Is Shell really as cheap as you might think?

Royal Dutch Shell (LON:RDSA, LON:RDSB) usually needs little introduction. It is one of the world’s largest oil and gas companies, originally formed in 1907 through the merger of Royal Dutch and Shell Transport and Trading, although the two companies only formally unified into a single holding company in 2005.

Shell is now the largest company on the London Stock Exchange with a market capitalisation of some £137bn taking into account its ‘A’ and ‘B’ classes of share capital. In 2012 it was also the largest dividend payer on the FTSE when excluding the special dividend of Vodafone so perhaps unsurprisingly then it is a core shareholding of many funds and income portfolios.

In Shell’s results for the year ended 31 December 2012 the company reported basic earnings per share (on a current cost of supplies basis) of $4.32 and a dividend for the year of $1.72. At a current share price for the class B shares (the ones usually purchased by UK investors for withholding tax reasons) of 2,178p and based upon current exchanges rates I make that a trailing P/E ratio of just 7.7 and a dividend yield of 5.2%.

In the context of the FTSE’s current P/E ratio of 14 and dividend yield of 3.5% this might initially look to be an enticing large cap value proposition and I have read a few opinions recently which suggest that Shell is very ‘cheap’. However, I am rather more cautious than that, principally because I think the accounting earnings overstate the true earnings of the company.

Shell’s ‘owner earnings’

In my last article discussing the concept of ‘quality’ I referred to Warren Buffett’s definition of ‘owner earnings’ which he considers to be more relevant for valuation purposes than accounting earnings. The reason for this is that it more closely reflects the amount of cash an owner of the business could take out each year after allowing for the cash needed to be spent in order to maintain the company’s operating capacity. Interestingly, in the same piece Buffett then when on to say this in the context of owner earnings usually being lower than accounting earnings:

The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only [their depreciation, depletion and amortisation charge] each year, they would have guaranteed their shrinkage in real terms.”

Although Buffett wrote that statement in 1986, I believe that it is as relevant to Shell’s earnings today as it was back then, as we shall see below.

Free cash flow

When it comes to dividend investing, I usually calculate free cash flow cover in addition to the more common earnings based dividend cover as it provides me with further comfort that the company is actually able to afford to pay the dividend after reinvesting in both maintaining the business and its organic growth requirements without relying on borrowings. It also helps us to consider the capital expenditure requirements of a company and how it differs from its depreciation charge.

Below is a summary of Shell’s free cash flow and earnings cover for the period from 2006 (the first full year after the unification in 2005) to 2012:

On average over the 7 years, EPS covered the dividend a healthy 2.4 times. By contrast however, the dividend was approximately equal to free cash flow. Perhaps the stalled dividends in 2010 and 2011 and the compounded annual growth rate of the dividend over the period of only 5% is reflective of this.

Conversion of earnings to free cash flow was only 43% on average, the reason largely being due to net capital expenditure being significantly higher than the depreciation, depletion and amortisation charged against earnings. Based on the figures below we can see that net capex was between 121% and 222% of depreciation, and on average 166%:

Maintenance capex

Free cash flow isn’t however the same as owner earnings since the former takes into account all capex whereas the latter is supposed to only reflect maintenance capex which Buffett defines as that required to “fully maintain its long-term competitive position and its unit volume”. He goes on to admit that we will usually need to take a guess at this figure – note that the split between maintenance capex and total capex is not required by financial reporting standards and so unless the directors’ commentary gives us some clues about this, it may be difficult to estimate. But, as Buffett notes, it is better to be roughly right than precisely wrong.

What I do know from Shell’s annual figures however is the level of annual production of oil and gas, as well as the proved developed and undeveloped oil and gas reserves; both stated in millions of barrels of oil equivalent (boe) which converts the gas into an oil equivalent figure for comparability. These figures are as follows:

So we can see that over the 7 years production has marginally declined and reserves have increased at a compounded annual rate of just 3.5%. It seems to me therefore that the vast majority of capex has simply maintained the company’s production volumes, albeit some growth has been seen in levels of oil and gas reserves. I imagine that the combination of the effects of inflation over such long term capital investments and other increases in the cost of extracting oil and gas inevitably lead us to this conclusion. I’m no oil expert though and if any better informed readers can offer an alternative analysis to this it would be very interesting to read them in the comments below.

A revised valuation

If we conservatively assumed that the ‘owner earnings’ for Shell are in fact based upon 166% of its depreciation charge, this would have the effect of reducing the 2012 reported earnings by approximately $9.6bn. The EPS figure would then fall from $4.32 to $2.78, resulting in a revised P/E of 12.0. Whilst this may be a little on the conservative side, my feeling is that this is a more appropriate figure to use for valuation purposes than the P/E of 7.7 obtained from the reported earnings per share.

I also note that Shell’s accounts for 2012 disclose a return on average capital employed figure of 12.7%. Again, if we were to use our conservative owner earnings figure, this return would reduce to a very mediocre 8-9% which is probably close to the company’s cost of capital.

As we can see from the above, there is a lot more to a P/E ratio than meets the eye and we should be particularly careful when comparing different sectors due to the different economics involved. We would probably also take a different view of earnings if we carried out similar analysis for most miners which also tend to trade off low P/E multiples. Both of these sectors can be very difficult to value: not only do we have the issues referred to above, but also fluctuating commodity prices to deal with, making the prediction of future cash flows much hard to pin down. It is not surprising therefore that many experienced and competent investors declare these sectors outside their ‘circle of competence’ notwithstanding the potential for mediocre returns on capital.

I personally don’t view Shell as the bargain that some people do based on the above analysis, but that is not to say that it won’t continue to be a solid and dependable income share.

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