Shell: Uncertainties Keep Shareholders Guessing (NYSE:SHEL)

Introduction

Despite disappointing shareholders with a meager dividend increase of 4% back in early 2022, the management of Shell (NYSE:SHEL) aimed to impress this time by taking the unusual action of pre-announcing their recent 15% dividend increase back in late 2022. Thankfully as my previous article highlighted, this finally saw proof their plan is benefitting shareholders with their share buybacks translating into higher dividends. As we move into 2023 and their net debt falls to the lowest level in years, it raises questions about their future capital allocation strategy but unfortunately, numerous uncertainties keep shareholders guessing about what comes next as the benefits of deleveraging diminish.

Coverage Summary & Ratings

Since many readers are likely short on time, the table below provides a brief summary and ratings for the primary criteria assessed. If interested, this Google Document provides information regarding my rating system and importantly, links to my library of equivalent analyses that share a comparable approach to enhance cross-investment comparability.

Detailed Analysis

After seeing their cash flow performance begin to slow during the third quarter of 2022, it continued easing during the fourth quarter versus the first and second quarters, which was not surprising given the lower oil and gas prices towards the end of the year. Nevertheless, they still ended the year with operating cash flow of $68.413b, which is a simply massive result that few investors would have ever imagined to be forthcoming several years ago. Obviously, this eclipses anything in their history and thus resulted in free cash flow of $39.064b, which provided immense scope to fund shareholder returns via dividend payments of $7.405b alongside share buybacks to the tune of $18.437b, whilst still leaving billions for deleveraging, as subsequently discussed.

When viewed on a quarterly basis, it shows the fourth quarter of 2022 saw a big cash infusion from a $10.39b working capital draw, which almost doubled their underlying result of $12.014b. Even though the latter was a still solid result, it nevertheless pales in comparison to the equivalent $22.24b and $22.898b they saw during the respective first and second quarters and thus highlights how their financial performance is easing on the back of lower oil and gas prices.

More so, it was positive to finally see their working capital builds begin reversing into draws that instead of hindering their cash generation, actually provide an additional cash infusion. This dynamic was discussed in detail within my earlier article around the middle of 2022, which at the time saw their collective working capital builds total a massive $22b between 2021 and the first half of 2022. Even after this latest big working capital draw, their collective net build across 2021 and now full-year 2022 still amounts to a massive $15.8b and thus means there is plenty more latent cash that could potentially be unlocked during 2023.

Going forwards into the year ahead, management cannot provide any guidance regarding their earnings or cash flow performance for 2023 given the inherent volatility of oil and gas prices. This is merely par for the course and more so, the bigger uncertainty right now relates to their future capital allocation strategy, as subsequently discussed. At least when it comes to spending, they are fighting inflationary pressures and forecasting their capital expenditure will remain within its usual targeted range of between $23b and $27b, as per the commentary from management included below.

Demonstrating discipline, our total cash capital expenditure for 2022 was $25 billion. And our outlook for 2023 is to maintain the $23 billion to $27 billion range, absorbing inflation.”

– Shell Q4 2022 Conference Call.

Despite the fourth quarter of 2022 seeing another $4.474b of share buybacks, their big cash infusion ensured their net debt continued dropping, thereby landing at $43.549b versus its previous level of $46.012b following the third quarter. If also including their leases and debt-related derivatives as practiced by management in their quarterly reports, these numbers increase slightly to $44.838b and $48.343b, respectively. When everything is said and done, 2022 was a good year for their capital structure with their net debt now at the lowest point in many years. That said, if not for their aforementioned $15.8b net working capital build across 2021 and 2022, this would be around one-third lower.

Excitingly, even without any potential boost from a working capital draw during 2023, this already sees their gearing ratio ending 2022 at 18.90%, which unsurprisingly is also at the lowest point in many years. Furthermore, it now sits closer to the bottom end of their targeted range of 15% to 25%, as discussed back in the middle of 2022 within my other earlier article. In light of these improvements and the beginning of a new year, I was hoping for new information regarding what comes next for their future capital allocation strategy but unfortunately, their guidance was still only generalized, as per the commentary from management included below.

We intend to continue to reduce our net debt as part of our robust financial framework.”

– Shell Q4 2022 Conference Call (previously linked).

