Stockwatch: Can you trust Shell’s 15% dividend yield?

They say never sell Shell, but plenty have recently. Our companies analyst decides if it’s time to buy.

At truly dire times, those of wise silver hair have in the past bought into Royal Dutch Shell (LSE:RDSB) for its long-term proven strength of cash flows that underpin its dividend paying capability.  

Not only is the income welcome for older retired investors, astute enough to know that smaller companies can be very high risk if markets have plunged in anticipation of recession, but before the economic impact has manifested itself.

Shell’s size means it has previously borrowed to smooth its payouts after oil price slumps and, in due course, the stock has re-rated once a fat yield is deemed too generous for the risks. So, for total return, Shell has to date been a crisis stock par excellence.

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Moreover, at around 1,000p and yielding over 15%, it now leads the income yield league among international oil stocks, over BP (LSE:BP.) at 12.3% and Exxon (NYSE:XOM)/Chevron (NYSE:CVX)/Total (EURONEXT:FP) in high single digits.

Source: TradingView Past performance is not a guide to future performance

Clarity first on Royal Dutch Shell Class A (LSE:RDSA) versus RDSB, the two classes of Shells stock you will encounter. The A shares have a Dutch source, hence are subject to a 15% withholding tax, while the B shares are UK source hence no withholding tax. So, I am referring to the B shares, although directors’ trading more likely involves A shares where price differs. 

Macro influences, especially debt, dictate direction

We’re now at a phase like in 2008-09 when feverish markets twitch en masse, stocks moving together by the minute. So apart from a 20% jump early yesterday in funerals provider Dignity (LSE:DTY), the extent of downside risk is a matter of crowd psychology. Pin your tail on the donkey, perhaps, but, in chart terms, you can take Covid-19 out of the equation and view Wall Street’s downdraft as a sharp but inevitable mean reversion.

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Even after 30%-plus falls since January peaks, indices have yet to reach the US market’s dominant trendline from March 2009 lows; Nasdaq especially. Call it witchcraft, but if there’s any truth to Fibonnaci retracements, a 50% retracement would be more normal.

Some observers have long-warned the central bank stimulus years went on for far too long, creating dangerous bubbles, now deflating noisily – with a risk of excess on the downside.

So, while I can address industry/stock specific issues, they are subject to the macro context. 

Crude oil is already very interesting 

A week ago I warned how oil’s plunge has hugely increased risks for Premier Oil (LSE:PMO) and Tullow Oil (LSE:TLW) which are heavily borrowed. But Shell has also run up its gearing, which may have contributed to fear just as cash flows will contract from lower oil prices and demand.

On the bear tack: a global recession looks certain, while Saudi Arabia can pump high-quality oil at $8-9 a barrel extraction cost, so has a lot more cushion than other producers. Russia also has comfortable strategic stockpiles, implying that oil could go lower into a $20 range, especially if traders exacerbate the trend.

On the bull tack: this is taking crude back to long-term historic lows of $26 a barrel at start of 2016, and it has not been sub-$26 since 2001 when it fell to $17.

Those times did not involve the black swan of global shut-down coinciding with a price-war; but the take-away lesson is that oil does rebound from lows. Eventually, buyers start adding to strategic reserves and a spike can happen given production capacity will have curtailed. Despite the environmental crusade we will not be oil independent for a long while. 

So, yes, amid savage plunges of strong integrated oil company stocks especially, it is already time to be alert – potentially averaging in.

Mind: “You can’t step into the same river twice”

This ancient proverb of Heraclitus implied currents and sediment will be different. For example, oil drilling won’t be profitable around current prices yet production will largely continue by the majors to sustain necessary cashflow, while marginal operators are forced out.

Fortunately, Shell’s purchase of BG Group has raised its natural gas profile, contributing $11 billion cashflow last year, in context of $47 billion from operations overall, enabling over $25 billion to be returned by way of dividends and buybacks.

Mind, the end-2019 balance sheet showed total debt up 25.5% to $96.4 billion and cash down 32.5% to $18.1 billion – not the kind of dynamic you want to see, albeit with interest expense of just $4.7 billion in context of $326.6 billion.

Shell’s Altman Z1 score – a measure of financial health, especially the risk of corporate distress – is 2.1, indicating that caution is needed. The company is not fully safe from financial distress.

Moreover, such a score may be substantially derived before oil prices having halved this year (a dilemma for risk measures in a fast-moving environment).

It is less risky than BP, however, at 1.24, which indicates a serious risk of financial distress in the next two years. Both are better than Premier and Tullow though. 

So, the market is rational to mark these producer stocks down aggressively in response to negative shocks both for oil demand and supply.

A silver lining is Covid-19 data in China, Taiwan and South Korea looking better, suggesting potential to take up some slack in global demand – unless the virus resumes as travel and social restrictions come off. China had a 13.2% share of oil consumption in 2019, versus 20.3% in the US and other countries in mid to low single-digits.

Dividend sustainability is crux of the issue

Shell had guided for $28-33 billion free cash flow this year albeit based on $65 oil – so the price and demand shock will trash this.

The 2019 cash flow statement shows Shell’s 154p sterling equivalent dividend costing just over $15 billion, suggesting additional borrowing looks very likely to sustain this.

Given the way debt costs are being slashed, I expect this will happen, and possibly risk scores should be mitigated (realistically) to reflect exceptionally low debt cost.

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It is also possible the board embarks on more aggressive buybacks to take advantage of low prices and enhance long-term per share ratios; which might also add some technical support.

So, shareholders must steel for the next two quarters at least, producing dire results, albeit probably priced in already. The oddball scenario being a “2018 Spanish flu redux” where the virus mutates deadlier for a second wave from next autumn, albeit that is a very worst-case scenario.

The dicey element, impossible to predict, is whether the board cuts the dividend so as to be regarded as overall prudent, and/or prioritises buybacks as a better way to return value.

My sense is that they’ll sustain the dividend with debt – at least in the short term - otherwise this will encourage fear as to what’s happening at the underlying level, not to mention Shell’s reputation among income investors – it famously hasn’t cut the payout since the Second World War.

If the human gets crippled by pestilence, longer-term, then re-consider.

For now, therefore, risk-tolerant investors should indeed consider averaging into Shell. Its price is currently blipping around the 1,000p level, looking psychologically significant for support – so if it fails in days ahead then there’s possibility of further downside.

Yet the monster yield may well tip the balance of trading positively, and, on a two-year view, lock in upside.  

It’s also worth noting that yesterday Gerard Kleisterlee spent €137,000 (£124,000) buying 10,000 A shares, clearly believing the fall is overdone – in the long run. His action underlines the rationale I describe. Buy.   

*Note: Many funds will already own Shell shares in significant quantities, especially income funds. Before buying individual stocks, investors should always check holdings across funds to avoid overexposure to any one stock or sector. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.