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By Ray Merola


-Investors seeking exposure to the energy sector, but looking to avoid the high volatility often associated with the space, may find Shell’s stock to be a superior choice.

-Shell has enormous global span and scope. It is truly a balanced, integrated Super Major energy company.

-Royal Dutch Shell is not an overlay of the other Super Majors. Shell’s management has taken high stakes in LNG, electric power production, and renewables.

-The stock is undervalued and offers a safe, 6.3% dividend yield; 10-year Treasuries pay ~1.9 percent.

-Diversification is a key to a well-managed portfolio. There are 11 S&P 500 sectors, one of which is Energy. Currently, Energy stocks are weighted a bit over 5% as a function of the total S&P 500.

-In 2019, Energy was the worst-performing sector.

-For 2020, contrarian investors (or those electing to redeploy capital away from “hot” sectors to “hated” sectors) may wish to look at Energy stocks.

An Investment Case For Shell
The investment case for Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) may fit investors desiring exposure to the energy sector, but seeking to avoid significant volatility often associated therein.

I haven’t written about Royal Dutch Shell in a while, but it remains the largest single position in my personal portfolio.

The investment thesis looks something like this:

Shell is a well-managed company, as indicated by improving return on capital, improving gross margins, and the highly successful integration of the BG Group. Shell management’s stated objective is to make a world-class investment case for the company. Few CEOs make this kind of statement a corporate centerpiece. Yet current CEO Ben van Beurden did just that. I contend BvB is the “real deal.”
Source: Shell 3Q 2019 earnings report slide deck

RDS has a sound balance sheet. In early 2016, Shell sealed a $70 billion deal to acquire the BG Group. Long-term debt leapt from $53 billion at the end of 2015 to $83 billion by year-end 2016. Gearing (a form of debt-to-equity calculation) doubled to 28% from a pre-acquisition 14% marker. 

Subsequently, management has driven gearing down to 23.5% (using apples-for-apples 2015 accounting standards; see third panel in the graphic below). 

Meanwhile, total common equity rose, and Shell maintains strong liquidity (including $15.4 billion cash and equivalents on hand).

Royal Dutch Shell earns its profits in cash. Since 2005, annual operating cash flows have been greater than operating earnings; generally by a significant margin. You can’t buy groceries with net income. You buy groceries with cash.

Shell’s management is shareholder friendly. In addition a focus upon making a world-class investment case for stock ownership, senior leadership emphasizes returning capital to shareholders in the form of dividends and share repurchases. 

The current dividend yield is 6.3%, and it’s well-covered by free cash flow. The company maintained the payout even during the dark days of 2016, promising stockholders it would not cut the dividend.

 Longer-term, Shell hasn’t reduced its dividend since World War II. More recently, the company enacted a $25 billion share repurchase plan; the objective of which is to sop up many of the shares distributed in conjunction with the BG Group buyout.
RDS owns a strong franchise. As one of the five Super Majors, Shell has an asset base that cannot be duplicated. It is a true wide-moat, global business. The Shell pectin is one of the world’s most-recognized symbols. Worldwide, Royal Dutch Shell is most often associated with genuine products sold at a fair price.

Drilling A Bit Deeper

While Shell is typically considered an “oil company,” it’s actually the largest private LNG company in the world.

The 2016 BG Group acquisition pushed Shell to the top of the LNG market. BG increased the company’s total gas output by 25%, and solidified its presence in the LNG market. This was a deliberate, strategic move.

Currently, Shell operates 13 gas liquefaction plants with a capacity to produce 41 metric tons of LNG per year.

Shell Trading augments the company’s position, purchasing LNG from third-parties, then selling it to other users. In 2018, such activity bumped Shell’s total worldwide LNG sales to 66 million metric tons.

