Dutch Discount Bin: Royal Dutch Shell

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

The Dutch discount is the phenomenon of the comparatively low valuation of Netherlands traded stocks and has been around for a long time. There are a few reasons for this discount but those had been fading in recent years. However, recently the Dutch discount re-appeared in Dutch financial news because the main index lagged the broad European stock market over the past year.

The explanations for the recent Dutch discount can be found in the underperformance of some individual stocks that weigh heavy on the Amsterdam market index, as well as the deteriorating economy and uncertainty concerning government budget cuts. Some stocks in the slipstream of this discount have shown solid profits and a great international presence and might be unjustifiably affected by bearish market sentiments.

Let's take a closer look at the largest company traded on the Amsterdam exchange: Royal Dutch Shell (NYSE: RDS-A). It’s a major integrated oil company so there are many factors to look at in an analysis, but let’s keep it simple and effective. The geographical presence of a business like Shell isn’t tied to Europe, so it’s very well comparable with US traded oil companies.

The obvious metrics we should examine include Price/Earnings, Price/Tangible Book value and Return On Assets (ROA). ROA is important because this industry requires very high capital expenditures and the ROA signals the efficiency and organizational capabilities of the oil major. In addition, like any other industry, oil companies have one issue that can keep their executives up at night because of its importance and uncertainty. For big oil, it is the proven oil (and gas) reserves, as once stated in an interview by Lee Raymond, the former CEO of ExxonMobil (NYSE: XOM). In fact, it’s so vital that in the multi-billion dollar oil company Shell, a fraud concerning 20% of its proven reserves in 2004 caused a one day 7.6% drop in its stock price upon announcement.

So let’s take a look at the key metrics of Shell and some of its competitors. For the comparison ExxonMobil, Chevron (NYSE: CVX) and Total SA (NYSE: TOT) are the best picks because of the same nature of their business and similar size. BP is omitted due to ongoing legal uncertainties concerning the oil spill in 2010. 

Valuation metrics

<table> <tbody> <tr> <td> </td> <td>P/E (TTM)</td> <td>P/B</td> <td>ROA</td> </tr> <tr> <td>Chevron</td> <td>8.9</td> <td>1.7</td> <td>11</td> </tr> <tr> <td>ExxonMobil</td> <td>9.1</td> <td>2.5</td> <td>14</td> </tr> <tr> <td>Shell</td> <td>8.1</td> <td>1.2</td> <td>7.3</td> </tr> <tr> <td>Total</td> <td>9.6</td> <td>1.4</td> <td>8.1</td> </tr> </tbody> </table>

From this table it seems as if Shell is cheap compared to its French competitor when looking at P/E and P/B. From the figures in the table it also seems as if ExxonMobil trades at a fat book value premium because of its proven ability to achieve superior returns on assets (that have been like this for many years). The forward P/E's for 2014 are in the 7-8 range for Shell and Total and 9-11 for Exxon and Chevron. The forward P/E's imply a bigger discount on Total and Shell, which is a sensible result from their low ROA.

Proven reserves

<table> <tbody> <tr> <td> </td> <td>Replacement*</td> <td>Current total reserves</td> <td>Remaining years**</td> </tr> <tr> <td>Chevron</td> <td>0.1</td> <td>11.3</td> <td>11.9</td> </tr> <tr> <td>ExxonMobil</td> <td>2.2</td> <td>25.2</td> <td>16.3</td> </tr> <tr> <td>Shell</td> <td>1.7</td> <td>13.6</td> <td>11.0</td> </tr> <tr> <td>Total</td> <td>-1.4</td> <td>11.4</td> <td>13.5</td> </tr> </tbody> </table>

All figures are in billion barrels of oil equivalent. Current reserves are official estimates filed with the SEC.
* Net reserve replacement in the past 4 years
** At current production

The table above shows Shell and Exxon as the most successful at replacing proved reserves. Also, Exxon is clearly the winner, both in reserve replacement and total reserves. Total is the loser of the selected four with a negative replacement rate. Being able to add reserves is a key capability for any oil major. There are multiple factors that influence that key capability. What helps Exxon and Shell is the presence in less developed countries on the field of energy. This was a primary reason why Exxon pursued the merger with Mobil. Technology is also a factor as most oil in an oilfield can’t be economically extracted due to pressure depletion. So the better the production technology, the more reserves an oil company can add.

Although it must be said that most additions to Shell and ExxonMobil reserves consist of natural gas, which is considered of less value than crude oil and NGL. A weakness of Shell is the low number of years before it runs out of reserves. If no oil company would find a single barrel of oil from now on, Exxon would outlast Shell by over 5 years. 

On top of the things mentioned before to take into account, I can add that Royal Dutch Shell has never skipped or lowered its dividend since WWII. They know this reputation is of importance to investors and will not squander it lightly. Thus, it is a good sign that Shell has recently increased its quarterly dividend by 5%. This demonstrates management’s confidence that the business is healthy enough to afford this perpetual outflow of cash, which is about 35% of earnings right now. The dividend yield for Shell is at around 5%, depending on the type of share, while it's just 2.8% for Exxon. Total and Chevron's yields are in the middle with 4.5 and 3.4 percent respectively.

Bottom line

From the valuation metrics and proven reserves, a clear picture of the oil industry arises. ExxonMobil demonstrates operational excellence and is somewhat priced accordingly, while Total performs much worse but still has some credibility with investors. Shell has mixed operational performance measures but a great stock price. Chevron is quite the average of the other three. So is Royal Dutch Shell an undervalued bargain? I think so. And if Shell manages stay on track, the current stock price and dividend yield provide a great deal. If, however, you want an impressive track record of operational superiority and are not reluctant to pay a premium for that, ExxonMobil is still the stock for you.


Robbert Manders has a long position in Royal Dutch Shell.  Motley Fool recommends Chevron and Total SA. (ADR). 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!

blog comments powered by Disqus