Ouch!

That’s what I thought yesterday when the news came in that Royal Dutch Shell has cut its quarterly dividend from $0.47 to $0.16. A 66% dividend cut. This hurts, because it is/was a cornerstone of my portfolio and a Tier-1 member for the future. Shell was also the leading company in the Noble 30 ⚔ list with not having had any dividend cut since the second world war. So far the only European company that I was aware of.

What to do now?

First of all, we need to remove Shell from the Noble 30 list. This is something that I will do anytime soon to ensure that people are fully aware of it.

Besides that, I am probably not the only one out there in the community who’s thinking about what to do now with having Shell in their portfolio. Some dividend growth investors are quite strict in their rules by directly selling the stock after a dividend cut. I don’t have such a strict rule, but it is a strong consideration for me.

But before I get down to my decision, let’s first take a step-back and look at my learnings from the past.

Past dividend cuts in my portfolio

A dividend cut happened two times to me since I started dividend growth investing 6 years ago. The honorable companies were General Electric and TupperWare.

General Electric

In the case of General Electric it was in hindsight a clear case of financial engineering. GAAP earnings and non-GAAP earnings showed a clear and growing deviation and as a shareholder I should’ve paid way more attention to that. GAAP rules are created to create transparency to us as investors. That’s why you often see me referring to those numbers instead of the non-GAAP numbers. The GAAP numbers clearly showed that GE was hardly making any profit during those quarters. Now is actually no difference. The infamous Jeff Immelt should have had “financial engineer” as his job title instead of CEO 😉

What did I do after GE’s dividend cut? I have held on to my shares. The shares dropped already that much that I started to consider it a turnaround story. I like their new CEO and he has a very strong reputation based on his past experience. The stock has been dead money though and 2 years later I am still waiting for the turn around to happen. I call this clearly one of my biggest failures.

Tupperware

In the case of Tupperware I was thinking that their international expansion into Asia-Pacific including its pro-female entrepreneurial targeting would give it a new leg of growth for their historic brand. They are actually successful in that, but quarter after quarter they were blaming currency-headwinds for negative impacts on their earnings.

In the end they cut their dividend and in hindsight the victim loop signal of currency headwinds should’ve been very clear to me. This was a good lesson for me to really understand the difference between a nice company and a pretty poor stock.

In the case of Tupperware I directly sold my shares and reinvested them elsewhere. I am happy with that, because I was not “emotionally” attached to the stock anymore and I think it also reduced the “confirmation-bias” on my side. It was also easy, because it was a tier-4 stock in my portfolio so I had rather limited exposure to it.

Conclusion: Financial Engineering (GE) and a poor sequence of earnings with empty promises (TUP).

Back to Royal Dutch Shell

Ben van de Beurden was quite quick in saying that they will keep investing during the 2015 oil crisis without severe cutbacks (capex & workforce). He got quite quickly back on those words after he realized the severity of that downturn, because not long later he did cut quite deeply in their CAPEX and the workforce. I consider this a bit of newcomer-bias and naivety.

Since then he has clearly learnt from that and this time he was very quick in taking drastic measures. I think one big reason is that the 2015 oil crisis is still lingering on today and that Shell was operating on a thin line regarding their dividend in their investment case. $60 per barrel was probably the minimum that they needed to sustain their dividend in the long term.

Therefore I believe that the current decline in oil prices as a result of the Saudi price war rapidly followed by a global pandemic was the final nail in the coffin regarding the dividend.

Conclusion: strong and lasting industry headwinds. There is only so much a company can handle.

So really, what to do now?

You might say now based on these learnings: just sell!

The reason why I don’t directly sell is due to the terms sunk cost and opportunity cost. Let me clarify the meaning of both terms first:

Sunk cost

A sunk cost refers to money that has already been spent and which cannot be recovered. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision
Source: https://www.investopedia.com/terms/s/sunkcost.asp

Opportunity cost

Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another
Source: https://www.investopedia.com/terms/o/opportunitycost.asp

If you have studied Warren Buffett, then you will have actually heard him mentioning opportunity costs quite a lot when he was talking about his investment decisions.

Knowing this, I first want to do some further analysis first (will keep it short, I promise ;-)).

