Can Royal Dutch Shell Sustain Its High Dividends?

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RDSA: Royal Dutch Shell logo
RDSA
Royal Dutch Shell

Royal Dutch Shell‘s (NYSE:RDSA) dividend yield has reached a high of over 8%, given that its stock price fell by almost 18% in the last three months.  The company has committed to paying its current dividend for the current financial year despite the pressure on its net income. However, it is now uncertain whether the company will be able to sustain this dividend in the future.  The market seems bearish on Shell’s growth prospects.Our current price estimate for Shell stands at around 30% above the market price. In our bear case scenario, our price estimate faces a 20% downside, based on a reduced forecast for global crude oil prices, Shell’s exploration success, and downstream EBITDA margins.  However, we remain optimistic on Shell, given its long standing history of dividend payments, we believe that Shell will not initiate a dividend cut.

See Our Complete Analysis for Royal Dutch Shell Plc.

Dividend Per Share Is Increasing Despite Declining EPS

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Below is a quick snapshot of the company’s dividend history:

Shell New

 

A steady increase in dividend per share and a significant drop in the EPS brought the dividend pay-out ratio to 80% in 2014.  This implies that the company is using most of its net income to pay dividends, thus putting pressure on its internal reserves.

The high dividend pay-out seems to be getting offset by low capital expenditure.  Over the past three years, Shell’s capital expenditure has been reduced from 223% of D&A to only 130% of D&A.  Capital expenditure as a percentage of revenue ranged between 7-9% in these three years.

If there is further decline in the company’s EPS, the pay-out ratio would be too high to sustain and will put a strain on liquidity.  The company would then have to depend on free cash flow or borrowings to fund capex requirements.

Concerns Around Net Income Growth

Our price estimate is almost 30% higher than the current market price.  However, if the company is unable to maintain its downstream EBITDA margins we see a 10% downside in the price.  Our estimates face another 10% downside if the company’s exploration success ratio deteriorates and global crude oil prices remain below $85 a barrel in the long run.

Using Trefis interactive technology, if we create a hypothetical scenario by changing key drivers, to arrive at the current market price, we can conclude that the market valuation does not factor in much growth for the company.

Royal Dutch Shell 2

In the above hypothetical scenario, we have modified several drivers to arrive at the valuation of Royal Dutch Shell.  Reducing the long-term forecast for average crude oil and NGL (natural gas liquids) sales price to around $65 per barrel is just one example.  If the growth in the key drivers is flat, our valuation comes close to Shell’s current market price.  So the market’s expectations are not high.

How Much Cash Is Needed To Maintain Dividends?

The company paid $9 billion as dividends in 2014. Our net income estimate for 2015 is $13 billion and we expect the figure to grow over the forecast period.  These estimates indicate that Shell might be able to generate enough cash to maintain its dividends.  However, when the business is experiencing growth, cash flows will have to be allocated towards additional capital expenditure.  The balance between using cash generated in operations for dividends and plowing it back into the business for growth, will be the deciding factor for the dividends.

Historically, large oil companies do not like to cut their dividends and have weathered financial downturns and not cut dividends even when oil fell to $10 per barrel in the 1980’s.  Royal Dutch Shell last cut its dividend in 1945 . [1] Going by the current market valuation, it appears that Royal Dutch Shell may find it difficult to maintain its dividend per share in the future if the bear case played out instead of our base case.  However, our view about the company’s future outlook is more optimistic. If our bear case scenarios do not play out, then the company should be able to continue paying dividends.

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Notes:
  1. Rakteem Katakey on Bloomberg []