Finding 7.5% Dividend Yields

Since 1980 onward, it has been unusually difficult to find stocks that yield over 7% at the time of investment, are of sufficient quality, and can support the high dividend payout with earnings. Almost three decades of expanding P/E ratios (or, in the case of cyclical companies, just valuations) and a shift towards stock buybacks or dividends has put income investors in the hard spot of finding assets that generate high current income.

Possibly my favorite income stock right now is Royal Dutch Shell (RDS.B). It’s quality comes near that of Chevron and Exxon, but offers a much higher starting dividend yield. It doesn’t have the elevated debt levels at Kinder Morgan or BP that could make a dilutive share offering at low prices a realistic possibility if the price of oil stays low for a while. And it doesn’t have the issue of Conoco where it is almost exclusively reliant on upstream production which tends to sustain losses when oil trades in the $40s.

The profile of Royal Dutch Shell is this: It trades at $48.59 and yields 7.63%. This is very unusual for the stock. I can’t find a time since the oil slide of 1986 when Royal Dutch Shell offered such a high amount of current income.

There are a few reasons why the stock has gotten cheap. The company called it quits on projects in the Northwest–Alaska and parts of Canada–as the sustained environment of $40 oil has made it impossible to turn a profit on drilling. This resulted in a huge write-off that forced Royal Dutch Shell to report -$2.32 in third quarter earnings (the first quarterly loss for the company in over a decade.)

This will push Royal Dutch Shell’s payout ratio to the highest level in almost three decades. At current oil prices, Shell makes $4.05 per share in profits. It is committed to making $3.76 in annual dividend payments. That is a 93% dividend payout ratio, which makes it difficult for Shell to self-fund any projects (and it’s also hard to find projects that make sense if you are projecting $40 oil for years.)

But still, Royal Dutch Shell is one of only four non-refinery oil companies in the world that is able to support its pre-crisis dividend rate based on ongoing earnings. It pays out over $11 billion in annual dividends, and has built up a cash hoard of $31.8 billion. Depending on how oil fluctuates in the next year, Royal Dutch Shell stands to make between $13 billion and $15 billion in profits if oil hovers in the upper $40s and low $50s during that time.

If Shell maintains its payout, the amount of income generated for just paying $48 per share is enormous. It really would be the equivalent of owning your own oil well. Even if the dividend remained static, you’d collect your full investment amount back in the form of dividends alone during the next 12 years. That doesn’t even speak to the turbo-charging effect of reinvesting Shell dividends, which could accelerate the arrival of that day you realize your stock holding paid for itself.

The reason why Royal Dutch Shell is trading at a discount compared to Chevron and Exxon is because analysts aren’t thrilled about Shell’s acquisition of the giant BG Group.

Shell agreed to pay $70 billion in a combination of cash and B share stock to buy the upstream producer BG Group. BG produces 280,000 barrels of oil per day, and this would mark Shell’s first attempt at growing production by a heavy clip in at least a decade. Shell itself produces 1.4 million barrels of oil per day, and this acquisition adds 20% to Shell’s production totals.

However, it does not add 20% to Shell’s profit levels, based on current oil prices. BG’s upstream projects don’t turn a guaranteed profit until oil hits $70 per share. That is why Shell isn’t the darling of Wall Street right now–it needs the price of oil to rise by 75% from current levels in order for its signature acquisition of the decade to pay off. Given the recent termination of projects in Canada and Alaska, it is fair to wonder what would to the BG Group’s upstream assets if oil stayed in the $40s until 2018. People in the oil industry give Exxon’s management a hard time about the XTO Energy acquisition back in 2011; well, if oil stayed in the $40s and low $50s for a few years, the Shell acquisition of BG would be about ten times as bad.

The nature of oil has always been cyclical. When prices are high, people are quick to remind you that the energy is nonrenewable, there is no cost-effective alternative to the usage of oil, and growing global demand due to population growth and the further industrialization of South America and Asia raises the prospect of indefinitely high oil prices. Those facts are worthy of consideration when the price of oil is low.

Personally, I think it’s a great buying time for people looking at Shell. There is no guarantee on what the Shell Board of Directors will do with the dividend if oil stays low, but I consider the fundamentals of the company solid given the $31 billion cash hoard and the ability to make $13 billion to $15 billion in profits even when oil is in the $40s and $50s. Even right now, this is still a company that makes $41 million in profits per day–it is one two dozen companies in the world worthy of the title global colossus.

Even if there is a dividend cut, an eventual improvement in oil prices would facilitate a higher dividend growth in the recovery like shareholders of Wells Fargo and General Electric saw in the years coming out of the financial crisis. If the dividend is maintained, and the price of oil climbed by a lot, I would expect minimum dividend growth as Shell would focus its cash on re-opening projects that had to get shelved while oil was low.

It’s a near truth of value investing that stocks go on sale when people don’t want it. A lot of investors agree with this notion in the abstract, but then blanche at the prospect of actually buying a disfavored asset when it has a name and the problems can become specifically documented. Shell is not a stock you worry about. It’s making over a $1 billion in profit every month, and is only trading at $48 per share. You don’t need to know precisely how the dust will settle long-term regarding an eventual oil recovery or the specifics of Shell’s dividend payout during those years. The point is that Shell gives investors a margin of safety today, and a whole lot of income will be generated in the coming decades from this point forward. The messiness in the near term is what has provided the valuation to make that assertion possible.

Originally posted 2015-12-04 13:54:39.

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