MicroStockHub/iStock via Getty Images

MicroStockHub/iStock via Getty Images

I haven't written about Royal Dutch Shell (RDS.A) (RDS.B) in quite some time. My election to defer was based upon a simple premise: I really wasn't sure what to make of the company.

In this article, I'll offer my views on several issues on the minds of many investors.

At the top of the pile is the dividend. Long considered sacrosanct, management received criticism when they slashed the 1Q2020 payout by 66 percent. Citing a “crisis of uncertainty” around the Coronavirus pandemic and energy demand, it marked the first time the company cut the dividend since 1945.

Management referred to the reduction as a dividend “reset.”

After the announcement, the stock wasted no time rolling off the table. The ADRs tumbled ~50 percent, falling to about $30.

In the aftermath of the initial cut, the most recent annualized dividend has been raised to $1.92, or about half the pre-2020 amount. In the face of an enormous oil and gas commodity rally, the stock has recovered to approximately $44 per ADR.

In my opinion, the cut appeared overly cautious; it seemed hasty and excessive.

Of particular concern was the messaging. For your review (found below) is a January 30, 2020 CNBC interview with CEO Ben Van Beurden. I very much encourage you to listen to the entire 4:38 broadcast, but pay particular attention to Mr. Van Beurden's remarks at the 1:30 mark.

Shell CEO: Coronavirus will keep people on edge (cnbc.com)

Some context: when BVB took over the CEO role in January 2014, I was impressed with the direction he wanted to take the business, and his style. He looked like the real deal. He was forthright, clear-speaking, and focused upon making a better investment case for RDS stock; long a corporate shortcoming. He planned to run for cash flow, reduce expenses, and streamline the company. Based upon Ben's previous work running Shell Chemical, I was confident he had the chops accomplish the task.

During the 2015-16 energy price downturn, Mr. Van Beurden continued to stay the course. The dividend remained intact; expenses and capex were cut; and management spoke of a "more resilient" business. Notably, the capex reduction was in part offset by smarter, more focused spending: getting the same results for less money. It was all good stuff, and much of it was long overdue.

So, what happened to the dividend in 2020?

I'm of the opinion it was altogether possible Ben Van Beurden had the rug pulled out from under him. Of course, I cannot prove this with hard evidence. However, I saw the CEO granting a major, televised interview in late January 2020 stating the dividend was safe. Then just a few months later, the board of directors slashes the dividend by 66 percent.

To this investor, these actions indicate poor messaging, or the CEO got blindsided. Shell management has long been highly deliberate and cautious. It remains hard for me to see how senior management could pivot from, “...there isn't any risk of our meeting our dividend commitments,” in January to slashing it by 66 percent in April.

Let's turn to the fundamentals leading up to and through the situation.

In 2019, RDS recorded $20.1 billion free cash flow. In 2020, FCF eased to $17.6 billion; a 12 percent decline. This year, the company is likely break $30 billion in free cash flow. Clearly, the cash flow situation didn't play out nearly as dire as management expected back in 2020. Meanwhile, Super Major competitors Exxon Mobil (XOM) and Chevron Corp (CVX) increased their respective dividends through the pandemic, thereby maintaining their Dividend Aristocrat status.

Currently, Exxon and Chevron offer investors better dividend yields, while these respective stocks experienced less drawdown between December 2019 and today.

The following chart recaps how the situation played out:

source data: company SEC filings

Through the period 2019-21, RDS generated significantly more free cash flow than either peer; yet Shell management cut the dividend while the others grew their respective payouts.

Shell management cited a need to cut the dividend in order to bolster the balance sheet. Here's how Shell, Exxon and Chevron stack up versus each other on sequential debt-to-equity ratios and current credit ratings:

source data: company SEC filings and author calculations

To Shell's credit, the company has lowered its D2E ratio within shouting distance of what it was back in the 2019 pre-pandemic days. By maintaining dividends, Exxon and Chevron took on more debt (borrowing to pay the 2020 dividend), but started with better 2019 balance sheets.

Nevertheless, despite the adding to their respective D2E ratios, XOM and CVS enjoy slightly higher S&P credit ratings.

Meanwhile here's how shares prices fared. RDS stock is the black line:

courtesy of bigcharts.marketwatch.com

With the benefit of hindsight, one may conclude Shell management was too cautious. The dividend was cut, the share price tumbled, and despite a focus upon making a better investment case for the stock, RDS continues to lag peer performance. Shell elected to zig while its U.S. counterparts decided to zag.

