Royal Dutch Shell plc (ADR)'s S&P 500 Underperformance Cannot …
Royal Dutch Shell plc (ADR) (NYSE:RDS.A) has consistently underperformed the S&P 500 and the energy sector during the last five years. To counter the deficiency, the company is improving its return on capital, reducing cost, and maintaining adequate liquidity. These steps will result in improved profitability once crude oil prices begin to rebound. Shell will then be in a better position to demonstrate its earnings power. It has been working to increase the returns on its portfolio, first through asset sales that began before the oil price downturn, and more recently, by cutting capital and operating costs. As the company moves past the recent period of heavy capital spending and continues to lower operating costs, Argus expects free-cash-flow (FCF) to improve significantly. The equity research firm expects oil prices to bottom and then begin to turn up next year, which should also benefit earnings and cash flow. However, even if oil prices rise less than the current market expectation, there is still value in Shell shares.
Stock Price Performance
The Royal Dutch Shell shares have been relatively weak performers over the past quarter, dropping 28%, while the S&P 500 has fallen 4%. They also underperformed the Energy Industry (ETF:IYE), which has declined 19% over the past quarter. On October 30, Shell reported third quarter (3Q) earnings on a current cost-of-supplies basis (CCS), which came in sharply lower YoY, excluding one-time items. The following graphs show Shell s stock performance relative to the S&P 500 and energy sector ETF, in fourth-quarter fiscal year 2015 (4QFY15).
The company reported non-GAAP earnings of $1.8 million or 56 cents per American Depositary Shares (ADS) in 3QFY15, compared to $5.8 billion or $2.80 per ADS in the same quarter in the prior year. The YoY decline in earnings was driven mainly by lower commodity prices, which hurt upstream results. These were partly offset by stronger results in the downstream business. Cash flow from operating activities for 3Q was $5.3 billion, compared to $11.1 billion in 3QFY14. For the first nine months, Shell s non-GAAP earnings came to $2.80 per ADS, compared to $6.12 a year earlier. The management also provided an operational outlook for 4Q along with the results. It expects lower upstream production, lower refinery availability, and higher availability of chemical manufacturing plants.
Merger And Acquisition (M&A) Story
Shell, one of the largest companies in the world, is looking to take advantage of the volatility in the oil industry, to grow through M&A. On April 8, 2015, Shell announced plans to acquire BG Group for 47 billion pounds (around $71 billion), or 1350 pence per share, in a cash-and-stock transaction. The offer represented a 50% premium to BG Group s closing share price on April, 7. When the deal is finalized, presumably in early 2016, BG shareholders will own 19% of the combined company. The deal is likely to facilitate an expansion in Shell reserves and generate meaningful synergies, and Shell said it would also lead to accelerated portfolio restructuring, with expected asset divestiture of about $30 billion between 2016 and 2018. The company is selling assets to reduce its capital base and focus on improving profitability. The proceeds from the asset sales will be used first for debt reduction, next for dividends, and finally for share buybacks and capital investment. Shell will see its debt-to-capital ratio rise as a result of the deal, though the management remains committed to maintaining its investment-grade credit rating. Overall, Argus believes the deal will be positive for Shell s earnings and cash flow generation, despite potential near-term dilution, which in the investors view, has already been factored into the share price.
Measures To Counter Downturn
The company’s management continues to focus on cost-cutting. In 3Q, the management decided to stop offshore Alaska exploration, and construction in the Canada-based Carmen Creek oil project. The company has also embarked on a workforce reduction plan that will eliminate 7,500 jobs and contractor roles, saving $4 billion. In December, Shell announced that the combination of BG Group would likely lead to the cutting of 2,800 jobs.
At the end of 3Q, Shell had $32 billion in cash on its balance sheet, up from $19 billion a year earlier. Total debt was $56 billion, and the debt-to-total capitalization ratio was 25%. After the BG Group merger in early 2016, Shell s net-debt-to-capital ratio is expected to be about 20%, which sell-side firms view as highly manageable. Both Moody s and S&P give Shell a high investment grade credit rating with negative outlooks.
Shell has the ability to manage the sinking ship and to overcome the fragility in the oil industry due to its solid balance sheet, solid margin profile in the downstream segment, and timely cost reduction steps.