A good source to start in these situations are are CEO interviews and luckily Bloomberg shared an excellent interview with Ben van de Beurden on Youtube.

Have you had a chance to watch it?

I see a strong leader here who’s on top of it. He talks no bull-shit and is very clear in his messaging: the dividend was not sustainable anymore during these severe times with no certainty on what will be next.

When he mentioned that they did scenario-analyses with different likely outcomes was the main take-away for me. It seems to me that this dividend cut supports those scenarios that they analysed in their board room.

Ben also seems to believe himself that a 66% cut is prudent, although I can understand that he can’t give any certainties. That would have been stupid from both a legal point of view and a lack of empathy towards income investors that just lost a large chunk of their income.

Financials

While the free cash flow looks actually pretty strong in the Q1 headlines, don’t get fooled by what you might read in social media. The reason why free cash-flow looks very strong is due to the high operating cash-flow. But please pay attention to the below item from their Q1 earnings report highlighted in yellow:

So what does this really mean?

Effectively Shell decided to delay payments to for instance their suppliers which makes it boosts its working capital. This is typically a one-off trick often done by companies whom are the main leaders in a value chain. I am not sure though to what kind of suppliers this really applies, because I couldn’t get that out of the report.

Having said that, I do love Shell’s transparency, because in section H they also published an adjusted cash flow statement excluding the working capital impact:

Looking at the above then we can conclude that Q1 was definitely already a deteriorating quarter. So buckle up and let’s brace for impact in Q2! I think that it will be bad.

Forward prospects

Knowing that Shell will has freed up ~8 billion USD in cash annually means that they will be much better positioned to run through this horrible pandemic and it’s related recession.

Freeing up the dividend means that they will have an approximate 2.4 BLN USD obligation per quarter in regards to their free cash-flow. 1.1 BLN for interest payments and 1.3 BLN for dividends. Q1 2019 free cash flow was 4 BLN and Q1 2020 without the working capital boost would have been 4.6 BLN. A 32.5% free cash-flow payout under those circumstances is much more prudent

I also strongly believe in their intention to be the leading company in the energy transition. We still need oil, but we also know that we need to get rid of it more and more. Therefore I like Shell’s strategy and ambition, highlighted again in their Q1 webcast presentation slides:

Knowing their vision and their improved cash flow situation, I believe that Shell has taken a bold decision that they will benefit from in the years to come.

So what will I finally do?

I believe in the Energy sector and I do want to have exposure to it in my portfolio. What I also believe is that I will need to strengthen my portfolio into more “energy-friendly” business models. Therefore I decided not long ago already to not further increase my exposure to oil companies and use the rest of the “space” left in my allocation strategy to look into other companies.

From an opportunity cost point of view I am considering the following facts:

• Shell is a company with a vision for the energy transition that resonates very well with me
• It pays approximately 4% dividend under their new policy
• With their new cash flow model it sets them up for lowering their debt and for opportunities to do quite some mergers & acquisitions (shout out to Twitter response from @letuscompound)
• Shell has to change their culture into more like a holding to nurture new growth initiatives either incubated internally or via M&A

I think a culture change is very hard. Therefore my final decision is to reduce Shell into a 3-Tier stock in my portfolio allocation strategy and closely observe the execution of their strategy and how it reflects in their earnings. This means to me a little bit of selling (~20%) and I will reallocate that money towards another Tier-1 position in my portfolio. If the share price grows, then I might do some further trimming to keep the stock within the Tier-3 portfolio allocation range.

At the same time I will keep monitoring the company over the upcoming quarters to see if my thesis plays out. If not, I might decided to remove the company entirely from my portfolio. This will probably be a decision 2 years from now.

What’s up next?

Reassess my position in ExxonMobil and Chevron. Is their dividend safe? 🤔

I hope that my thoughts in this flash update regarding Shell’s dividend cut helps in your thinking and decision making process.

I just count myself lucky that I am not in the accumulation phase, because if this would be during my retirement, then this would’ve been probably a 5% cut in dividend income. It would be bearable, but another dividend cut would’ve been tough.

I guess this triggers considering a stronger margin-of-safety for my FIRE target as well 😉

Please invest carefully, wear face masks and speak to you soon again!

Yours Truly

European Dividend Growth Investor