From a shareholder standpoint, was Shell's climb worth the view? Did strengthening the balance sheet set up the business for superior long-term performance versus peers? Have these decisions improved the company's investment case? I cannot answer in the affirmative.

I believe the dividend cut was premature and overly severe. Despite generating significantly better free cash flow than peers, the stock has stayed in the penalty box. The share price fell harder than XOM or CVX, yet the dividend yield still trails.

And it really bothers me how the CEO could offer an interview just a few months before the dividend cut indicating Shell could meet its dividend commitment, then chop it.

For decades, a Shell management has been criticized for their propensity to change course. Part of this reflects the difficulty directing an enormous worldwide enterprise of immense span and scope. However, some of it may be the Euro-style management system. In previous years it was called “matrix management.” In a nutshell, the style emphasizes collaboration, internal negotiation, and compromise. Indeed, it can build strong consensus. On the other hand, it can result in soft decision-making and result in taking paths of least resistance.

Recently, Royal Dutch Shell has revamped its strategy with a heavy tilt to going Green. However, management continues to cite the need to remain in hydrocarbon extraction and downstream business. There's been a great deal of discussion around making Shell smaller, yet expanding its Green footprint. I find this approach somewhat confusing. I do not think I'm alone.

The current Shell approach seems to make no one happy. Investors who expect the Shell business model to focus upon traditional hydrocarbon production, refining, and distribution question the transition. Unfortunately, many Green stakeholders don't like the transition, either. It's not fast enough or clean enough.

At the October 25, 2021 TED Countdown Conference, here's a clip of CEO van Beurden getting skewered by a Green advocate:

Watch as 'evil' Shell CEO is confronted by protestors on stage at TED event | Euronews

Please note Shell is attempting to LEAD a transition from hydrocarbons to alternative fuels and a net-zero carbon world. In my view, and in my experience, NOTHING will satisfy the most ardent Greens from castigating energy companies. It is not possible to make these stakeholders happy; short of shutting down the business.

Shell's trip into no-man's-land is precisely, in my opinion, why activist shareholder Third Point LLC is pressing the company to split up in order to unlock value. While I agree with Shell management this isn't the right course of action, I also agree with Third Point: the current strategic path doesn't seem to be pleasing anyone. In an open letter, Third Point explained why they believe the company should be split up. Here's an excerpt:

Given all these positive attributes, why can’t Shell attract investor interest? In our view, Shell has too many competing stakeholders pushing it in too many different directions, resulting in an incoherent, conflicting set of strategies attempting to appease multiple interests but satisfying none.

All the while, Shell is making more cash than its competitors, continues to enjoy an “A” credit rating, and gets no love for it. Uncertainty and messaging are killing the stock.

So, let's move onto the recent news entailing the company moving its headquarters from The Hague in the Netherlands to London, U.K.

My view is this has to do with the Dutch government's recalcitrance to eliminate the dividend tax on RDS.A shares; not the recent environmental court ruling. This ruling REQUIRED the company to change its business model to accelerate carbon emissions to a court-prescribed reduction. IMHO, the ruling is a ridiculous case of overreach and will be overturned. The world is no longer safe for democracy when courts get to decide and impose overarching business strategies for global corporations.

I contend Shell was on the outs in the Netherlands after the government indicated it would rescind the 15% dividend withholding tax, then reversed courts and elected to retain it. I believe the tax is a money grab that encouraged the business to seek more accommodating jurisdictions. The on-and-off about-face simply added insult to injury.

It's possible the Dutch government may choose to play nice on the tax now that Shell management has announced its withdrawal, but I believe it's too late.

I applaud management's decision here, but I do not believe it has much to do with the activist Dutch court environmental decision. My sources indicate the decisions to relocate to the U.K. was in motion (over the dividend tax) long before the court ruling was issued.

An investment discussion about Royal Dutch Shell wouldn't be complete without addressing the question of stock valuation.

My view is company narratives are important; however, when considering stock prices, what matters most is valuation. Over the long-term, valuation is what drives the bus.

Indeed, the aforementioned overview (the dividend cut, forward corporate strategy, and moving the HQ out of the Netherlands) paints a somewhat muddled picture.

