Warning: This is One of the Riskiest High-Yield Stocks You Can Own

With interest rates still at historic lows and the stock market soaring, income investors are hard pressed to find good places to put new capital to work.

As a result, high-yield stocks such as Royal Dutch Shell (RDS.A) often attract investors with the promise of mouthwatering yields.

But while there are excellent high-yield stocks out there, a very high yield can also be an important red flag that a company’s fundamentals have deteriorated to the point that the payout may no longer be safe.

Our Dividend Safety Scores can help separate the risky high yield stocks from the safer ones.

Let’s take a closer look at this integrated oil company for our Conservative Retirees dividend portfolio to see if Royal Dutch Shell represents a solid value investment or a value trap that should be avoided.

Business Overview
Founded in 1907 in the Netherlands, Royal Dutch Shell is one of the world’s largest publicly traded integrated oil companies with 13.2 billion barrels of reserves, 23 global refineries, 100 distribution terminals, and 770 supply points.

The company operates with three major segments: upstream (oil & gas production), downstream (refining, petrochemicals, and oil & gas marketing), and integrated gas (the company’s liquefied natural gas or LNG operations).

The class A shares are domiciled in the Netherlands, while class B shares (RDS.B) are domiciled in the U.K. Investors should choose Class B shares to avoid having any of their dividends withheld for tax purposes (the U.K. doesn’t withhold dividends on U.S. investments).

In Q4 of 2016, the company’s upstream operations produced an average of 3.9 million barrels per day of oil equivalent, a 28% year-over-year increase.

Meanwhile, the company’s fleet of global refineries has a daily capacity of 2.7 million barrels per day and 17.3 million tons per year of high margin petrochemicals.

As for the LNG operations, which are expected to be the main growth driver going forward, the company’s capacity is now up to 30.88 million tons per year, up 50% year over year.

As you can see, Shell’s upstream oil business continues to suffer from the worst oil crash in over 50 years.

Fortunately, however, its highly diversified business model still allows it to achieve substantial profits thanks to its LNG and refining/petrochemical businesses.

CaptureBusiness Analysis
Like most oil companies Royal Dutch Shell’s sales, earnings, and cash flow are highly cyclical, coming in booms and busts based on energy prices.

Source: Simply Safe Dividends
Source: Simply Safe Dividends
Source: Simply Safe Dividends

Following the bust in oil and gas prices in 2014, business conditions have been challenging, to say the least.

Sources: Royal Dutch Shell Earnings Release, Morningstar

Fortunately for shareholders, management has spent the last several years working hard to diversify its business, stabilize cash flow, and cut costs to the bone.

And thanks to the recent recovery in oil and gas prices, Shell has returned to profitability, despite a continued slide in revenue.

Source: Simply Safe Dividends
Source: Simply Safe Dividends

Most of this has come from a major corporate restructuring, which includes several major changes.

First, the company slashed its capital expenditures, primarily by reducing what it spends on searching for and producing new, higher cost oil reserves. That process is ongoing, with Shell targeting 2017 capital expenditures of $25 billion, down 57% since 2013.

Source: Royal Dutch Shell Investor Presentation

Next, Shell diverted funding to lower cost, higher profitability shale oil production, especially to its prolific Permian Basin assets.

Thanks to the oil crash, shale production costs have plummeted as desperation has resulted in an acceleration of new super-efficient technology adoption, such as more efficient rigs, closer drilling spacing, more laterals per well, more frack stages per lateral, and a prodigious increase in frack sand usage (up to 10,000 tons, a trail load, per well).

The company also divested itself of non-core, higher cost assets, to the tune of over $20 billion (with another $30 billion planned over the next two years). These are funds that were spent on its most profitable projects, as well as to sustain the dividend.

Shell has also invested heavily into its downstream business, especially its petrochemical factories. These take advantage of low cost energy inputs to generate high margin products, for which demand is growing courtesy of lower prices.

In addition, Shell launched a Midstream Master Limited Partnership (MLP), called Shell Midstream Partners (SHLX).

This allows it to recoup the cost of its midstream infrastructure (storage and transportation infrastructure) by dropping down (i.e. selling) these assets to the MLP.

Since Royal Dutch Shell is the sponsor, general partner, and manager of this MLP, it benefits from fast growing regular distributions (tax deferred dividends) because it owns 50% of the limited partner units (what investors buy), a 2% general partner stake, and 100% of the lucrative incentive distribution rights (IDRs).

These IDRs grant a larger cut of marginal distributable cash flow or DCF (MLP equivalent of free cash flow) to Royal Dutch Shell as its MLP’s payout grows over time, up to 50%.

In other words, Shell Midstream Partners is a cheap, tax-efficient way to monetize the massive infrastructure base Shell has built over the past century, while still retaining the majority of the cash flow from these stable, cash-rich assets.

However, by far the most important change Shell has made in recent years has been its pivot to LNG production and sales.

That includes the company’s 2015 $70 billion acquisition of BG Group, the world’s largest publicly-traded producer and marketer of LNG.

Why is Shell betting so heavily on LNG? Because it’s a far more stable long-term business with a potentially very bright growth runway.

Thanks to the BG Group acquisition, Shell is now the world’s second largest producer and marketer of LNG (after Qatar).

This acquisition is the main reason that Shell’s production and profits have recovered so nicely this year (along with a strong boost to energy prices).

