annually. Over the last year, Shell’s share count declined by 8%, and the effect should be even larger going forward — the company only spent a small amount of cash on buybacks last year, thus this year’s Q4 will be better than the comparable period from last year.

When it comes to Shell’s dividend, the company has paid out $0.50 per ADR in the most recent quarter, which cost the company around $1.8 billion, or $7 billion a year. That’s less than 20% of this year’s expected free cash flow, thus it is not surprising to see that Shell has announced it will increase its dividend soon. For the fourth quarter, Shell plans to increase its dividend by 15%, which will result in a $0.575 per share dividend, which translates into a dividend yield of 4.1% at current prices. Relative to what peers Exxon Mobil (XOM) and Chevron (CVX) offer, Shell’s future dividend yield is compelling, although European peer TotalEnergies (TTE) offers a substantially higher dividend yield of more than 5%.

Analysts are currently predicting that Shell’s profits and cash flow will decline slightly next year. Since oil prices are off their multi-year highs from Q2, that could come true, although the potential upcoming end of SPR releases and OPEC production cuts could result in higher oil prices in the coming quarters. If Shell were to see its free cash flow compress by 10%, it would generate around $33 billion in free cash next year. With the dividend eating up $7 billion of that, $26 billion would be left over for buybacks and debt reduction — capital investments are already accounted for when we look at free cash flows. If Shell were to spend $5 billion per quarter on buybacks, it could reduce its share count by 10% next year, which would be very attractive. In that scenario, Shell would have $6 billion left over for debt reduction, which is more than 10% of Shell’s current net debt position. So we can sum up that the company is very well positioned for strong shareholder returns in the current environment, with dividends and buybacks likely offering a 10%+ yield, potentially as much as 15% over the next year. And still, Shell should also be able to reduce its debt load further.

Takeaway

Working capital moves worked against Shell in Q3, but cash generation nevertheless was strong. The company offers a hefty combined shareholder yield between its dividends and share repurchases, and since energy markets continue to be tight, the compelling shareholder returns should continue for the foreseeable future. The upcoming 15% dividend increase might only be the first of several significant payout bumps over the coming years, as the payout ratio is pretty low.

Shell is trading at a free cash flow yield in the high-teens, and its EV/EBITDA multiple is around half as high as that of XOM and CVX. There are some uncertainties around windfall profit taxes in Europe, but similar plans exist in the US as well, which is why Shell looks attractively valued versus its American peers (which are inexpensive as well on an absolute basis).