Is This Energy Stock a Value Trap?

Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Analysts at Credit Suisse have upgraded shares of Royal Dutch Shell (NYSE: RDS-A) to Outperform from Neutral. The price target was set at $79. "We think the market has now digested Shell's 25% capex increase and small dividend hike of Feb. 2012, and has put Shell on a more attractive valuation," said Credit Suisse. "In our view, Shell's story is well understood and lacks catalysts, but we believe that a safe dividend yield (covered by FCF) and predictable cash flow growth may be enough to make Shell outperform a lackluster group in 2013." In this article I will analyze whether Shell deserves this upgrade.

2012 Earnings: In Line With Forecast

ExxonMobil (NYSE: XOM), the largest integrated oil and gas company, reported 3rd quarter earnings 7% lower than a year earlier. For Royal Dutch Shell, the second largest energy company based on revenue, the decline was 6%. But this is in line with the 5.9% earnings drop forecast for 2012 by S&P Capital IQ for the energy sector. Another competitor, Chevron (NYSE: CVX) saw earnings dropped 17% in oil and gas production.

Shell’s Capex: It Will Take Years for Revenue Generation

This year Shell has raised its capital expenditures to more than $32 billion, that’s a 25% increase over its spending for all of 2011. The company’s current operations are mainly focused on long term investment that will take years of drilling and infrastructure building before it generates revenue. Earlier this year, the company said that exploration spending would hit $5 billion in 2012, a 35% increase over 2011’s exploration outlays, which were already 30% more than what was spent in 2010. The firm has targeted a 25% increase in its oil and gas production by 2017-2018.

Shell’s Valuation: Is it Cheap?

Given that Shell will spend lots of money in the next few years, earnings are not expected to grow significantly from here. While it’s true that a spike in oil and gas prices will help on the earnings front, no one is expecting oil prices to jump in the next few years based on pure demand.

Although Shell is trading at a marginal discount in terms of PE (8.1x) compared to its competitors, ExxonMobil (9.4x) and Chevron (8.9x), investors should keep in mind that historically Shell trades at a sub-10 PE, most of the times. So, the scope of PE expansion is also quite limited going forward.

<table> <tbody> <tr> <td> </td> <td><strong><span>Royal Dutch Shell</span></strong></td> <td><strong><span>ExxonMobil</span></strong></td> <td><strong><span>Chevron</span></strong></td> </tr> <tr> <td><strong><span>P/E</span></strong></td> <td>8.1x</td> <td>9.4x</td> <td>8.9x</td> </tr> <tr> <td><strong><span>P/S</span></strong></td> <td>0.47x</td> <td>0.9x</td> <td>1x</td> </tr> <tr> <td><strong><span>P/B</span></strong></td> <td>1.27x</td> <td>2.5x</td> <td>1.78x</td> </tr> <tr> <td><strong><span>Dividend Yield</span></strong></td> <td>4.85%</td> <td>2.55%</td> <td>3.24%</td> </tr> </tbody> </table>

Is Shell a Value Trap?

It’s possible that Shell is bit of a value trap for investors. However, one shouldn’t forget that Shell is a 5% dividend yielder, at the same time. With Treasuries and high-grade corporate bonds yielding only 1.5% - 2.5%, there are worse traps for investors, given Shell is a company with an AA financial credit rating from Standard and Poor’s and Aa1 from Moody’s. Shell's dividend yield is more than the average yield on BB-rated corporate bonds (the highest tier of junk).

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Royal Dutch Shell Dividend Yield data by YCharts

Note: Shell has A and B shares. Dividend income from the A shares entails mandatory 15% withholding from the Dutch Government. The B shares (NYSE: RDS-B) don’t have the withholding.

Recent Developments

  • Shell has recently shown gas drilling interest in Mozambique, which is a strong prospect for its future. After Anadarko's (NYSE: APC) and Italian firm ENI's recent discoveries of hydrocarbon in the region, the area has become attractive for drilling.
  • Turkey is a very promising market with large energy demands. Shell has recently signed an agreement with TAPO, Turkey's national oil and gas company, to explore oil and gas in the country's southern and eastern regions.

The Bottom Line

Earnings are not expected to improve significantly any time soon. But with huge capital investments in both upstream and downstream operations, the company expects the cumulative cash flow from operations, excluding working capital movements, to be approximately 50% higher over the next four years than it was over the past four years.

Royal Dutch Shell certainly deserves an upgrade on its shares, especially with a great dividend yield. However, given the company has taken large investments, I don’t expect the share price to appreciate more than 20% from current level in the medium term.

Anindya7 has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil. Motley Fool newsletter services recommend Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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