Why is LNG such a great growth opportunity for Shell? Because it is a more stable business, thanks to less volatile prices and long-term contracts of up to 20 years.

The basis of the LNG industry is global differences in natural gas prices. The U.S., courtesy of the fracking revolution, has some of the lowest cost gas in the world (see the yellow line below).

As a result, Shell has immense export potential, thus diversifying its business away from more volatile oil and traditional gas prices.

Thanks to growing demand for natural gas in Asia due to concerns over coal-fired power plant pollution, the demand for LNG is expected to grow strongly for many years and exceed industry supply additions.

All told, Shell believes that its current plans will allow it to greatly increase total energy production in the coming years, all while spending no more than $25 billion to $30 billion a year in capital expenditures.

Assuming a long-term oil price of $60 per barrel, the company believes that it will be able to increase its free cash flow to $20 to $30 billion a year, sufficient to pay down debt (which has soared in recent years thanks to the acquisition of BG Group), secure and grow its dividend, and start buying back shares.

Key Risks
While Shell is certainly making all the right moves to secure its dividend, especially by focusing on increasing LNG production, at the end of the day it is still a highly cyclical business that needs oil prices to rise to at least $60 per barrel and preferably $65 per barrel.

Otherwise Shell’s goal of achieving massively increased free cash flow may fall short. Further risks to its goals are a failure to achieve the $4.5 billion in annual cost synergies that were a vital part of the decision to buy BG Group.

Next, the company’s $30 billion in divestiture plans, which are vital to its debt reduction and safe dividend plans, could fall through if oil prices were to crash again.

After all, selling oil assets is best done in a rising oil price environment, lest you face the unenviable task of having to liquidate at fire sale prices to stop the troubling trend of a steadily rising debt load.

That’s a result of Shell’s falling profits and cash flow, the BG acquisition, and the company’s need to borrow in order to sustain the dividend.

Source: Simply Safe Dividends

Speaking of the dividend, that is perhaps the largest risk to shareholders.

Royal Dutch Shell’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

Royal Dutch Shell has a Dividend Safety Score of 9, suggesting that the company’s dividend is one of the riskiest in the market.

That’s not surprising given that Royal Dutch Shell’s payout ratio has reached dangerous levels over the past few years, leading to the current freeze in the payout. The company has been forced to tap into cash reserves and take on debt to continue paying its quarterly dividend.

Shell’s dividend has looked dangerously unsustainable since 2015, with the EPS payout ratio soaring to over 200% and the FCF payout ratio turning negative.

Source: Simply Safe Dividends
Source: Simply Safe Dividends

While the company’s projected long-term free cash flow of $20 billion to $30 billion a year would indeed help to both secure the current payout and allow for its growth, at the same time the company’s deteriorating balance sheet means that the dividend is living on borrowed time.

Source: Simply Safe Dividends

Despite a lot of cash on the balance sheet (enough to pay for the dividend for the next two years), the mountain of debt that Shell took on to acquire BG Group (and continue spending billions a year on growth projects) means that management may be forced to make the painful choice to sacrifice a dividend that is costing the company almost $10 billion a year.

That’s especially true if energy prices were to drop instead of rise in the coming months and years.

While Shell’s current debt load isn’t necessarily dangerous relative to its size and EBITDA, its leverage ratio remains above that of its peers, and oil prices still haven’t recovered to levels that will allow the company to deleverage.

CaptureThe safety of Shell’s dividend hinges on a lot of “ifs.”

The dividend could be safe if management can make good on its ongoing cost cutting efforts, if divestitures are successful, and if oil prices rise over $60 per barrel sooner than later.

Simply put, dividend investors have a very small margin of safety, which explains why this is a stock that should only be held by the most risk tolerant investors.

If you have a shorter investment time horizon, such as retirees living off dividend income, then you should probably avoid owning this stock in your portfolio.

Royal Dutch Shell’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Royal Dutch Shell’s Dividend Growth Score of 3 means dividend lovers should not count on much growth in the coming years.

That’s a function both of the danger of a dividend cut at some point, and Shell’s track record of very slow dividend growth, even before the oil crash decimated the industry.

Source: Simply Safe Dividends

In fact, given that Shell has never grown its dividend faster than inflation, even assuming management is correct that long-term oil prices will result in much higher free cash flow that will save the current dividend from a cut, shareholders should likely only expect 2% to 3% long-term dividend growth.

Valuation
Royal Dutch Shell is one of the seemingly “cheap” stocks left in today’s overheated market. While it’s true that Shell’s price/operating cash flow ratio is higher than its historical median, that’s due to low energy prices reducing cash flow.

With energy prices currently higher than 2016’s levels, these will improve in the coming quarters, assuming gas and oil prices don’t fall.

CaptureFrom a dividend yield perspective Shell is currently trading at a substantial discount to its historic norm, as well as the oil industry’s median yield of 5.1%.

Then again, that’s for good reason. Barring a continued recovery in energy prices, the company’s current dividend is likely unsustainable.

Conclusion
While Shell has a lot going for it, including management’s detailed plan to return to positive free cash flow and pay a sustainable dividend, as well as a potentially attractive valuation, the company remains one of the riskiest high-yield stocks you can own.

Simply put, whether or not Shell can maintain its current dividend largely rests on the long-term price of oil – something management has no control over.

If you value dividend security, you should probably avoid this highly cyclical potential value trap.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends