Interactive Investor

Stockwatch: Are Shell shares overpriced?

20th May 2016 10:52

Edmond Jackson from interactive investor

Can you really be sure of Shell? The FTSE 100 'B' shares have recovered nearly 37% to 1,750p since their January low around 1,280p, but remain attractive for yield since last February's 2015 results committed to at least maintain the dividend.

The table shows trends in sterling, while Shell reports and bases its dividend in US dollars - potentially useful in the short-to-medium term if the "Brexit" vote regains support and sterling falls. Yet the brokers' consensus is for a 7% slip in this year's dividend, if mainly as the impact of an 'underperform' stance taken by Morningstar targeting a 99.8p per share payout which lowers consensus to 115p.

Best not to get hung up on specific analysts, when the range of 2016 net income forecasts is from minus $200 million (£139 million) to plus $2 billion, reflecting uncertainty over oil prices and the effects of integrating BG Group.

No one dares (at least via Company REFS data) specify a profit forecast for 2017, although Goldman Sachs has rated Shell a 'conviction buy' since 11 March. So projections scatter.

Dividend supported by reserves

The end-2015 balance sheet showed cash stable just below $32 billion, and the cash flow statement how annual dividend payments to shareholders cost about $9.4 billion. So the board can justifiably promise to at least maintain the dividend for now. Medium-term prospects, however, require oil prices to consolidate and build on their recovery.

The acquisition of BG Group has pushed up net gearing from about 16% to 26%The cash flow statement within the first-quarter 2016 results shows operational cash flow slumped from $7.1 billion to $0.7 billion like-for-like, or from $5.4 billion in fourth-quarter 2015. This reflects oil averaging $34 a barrel during first-quarter 2016 - cash flow break-even was $55 a barrel of oil in 2015, although some analysts reckon that without asset sales the underlying break-even level is nearer $70 a barrel.

Lower refining margins aren't helping either. Meanwhile, first-quarter capital expenditure was $5.3 billion, the lowest level since second-quarter 2011, leaving free cash flow in the red and Shell drawing on reserves to support its $3.8 billion quarterly dividend cost. So oil prices need to keep rising for Shell to meet its investment and dividend demands.

Then there is net debt of $69 billion, which has soared higher than expectations of $60 billion (or less), partly due to capitalisation of finance leases. The acquisition of BG Group has pushed up net gearing from about 16% to 26%, which would reduce if the current extent of dividend payout is prudent.

The 2015 annual results showed $1.9 billion interest expense, among other charges, against $2.2 billion income for the period (down from $14.7 billion in 2014). So the interest expense is becoming more pertinent and will rise.

Market remains awash with oil

A very few traders successfully called the turn since February, but no-one bet on an 80%+ rebound to test $50 a barrel. Supply interruptions from Canada and Nigeria and exceptional demand from India have contributed as fundamentals. There's also a weight of money chasing a new speculative trend in a belief the oil market is rebalancing. Mind that this is likely to spur more producers to sell output and keep high global stocks rising, also as Iran ramps up its production.

Oil only needs some speculative long positions to close to tip the trend against the merry consensusCombined output of the OPEC countries in April reached 32.76 million barrels a day, the highest since 2008, and the market remains oversupplied by some 1.5 million barrels of daily production. Bulls anticipate oil to enjoy further demand gains in India, China and Russia, combined with US demand that set records in March. The US driving season is imminent.

Mind, however, that OPEC production could stay on a rising trend, and the oil market's technical position has gone from record net short positions to record net long, i.e. could destabilise again in the event of surprise news. It now only needs an element of speculative long positions to close out, to tip the trend against the merry consensus.

For example, markets have just been mildly astonished at the US Federal Reserve indicating it may raise interest rates next month (boosting the US dollar, which has an inverse relation with oil prices), news which combined also with a rise in US oil inventories.

Integration of BG

Another chief factor on dividend capability is integrating BG Group, a major producer of oil and liquefied natural gas (LNG). Standard Life objected to this $70 billion acquisition on grounds that it was not value-accretive below $60 oil, and backed its words by halving its stake around the time the deal was approved.

Were BG acquisition cost projections initially set high to better enable beating expectations?That $60 estimate could reduce according to success with the integration, but be aware how history shows mega-mergers not meeting managers' claims. This is why Shell has expressed a careful PR line, for example stressing how detailed forward planning has meant "accelerated delivery of synergies" and BG absorbed at lower cost than envisaged.

Or were cost projections initially set high to better enable beating expectations? The proof won't be manifest for a while - meantime, a strategy presentation on 7 June may affect sentiment.

'Sell' or buy the dips?

The dilemma is the dividend yield owing more to boardroom bravado - trusting the merger will pay off substantially and oil prices regain strength - than established fundamentals.

Holders should beware downside risks while Shell's equity valuation rests substantially on yield and that oil prices will continue to surprise. In this respect, global growth figures are also influential, as well as whether the Chinese authorities can manage a way through more challenging times, or whether their latest credit boom stokes trouble.

So there is plenty to prove, despite Shell never having cut its dividend since 1945. If you already have exposure to commodity stocks including Shell, then consider reducing exposure.

More positively, if oil can rebalance over $50, it could be a watershed for sentiment towards this and other oil stocks. It's up to you to decide how much risk to bear on oil's rollercoaster.

For more information see their website.

Royal Dutch Shell - financial summaryConsensus estimates
year ended 31 Dec2011201220132014201520162017
Turnover (£ million)302,506287,390273,642270,553178,846  
IFRS3 pre-tax profit (£m)35,81531,07520,37118,1911,382  
Normalised pre-tax profit (£m)34,14429,12523,38320,3935,126568n/a
Operating margin (%)8.58.27.06.21.8  
IFRS3 earnings/share (p)32026215815220  
Normalised earnings/share (p)29223320418773.364.2105
Earnings per share growth (%)41.6-20.2-12.4-8.7-60.8-12.463.9
Price/earnings multiple (x)    23.927.316.6
Cash flow/share (p)366441377438291  
Capex/share (p)200320375222229  
Dividends per share (p)104105114114124115129
Yield (%)    7.16.67.4
Covered by earnings (x)4.13.21.91.60.60.60.8
Net tangible assets per share (p)16771639167243414,331  
Source: Company REFS

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