RDS seeks additional LNG upside, too. Shell Prelude is the world’s largest FLNG (Floating Liquefied Natural Gas) facility, accessing offshore gas fields that are otherwise too costly or difficult to develop. The facility is planned to operate in-place off the coast of Australia for 20 to 25 years. In addition, Shell is moving ahead with LNG Canada, a major project located on the west coast of Canada; investing in an expansion of the Russian-lead Sakhalin facility, already one of the world’s largest oil and gas export-related outlets; and working with major midstream company Energy Transfer (ET) to develop Lake Charles LNG, a potential 50/50 LNG processing/exporting joint venture located on the U.S. Gulf Coast.

Indeed, Shell’s management cast its lot with LNG, seeking to assert leadership in this market: outstripping the other Super Major competitors.

Nonetheless, Shell remains heavily invested in conventional/unconventional upstream activities and is a downstream titan, offering an array of fuels and chemicals to global customers.

RDS is truly a balanced, integrated global energy company.

Investors may also consider the fact Shell’s management is intent upon moving the company to become one of the world’s largest electricity producers/providers. In addition to traditional electric service, Royal Dutch Shell is investing in electric vehicle charging stations, electric distribution facilities, and electricity produced via renewable sources.

The stock may be a good choice for investors seeking an energy company with tremendous span, scope, and financial wherewithal. Shares are affected by commodity prices, but are generally not volatile. Notably, Shell’s business profile is not a simple overlay with its other Super Major peers. Management is steering the business towards outsized stakes in gas, LNG, electric power, and renewable energy production.


Any investment thesis must consider valuation. Currently, are RDS shares dear or inexpensive?

For reasons outlined earlier in the article, I prefer to evaluate major energy companies on a price-to-operating cash flow basis versus price-to-earnings. Commodity/natural resource companies with high capital requirements tend to be best gauged by cash flow generation capabilities.

Accepting the long-term 6.5x OCF multiple, we see the shares appear to be undervalued; now trading at just 5.9x. Without projecting cash flow past YE 2019, the stock may be valued at ~$67. While writing this article, RDS.A settled at a little under $60. The delta 12% Fair Value upside represents a reasonable differential, especially when considering the shares offer a 6.3% dividend yield.

Why not consider forward-looking Street cash flow forecasts? Well, I don’t put a great deal of faith in the Street’s forward projections for energy companies. There are just too many unknowns and variables, most of which revolve around commodity prices. It’s nearly impossible to predict 2020 energy prices with any accuracy.

However, when thinking about stock valuation, I do tend to keep an eye on dividend yield. When the company’s dividend yields fall below 5%, I want to look long and hard at my FVEs: just a tip from someone who’s owned Shell shares for over 30 years.

Shell and BP offer higher current dividend yields. We know the Shell payout is safe. I believe the BP dividend is likely to be maintained, too.

Exxon and Chevron show superior debt management numbers, as measured by D2E. Shell is highly focused upon working its debt-to-equity ratio lower. The BP ratio indicates a materially higher debt structure versus peers.

Shell appears to have the best operating margin; however, I always recommend performing additional due diligence on margins. The numbers can tell a story, but the numbers are not THE story.

Price-to-book (another good valuation metric for energy companies) suggests a fairly dense pack, with Shell and Total at lower P/B multiples and Chevron and Exxon higher. This offers reasonable comparison to the P/CF valuation metrics provided earlier.

Shell appears to offer investors a meaningful valuation discount versus peers. A strong dividend yield adds gloss to the view. BP shares trade at a steeper discount; however, additional due diligence is required to better understand company debt and corporate direction. To its credit, in 2020 BP should find its Macondo-related payments wind down. It should also be noted BP shares have a higher historical P/CF multiple versus Royal Dutch Shell. However, the price-to-book valuation doesn’t make a BP investment appear quite as compelling.

Exxon and Chevron exhibit good debt management metrics, but the shares do not appear cheap, nor is the dividend yield as robust as Shell or BP.

I find few reasons to invest in Total SA versus Shell. Frankly, I believe Shell is simply a better-run company, too.

On balance, considering management, metrics, and forward strategy, I contend Shell is a superior choice for income investors looking for energy exposure while seeking to avoid significant capital drawdown.

Source: Seeking Alpha

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