Industrials

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

Royal Dutch Shell has delivered a shock. Weeks after cheering investors with a big plan for living within its means, the oil major's second-quarter earnings plummeted from $3.4 billion to $239 million. Paradise -- a cash-generative company driven by February's $64 billion acquisition of BG Group -- has been postponed.

So much for the benefits of BG. This was the first set of numbers to include a full contribution for the acquisition, and so far the deal has pushed indebtedness higher while introducing a raft of one-off integration costs.

The latest result risks rekindling worries about the sustainability of the cash dividend, which costs $2.4 billion a quarter. The gap between earnings and payout, on first blush, looks hard to bridge. Hence the shares' outsize dividend yield of 7 percent -- usually a sign of fears the payout may be cut.

Back to Reality
Shell's shares decoupled from the oil price in June but disappointing 2Q results gave them a knock
Source: Bloomberg

In fact, the dividend should still be secure. On a rolling 12-month basis, cash flow from operations was about $20 billion and this was roughly in line with cash investment. So Shell is basically break-even before interest charges and shareholder payouts.

Meanwhile, the company has two levers it can use to defend the dividend. The first is by letting debt creep up. Net debt as a percentage of total capital was 28 percent against 26 percent at the end of the first quarter. Borrowing costs are low -- Shell has keen rates of around 3 to 4 percent -- and capital markets are open, so there's nothing to stop the company taking advantage of favorable market conditions.

Shell's Ups and Downs
The low oil price hit Shell's earnings from "upstream" oil operations worse than other divisions in Q2
Source: Royal Dutch Shell

The second lever is assets sales: Shell has 17 disposals on the go worth more than $500 million.

This can get Shell over the short-term hump. Further out, Shell's plan for cutting operating costs and capital investment through BG can take over. This seems to be delivering, with the enlarged group's rolling 12-month operating costs 9 percent down year-on-year.

The bad news on the deal may not be over -- "one-off" charges may endure a bit longer, with integration costs from BG are likely to be a feature of results for the rest of the year. But this will end, and by the first quarter of next year Shell should be reporting cleaner numbers with more progress on costs and capital expenditure savings.

The shares have given back some of the lift gained after unveiling of its long-term capital and cash plans on June 7 but don't look expensive. They trade at 13.2 times forecast 2017 earnings, a slight discount to BP. When the savings from BG really kick in, the results should enjoy a substantial uplift. In the meantime, there's the dividend as compensation.

Management has the tools and flexibility to deliver what it promised. Investors can rightly exact punishment if it fails to do so.

 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Hughes in London at chughes89@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net