When I opened the first quarter of 2020 results for Royal Dutch Shell (RDS.A) (RDS.B), I was shocked and incredibly disappointed that they decided to cut their dividend significantly. Although these operating conditions are certainly difficult, this decision has destroyed their perfect dividend sequence since the end of the Second World War. To make this decision even more questionable, their financial performance in the first quarter of 2020 was fairly solid given the difficult operating conditions and actually gave them time to wait and see how the future would look in the short term. takes place.
When evaluating dividend coverage, I prefer to forgo using earnings per share and instead use free cash flow because dividends are paid in cash and not based on “earnings”. The chart below summarizes their cash flows for the last quarter and the previous four years.
When examining their cash flow performance in the first quarter of 2020, it was very surprising to see that it actually increased 80.90% year on year to $ 13.819 billion from $ 7.639 billion. dollars, after including the impact of items that exceed the dividend payments as mentioned below. graphic. This strong operating cash flow, combined with reduced capital expenses of 13.30%, generated free cash flow more than sufficient to provide double dividend coverage of 258.31%. Even though their dividend coverage would likely have suffered more in the future, this surprisingly strong performance should have given them the freedom to wait and see longer in the event that conditions stabilize or start to recover within a quarter or two.
Admittedly, this solid performance was partly supported by a working capital drawdown of $ 7.448 billion against a working capital constitution of $ 3.483 billion in the first quarter of 2019. After eliminating the impacts of these movements of funds their operating cash flow actually decreased by 42.12% year-on-year. in the first quarter of 2020 to $ 11,122 billion compared to $ 6.371 billion for the first quarter of 2019. This means that their dividend coverage excluding working capital movements was only 44.47% for the first quarter of 2020 While this is certainly not ideal, still significantly better than their actual 56.62% negative result for the entire year of 2016, when they remained committed to maintaining their dividend, although they just saw their leverage increase after finalizing their massive acquisition of BG Group.
Looking to the future, as they have cut their dividend by two-thirds massive, this obviously improves their dividend coverage significantly. Based on their current number of combined Class A and B outstanding shares of 8,144,844,908, their new quarterly dividend of $ 0.16 per share will require only free cash flow of $ 5,212 billion to cover completely. Given that their average dividend coverage over the 2017-2019 period was 120.88%, this indicates that, under normal operating conditions, they were able to finance their previous dividend payments without resorting to debt. . This means that not only will they be able to easily cover their new dividend payments once conditions are restored, but they will also have the option to reinstate their previous dividend.
While their dividend coverage is always important to consider, their financial situation is of equal importance. The three graphs below summarize their financial situation for the last quarter and the previous three years.
When examining their financial parameters, it becomes apparent that they entered this slowdown with moderate leverage which was fairly secure. Even after the turbulent operating conditions of the first quarter of 2020, their debt ratio was still only 28.54% due to the above-mentioned good performance of their cash flows. This only underlines the surprise of seeing their dividend so greatly reduced. Even though their net debt to EBITDA and their operating cash flow have increased, this is normal in a downturn when their profits temporarily suffer.
During years of normal operating conditions like 2017-2019, I think you have to judge their leverage on all financial measures. While during years of severe downturn, I think the gear ratio provides a solid proxy for analyzing the damage inflicted. When this reaches around 40% or more, this normally signals that a dividend reduction is imminent unless conditions have fully recovered.
Based on my calculations, even if they were to finance previous dividend payments as well as $ 10 billion in additional capital spending through debt every three quarters, their debt ratio would reach 36.51. %. Although it is certainly not low, to provide the context, it is roughly equal to that of BP (BP) which has just decided to keep its dividend stable. In addition, this debt ratio includes rental debts, unlike the one BP recommends. This example shows that they had at least a quarter more to wait and see if not more. On the positive side, it also means that when conditions improve, they should not face a period of significant deleveraging and thus have more leeway to restore their previous dividend.
Fortunately, their liquidity is also strong and will play a decisive role in ensuring that they remain active and have the opportunity to reinstate their previous dividend once conditions have been restored. While operating conditions deteriorated rapidly during the first quarter of 2020, their liquidity did not keep up and there is therefore no reason to worry. Their current ratio of 1.11 is fairly safe for a massive business that also has a cash balance of $ 21.811 billion. Due to their massive size, solid financial position and policy of supporting central banks, there is no reason to worry that they will not be able to find support in the debt markets to refinance future debt maturities and provide cash when needed.
One of my concerns right now is that they will encourage share buybacks once conditions have improved compared to restoring their dividend to its former glory. While I have nothing against share buybacks in general, I think they are a bad choice for companies with volatile and cyclical profits, such as oil and gas companies. I discussed this in more detail in one of my previous articles on ConocoPhillips (COP) and to summarize briefly, they tend to make share buybacks when operating conditions are favorable and therefore have of the capital to be returned to the shareholders. Unfortunately, it is also when their stock price reaches its highest levels, which leads them to buy at high prices. If they decide to pursue this strategy, I will liquidate all of my investment once conditions have recovered.
Given the importance that many of their shareholders attach to the receipt of their dividend, not to mention their conviction to maintain it through the last oil crash, there is simply no need to see it reduced at the first opportunity . Given their aforementioned strong financial performance in the first quarter of 2020, they should have left it with at least one more quarter to wait, if not more. As management says economic uncertainty has motivated their decision, there should be much more details on any recovery from this global recession in three months and so they could have made a more informed decision.
Regardless of my pure disappointment, in the grand scheme, the fall in dividends, even for a few years, does not massively reduce the intrinsic value of their shares. Given this and the fact that they have the ability to reinstate their previous dividend once conditions have improved, I will continue to maintain my bullish rating.
Notes: Unless otherwise indicated, all figures in this article were taken from Royal Dutch Shell First quarter 2020, Fourth quarter 2019 and Fourth quarter 2017 reports, all calculated figures were made by the author.
Disclosure: I am / we are long RDS.B, BP. I wrote this article myself and it expresses my own opinions. I do not receive any compensation for this (other than from Seeking Alpha). I have no business relationship with a company whose actions are mentioned in this article.