Shares per ADS – 2:1 / (RDSB - NYSE) $65.75
Note: All new or revised material since last report has been highlighted.
Reason for Report: Non Earnings Update
Overview
Royal Dutch Shell plc is a large integrated oil and gas exploration, production, and refining and marketing company, with operations and assets worldwide. There are few areas of the world in which it does not have a presence. RDS’s head office is located in The Hague, Netherlands, with employees totaling 71,400. Additional information about the company can be found at: www.shell.com. The company operates on a calendar year basis.
On July 20, 2005, Royal Dutch and Shell Transport and Trading completed their merger and the name of the new company is Royal Dutch Shell plc. The shareholders of Royal Dutch/Shell approved the plan to amalgamate on June 28, 2005 (Royal Dutch holders receiving 60% of the share capital in ‘A’ shares of the new company with Shell holders receiving 40% in ‘B’ shares). The stock began trading effective on July 20, 2005 under the tickers RDSA for the old RD and RDSB for the old SC. RDS is negotiating with the Dutch government for the changes in corporate tax law that would ultimately allow the merger of the two stocks into one under the ticker RDS.
In summary form the key positive and negative arguments are addressed below:
Key Positive Arguments / Key Negative ArgumentsFundamentals
· RD is one of the largest LNG players in the world.
· Solid balance sheet with stable dividend yield.
· The share repurchase program expected to accelerate in 2H05.
· Merger of Royal Dutch and Shell into a single company could help valuation.
· Restructuring U.S. portfolio and disposing of non core assets.
Growth Opportunities
· High refining margins and high crude oil prices enabling increased cash flow.
· Capital expenditure program could help restore long-term growth.
· Company is guiding reserve replacement of 100% in 2006-2008. / Fundamentals
· Near-term production growth low.
· Weak reserve replacement in 2004 and 2005.
· Short reserves life (~9 years).
Growth impediments
· E&P capex budget may not be sufficient to realize any upstream volume growth.
Competitive Disadvantage
· RD has the lowest margins relative to its major competitors
Macro Issues
· Volatile oil and gas prices.
· Geopolitical risks associated with worldwide operations.
Royal Dutch Shell appears to be on its way to recovery with reserve issues settled, the unification completed, and the share repurchase program started, but there are issues at the operational front which needs to be resolved.
The production outlook is not yet clearly visible with projects being still at an early stage. A consensus of analysts note that solid fundamental progress appears to be underway, but this is not going to affect the near-term outlook. The analysts generally are concerned about low production growth outlook and a low return on capital in the current high oil price environment. However, there is also an opinion that the Company is on track to turn around with increasing cash flow, high capital expenditure, and new upstream projects in hand. The downstream business adds another positive in the strong refining margins environment as does the planned $3-$5 billion share buyback in 2005.
Revenue
Royal Dutch Shell generates revenue through four primary business segments: (1) Exploration & Production (E&P), (2) Gas & Power, (3) Oil Products/Refining and Marketing, and (4) Chemicals, each of which are further segmented into (a) United States and (b) Global – excluding U.S. A fifth operating segment represents Other Industries.
Segment Operating Income
No analyst consistently projected revenue for individual business segments. Very few analysts gave detailed models for operating income either. The table below highlights the group’s segmental operating income for the past and the future estimates.
Segment Earnings After Tax / Year-Over-Year Growth$ Millions / 2004A / 2005E / 2006E / 2007E / 04-05E / 05E-06E / 06E-07E
US / $3,051 / $4,454 / $5,100 / $4,400 / 46.0% / 14.5% / -13.7%
International / $7,096 / $8,572 / $9,960 / $8,600 / 20.8% / 16.2% / -13.7%
Total E&P / $10,163 / $12,497 / $13,600 / $11,898 / 23.0% / 8.8% / -12.5%
US / $140 / ($78) / $150 / $200 / -155% / 294% / 33.3%
International / $1,367 / $1,360 / $1,140 / $1,300 / -0.5% / -16.2% / 14.0%
Gas & Power / $1,470 / $1,278 / $1,368 / $1,664 / -13.1% / 7.1% / 21.6%
US / $1,515 / $1,842 / $1,586 / $600 / 21.6% / -13.9% / -62.2%
International / $4,611 / $5,099 / $3,551 / $2,100 / 10.6% / -30.4% / -40.9%
Total R&M / $6,106 / $6,878 / $5,858 / $4,343 / 12.6% / -14.8% / -25.9%
Chemicals / $1,538 / $1,708 / $1,395 / $1,058 / 11.1% / -18.4% / -24.2%
For specific details on operating income, please refer the ZACKS Research Digest Spreadsheet.