The dividend was slashed, and the share price followed suit. The current Green strategy creates uncertainty, and arguably appears to please few stakeholders. Moving the corporate center to the U.K. is most likely a positive action, and it tends to simplify the company's structure. However, the relocation process entails some level of business disruption.

Nonetheless, RDS' valuation calls to question simply dumping the stock and looking for greener pastures. (No pun intended).

Earlier in this article, I pointed out Shell has been a cash flow stalwart versus peers. This seems to have been lost amidst the current company narrative.

If we focus upon valuation through the lens of operating cash flow, there's a good case the stock is undervalued by a significant margin. A long-term F.A.S.T. graph highlights the disconnect.

Over the long-term, we see the price-and-cash flow multiple has been 6.4x. Today, the shares are trading at a 3.7x multiple. A reversion to the mean suggests an $80 stock. If we shorten the time frame to the last eight years, we can compress the mean to not lower than 5.8x. Even at 5.8x cash flow, we have a $70 stock.

Turning to Exxon Mobil or Chevron, these stocks have commanded long-term P/OCF multiples of 9.5x and 7.6x respectively. The trailing twelve-month price-and-cash flow multiples are 6.8x and 8.9x, respectively. All these figures are comfortably ahead of Shell. Despite generating much more cash flow and comparable forward growth, Shell valuation lags.

Indeed, through 2023, the Street forecasts comparable cash flow growth for all three Super majors.

If we truncate the Royal Dutch Shell long-term price-and-cash flow average multiple at 2019 (lopping off the last couple of years) the P/OCF multiple rises to 6.5x.

Therefore, no matter how one turns this Rubik's cube, it appears 2020 and 2021 have revealed just how negative investors have become on RDS stock. Not even during the energy price crises of 2008 and 2015 did RDS cash flow multiples become compressed like this.

Let's turn to another valuation metric: price-and-book value.

First, here's a post-Great Recession chart indicating Shell's year-end annual P/B:

At year-end 2020, the ratio fell to 0.9x, or about where it was during the depths of the 2015 oil crisis.

The current P/B ratio is 1.1x, determined after the 3Q21 earnings report. At the time I calculated it, the stock ADRs were trading at $47.

A review of the chart suggests one could make a reasonable argument the price-and-book ratio should revert to at least 1.2x. If so, the Fair Value would be ~$51.

A 1.3x price-to-book indicates a $56 stock.

On a positive note, through the most recent energy commodity boom-and-bust cycle, during which Shell management has been divesting non-core assets and paying down debt, RDS net book value has been rising.

Net book value was $24.49 in 2018, $23.87 in 2019 (reflecting significant asset divestiture), $20.30 at YE2020 (low water mark), and it's $21.45 now.

Given the valuation data points above, there's a good case to be made the stock is cheap. I may contend the stock is cheap for a reason. However, even if I dislike management decisions / direction, it's difficult to dismiss the Fair Value gap unless one subscribes the Street is wrong on the fundamentals: the expected forward cash flows will not materialize because current management actions will prevent it from doing so. I do not believe this to be the case.

So long as CEO Van Beurden is in place, cash flow will be focused upon.

For this investor, the bottom line is as follows:

Generally, I am negative on several major management decisions. The 2020 dividend cut resulted in lagging share prices; even after the recent dividend increases, RDS has the lowest dividend yield of the leading Super Major energy companies. I am not convinced the forward Green strategy, while politically expedient, will optimize shareholder returns. I doubt whether it will garner measurable goodwill from the Greens. I harbor concern that Shell may not stay the course on even its most current business strategies. My concerns are compounded by CEO Ben Van Beurden's tenure: he's completing his eighth year at the helm. Historically, this is around the time CEOs wind up, and the board of directors seek new leadership. Historically, new Shell leadership does not automatically mean continuity.

Nonetheless, the current valuation story is bullish. The shares are cheap; but are they cheap for a reason?

As a long-term stockholder, my current view is to hold shares for the time being. I plan to distribute slowly if / when the ADRs reach the mid-$50s, whereby using today's fundamentals, the stock ADRs would be trading around my opinion of Fair Value.

I have no compunction to accumulate additional stock, nor rush to bail out.

Your comments are welcome. I look forward to the reader interaction.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2021 investments.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of RDS.A, RDS.B either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.