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The energy firm offers a cheap way to play a change in the market backdrop
Thursday 27 Jan 2022 Author: Tom Sieber

There are many compelling reasons to buy Shell (RDSB) right now.

Oil and natural gas prices are strong which will boost its earnings. The stock should benefit from the current shift in market dynamics towards ‘value’ stocks.

An imminent simplification process is set to make the shares more investable and the company’s positioning going into an energy transition looks increasingly robust.

The current share price doesn’t reflect these attributes. Using simple benchmarks, derived from consensus forecasts, Shell trades on a 2022 price to earnings ratio of 7.9 times and yields 3.8%.

HUNTING HIDDEN VALUE

Activist investor Third Point believes there is significant hidden value in the business having recently taken a sizeable stake. It thinks the entire enterprise value of Shell (debt and shares) could be supported by the parts of the business which are exposed to the transition away from polluting fossil fuels, with investors getting the remainder of the group for free.

Third Point’s founder and CEO Dan Loeb has noted that, on most metrics, the company trades at a 35% discount to peers like Chevron and ExxonMobil ‘despite Shell’s higher quality and more sustainable business mix’.

He adds: ‘Compared to peers, Shell generates a much larger percentage of its cash flow and earnings from stable businesses that have a major role to play in the energy transition.’

Shell in a nutshell

Shell is an integrated energy company. This means it has operations in oil and gas exploration, production, marketing, refining, transportation and distribution.

It is involved in everything from drilling and finding new sources of oil and gas to selling you petrol at  the pump.

Currently the group is split into five divisions: Upstream, Integrated Gas, Renewables and Energy Solutions, Downstream and Projects & Technology.

‘STABLE BUSINESSES’ EXPOSED TO TRANSITION

This is a legacy of Shell’s decision over the past decade or so to target natural gas as it looked to adjust to the changing shape of energy consumption and the mounting pressure from the public, markets and governments over climate change.

A £36 billion merger with BG in 2016 helped it reach a market leadership in liquefied natural gas (also known as LNG), which involves cooling gas to a liquid state so it can be shipped and stored.

In Loeb’s eyes these ‘stable businesses’ encompass the LNG, renewables and marketing divisions, which by Third Point’s estimation will generate 40% of Shell’s 2022 earnings. Meanwhile the upstream (exploration, development and production of oil and gas), refining and chemicals units are expected to account for the other 60%.

Third Point is calling for Shell to be broken up to help realise the neglected value in the business with, potentially, a legacy energy firm focused on cash returns and a standalone renewables, LNG and marketing outfit more focused on growth.

GOOD PLACE TO BE

Separately, Shell and the whole ‘big oil’ space is well placed against the current backdrop of mounting inflation and rising interest rates, which has been reflected in its outperformance of the wider market year-to-date.

As Ian Lance, fund manager at Temple Bar Investment
Trust (TMPL)
, observes: ‘The energy sector is exactly the sort of place where you want to be in today’s environment of rising inflation and rising commodity prices, and yet you can access it very cheaply.

‘The big energy companies trade on free cash flow yields of about 15%. This is the cash flow after tax, interest and capex, dividend by market cap, and is the money available to pay back to shareholders. That is very cheap on a historical basis.’

A reduction in Shell’s dividend in 2020 and a series of divestments have helped reduce borrowings to the point that Third Point estimates the company’s net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) will have dipped below one times by the end of 2021.

Shell is also busily buying back shares as part of a $7 billion programme introduced to distribute the proceeds of the sale of its assets in the US oil hotspot – the Permian basin – to ConocoPhillips in 2021.

A SIMPLER STORY

Having renamed the company simply as Shell, the next steps in the present corporate restructuring will be to move its tax domicile to the UK and abandon its A/B share class. These moves, set to complete before the end of this month, should help lend greater clarity to the investment case.

Formed as a combination between Netherlands firm Royal Dutch Petroleum and the UK’s Shell in the early 20th century, the company has been incorporated in the UK with Dutch tax residence and a dual share structure since 2005.

The A shares are subject to 15% Dutch withholding tax on dividends and the B shares are exempt from this levy.

Having a single share class in Amsterdam, London and New York, with its primary listing in the UK, should make it easier for the company to use its own stock for acquisitions.

The next major catalyst comes in the form of fourth quarter and full year results which are scheduled to be released on 3 February.

 

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