Exploration & Production (53% of Total Earnings in 2Q05): Total adjusted E&P earnings were $2,894 million excluding the net charges of $149 million (from mark-to-market valuations, divestment gains, and net tax charges). The earnings were the second highest ever, up 20% from a year ago, but below 1Q05 record of almost $3 billion. Compared with a year ago, earnings benefited from higher realized oil and gas prices, which more than offset lower production. However, sequentially the impact of lower production volumes, because of seasonal demand (especially natural gas in Western Europe), exceeded the benefits from higher oil and gas prices. During 2Q05, realized prices averaged $40.30/boe, up 39% and 12%, respectively; $48.01/b for oil, up 42% and 10%, and $4.60/mcf for gas, up 34% and 6%.
Production Metrics:
Oil and gas production averaged 3.5 million barrels of oil equivalent per day (mmboe/d) down 1.5% from a year ago. The decline was mainly due to normal field decline, asset sales, facility maintenance, and lower entitlement under production sharing contracts due to higher oil and gas prices. Excluding the last three factors, production was higher 2% y/y.
Outlook: New production volumes from the UK, Malaysia and the U.S. helped to offset field declines. Guidance for 2005 and 2006 are unchanged at 3.5 - 3.8 mmboe/d. The company expects production to average 3.8 - 4.0 mmboe/d in 2009. The analysts expect full year 2005 volumes to average 3.5 mmboe/d, at the low end of the 3.5 - 3.8 mmboe/d range.
The company’s "Big Cat" high potential exploration drilling program is off to a good start in 2005. Three discoveries have been made in Nigeria, one in Norway, and one in Australia out of eight wells drilled. New projects are also in progress – LNG, Iran LNG, and Qatar LNG among others. Over the 2005-09 periods, the sanctioning of LNG reserves should provide Royal Dutch Shell with a long-lived resource addition. The company expects to nearly double its LNG capacity by 2009.
Management increased its 2005 exploration budget by $300 million, from $1.5 billion to $1.8 billion, following the huge cost over-run at the Sakhalin project. The company has also indicated that the spending program for 2006 is expected to rise. While cost inflation is an industry wide issue, following the cost increases at Sakhalin, cost control at RDS will likely face increased scrutiny going forward (B. of America). As upstream margin pressure continues, the exceptional upstream macro environment is not benefiting the bottom line.
The company's 2004 reserve replacement is estimated at just 25%-40%. Management said rebooking of re-categorized reserves would likely be delayed, as such, 2005 reserve replacement is also expected to be below 100%. The reserve downgrade has left the company with a considerably weaker reserve position.
Gas & Power (4.3% of Total Earnings in 2Q05): The operating earnings were $237 million, which excluded a $226 million charge primarily related to the divestment of certain assets. The income was down 26% and 45%, respectively from a year ago and the prior period. Benefits from the impact of higher LNG prices and volumes were more than offset by the impact from the sale of midstream assets, lower trading profits, and LNG shipping results. The 2% increase in LNG sales volumes as a result of North West Shelf project expansion, which came on stream in 4Q04, was partially offset by scheduled maintenance of other facilities elsewhere.
Oil Products (37% of Total Earnings in 2Q05): Earnings were $2,028 million up 30% from $1,546 million a year ago and 40% sequentially. Stronger refining margins were partially offset by lower marketing margins and lower volumes. Oil product sales were down slightly from a year ago and essentially unchanged sequentially, averaging 7,458 Mbls/d.
Volumes: Throughput volumes averaged 3,981 mbd, down 5% from a year ago and 2% sequentially, mainly due to asset sales. Adjusted for asset sales, average throughput volume increased by 1% from a year ago.
Chemicals (6% of Total Earnings in 2Q05): Earnings were $339 million (excluding legal and environmental charges of $80 million), down 9% from a year ago and 49%, sequentially, despite a 26% increase in realized prices, mainly due to sharply higher feedstock and energy costs and decline in sales volume. Chemical sales volumes fell 9% year/year due primarily to a planned reduction in lower margin volumes.