Since they did not specify any change of direction, it indicates they are working towards reaching the bottom end of their targeted gearing ratio range. Whilst not necessarily negative, this still leaves questions about what comes next because as easily evident so far, their net debt should keep dropping at a brisk pace and thus by extension, their gearing ratio could realistically reach the bottom end of their targeted range reached during 2023 or if not, soon afterwards.

When looking at their “robust” financial framework that was mentioned above, it does not provide any further details about what comes next, as per slide five of their fourth quarter of 2022 results presentation. It was not likely the intent of management but inadvertently, these uncertainties keep shareholder guessing about what happens when their gearing ratio reaches 15%. A prime example of a well-communicated capital allocation strategy is Suncor Energy (SU) who outlined clear targets and what should happen as they are progressively reached, as recently discussed within my other article.

Whilst this may not feel too important, it should be remembered they are directing billions of dollars per annum towards deleveraging that can meaningfully influence their shareholder returns if redirected in the future and thus by extension, influence the appeal of their shares. Furthermore, this is especially important to consider because the benefits of further deleveraging diminish as progress is made.

To no surprise, their net debt dropping makes it easier to keep their leverage very low, despite their financial performance easing during the fourth quarter of 2022. As a result, this sees their net debt-to-EBITDA at 0.50 alongside their accompanying net debt-to-operating cash flow of 0.64, which are both similar to their previous respective results that incidentally were both 0.56 following the third quarter.

Even if their net debt was to remain unchanged and there was another downturn as severe as the Covid-19 ravished year of 2020, their previous results from said year would only see their net debt-to-EBITDA and net debt-to-operating cash flow increasing modestly to 1.52 and 1.28, respectively. Both of these are within the low territory of between 1.01 and 2.00 and thus highlight how there is no requirement to continue deleveraging and thus by extension, the importance of a clear view of their future capital allocation strategy.

Even though their deleveraging thus far was positive and helpful for shareholders via lowering risks, I feel this shows they are nearing a point whereby the benefits diminish dramatically. Whilst lower leverage is positive, similar to many other aspects of life, the law of diminishing returns applies. To this point, there is a big benefit in reducing high leverage down to low leverage but afterwards, there is little benefit in reducing leverage because low leverage is already safe and thus making an already safe investment a little safer does not materially benefit shareholders. On the other hand, the benefits of shareholder returns do not diminish the higher they go, instead, they are linear because twice as much cash returned is obviously twice as good and so forth. When wrapped together, this highlights why their future capital allocation strategy is important to consider and influences the appeal of their shares.

Similar to their leverage, their net debt dropping lower also helped their debt serviceability during the fourth quarter of 2022, as the name already implies. Whilst their interest expense continues to fluctuate quarter-to-quarter alongside their financial performance, their interest coverage obviously remains perfect with results of 24.05 and 24.69 when compared against their respective EBIT and operating cash flow and thus they are in the same ballpark as their previous respective results of 22.71 and 23.13 following the third quarter. Once again as with their leverage, this highlights the minimal requirement to continue deleveraging, as their debt is not even remotely close to burdensome to service.

Thanks to their big cash infusion during the fourth quarter of 2022, their already strong liquidity saw further modest improvements with their respective current and cash ratios increasing to 1.36 and 0.34 versus their previous respective results of 1.25 and 0.28. Whilst it remains to be seen what 2023 holds for operating conditions, since they are a massive company they should never have issues accessing liquidity as required to refinance debt maturities and other general purposes, regardless of where monetary policy heads.

Conclusion

It was positive to see management follow through with their pre-announced 15% dividend increase when releasing their fourth quarter of 2022 results. They are also keeping their capital expenditure under control for 2023, despite the inflationary pressure, which also deserves credit. That said, I feel deleveraging cannot nor should it continue forever given and therefore, it would be good to have a clear view of their future capital allocation strategy once they reach the bottom of their targeted gearing ratio range. This is likely during 2023 and influences the outlook for their shareholder returns and thus by extension, the appeal of their shares. Since their share price enjoyed a decent rally in the last few months, I believe this junction makes a small downgrade from a strong buy rating to a buy rating now appropriate.

Notes: Unless specified otherwise, all figures in this article were taken from Shell’s Quarterly Reports, all calculated figures were performed by the author.