Margins
RD has the lowest margins relative to its major competitors. While the company has been trying for several years to restructure its U.S. portfolio, some analysts still believe that more has to be done while some analysts think that it is turning a corner. The disposal program has been effectively executed with nearly $15 billion likely to have been completed by end 2005 and more to come (LPG business) in 2006.
In downstream, management continued with the implementation of its strategy for reshaping the portfolio during the quarter. Much is expected of management’s attempt to turn around its U.S. downstream operations, though the results are expected to take longer to show up than initially indicated.
There is a continued increase in the level of costs, which contributed to the lower than expected increase in net income per barrel. However, this is industry wide and the analyst (MorganStanley) sees no evidence that the company is suffering disproportionately.
Earnings Per Share
EPS per ADR / 2003A / 2004A / Q105A / Q205A / Q305E / Q405E / 2005E / 2006EAverage / $3.59 / $5.22 / $1.58 / $1.53 / $1.68 ↑ / $1.53 ↑ / $6.48 ↑ / $6.33 ↑
Y-o-Y Growth / 45.4% / 37.4% / 24.4% / 24.3% / 2.7% / 25.1% / -1.4%
Qrtly. Growth / 6.0% / -3.2% / 9.6% / -8.8%
Low / $3.59 / $5.22 / $1.58 / $1.53 / $1.75 / $1.70 / $6.78 / $7.44
High / $3.59 / $5.22 / $1.58 / $1.53 / $1.53 / $1.36 / $6.15 / $5.10
# of Estimates / 4 / 4 / 9 / 9
Royal Dutch Shell had an adjusted net income of $5,170 million or $1.53/share ($0.05 below consensus), 23% above the year-ago period, but down 3% sequentially. Compared with a year ago, earnings benefited from higher oil and gas prices and better downstream results on strong refining margins, which more than offset the negative impact from lower production and income from chemical, gas and power segments, and slightly higher effective income tax rate.
Hurricane Katrina has increased commodity prices. Based on higher commodity prices, most of the analysts increased their 2005 and 2006 EPS estimates.
For specific details on EPS forecasts please refer the ZACKS Research Digest Spreadsheet.
Target Price/Valuation
The average target price is $71.15 per ADR. The target price ranges from $63 (Friedman, Billings) to $78 (MorganStanley). The valuation methods include EV/DACF and P/E multiples on 2006 estimates. The lowest price target of $63 is given by 15x mid-cycle earnings estimate. The analysts are equally divided in their opinions. Of the nine analyst recommendations, three are positive, three are neutral, and three are negative. Out of six analysts providing price targets, four increased their price targets based on high commodity prices.
Rating Distribution
Positive / 33%Neutral / 33%
Negative / 33%
Average Target Price / $71.15
Digest High / $78
Digest Low / $63
Number of Analysts / 9
Risks to the price target include volatile oil and gas prices, drilling and production results, successful restructuring, regulatory risks and geopolitical risks.
Upcoming Events
Event / Date3Q05 Earnings Results / Expected by end of October, 2005
Long-Term Growth
Royal Dutch Shell’s long term growth is contingent on its ability to reduce operating costs and achieve meaningful reserve replacements. With one of the shortest reserves life (of 9.4 years) amongst the peer group, RDS has significantly less visibility. Near-term production is declining and future production growth is uncertain. The unification is complete but the analysts think the focus is on fundamentals which still remain weak. While material acquisitions to replenish reserves would improve the growth outlook, it appears unlikely in the current macro environment. However, new projects for building LNG capacity are in progress and the company has indicated a material improvement in the success rate of exploration, giving some visibility on long term prospects. Capital expenditure is being increased to rebuild the upstream business and return the company to longer-term growth. Though 80% of capital spending over the medium-term is scheduled for E&P, it still faces upward risks due to continued high costs. Even if the company is able to maintain flat production, this is still well below the 3%–4% average growth rate expected from the other major integrated oil companies in 2005.
With regard to its refining and marketing operations, the outlook is fairly positive with refining margins on the rise. Strong commodity prices and refining margins will continue to increase cash flow and strengthen its balance sheet.