There are certain things in finance that seem to happen every generation. The stock market rises and falls. Coca-Cola purchases its bottlers under an increased efficiency theory, and then later spins it off on the theory that it was dragging margins. And Royal Dutch Shell shifts between encouraging its investors to elect for a scrip dividend and then cancelling its special dividend program on the theory that is no longer creates shareholder value.
If you reinvest, it is easy to think that a scrip dividend is indistinguishable from a cash dividend payout. However, this is a tribute to the efficiency of the modern brokerage houses rather than an accurate depiction of investment reality. Scrip dividends have a different effect on shareholders and the finances of an issuing company than a traditional cash dividend, and I discuss these effects below.
How Does A Scrip Dividend Differ From A Cash Dividend?
If you buy 100 shares of Exxon Mobil and elect to your reinvest your dividends, what you are really doing is receiving a free trade from your brokerage house to purchase more shares. Since Exxon pays out a $0.75 quarterly dividend, the mechanics of the transaction are that Exxon transmits $75 in cash to your brokerage house and then your brokerage house purchases $75 worth of Exxon stock from someone who is selling Exxon stock at the time. We call it auto-reinvest and use other terms to make it sound as if it were a self-charging battery type of transaction, but really, dividend reinvestment is the act of buying new shares with a $0 commission at your brokerage house.
Scrip dividends, on the other hand, reflect a new issuance of stock from the company directly to you. The Royal Dutch Shell Board of Directors grants the authority for new shares to get created that dilute the existing shareholder base, and it enables the company to evade payment for the dividend—they are surrendering part of the ownership of everybody else (of course, if they had to pay a cash dividend, their balance sheet would have less cash available and would trade for less).
Right now, Shell has 4,060,000,000 shares outstanding. It pays a $0.94 quarterly dividend, and about 25% of Shell shareholders receive scrip dividends. Essentially, a value of $0.235 per share is being transmitted through the issuance of new shares. With each scrip dividend payment, Shell dilutes itself by $954,000,000. At a current Royal Dutch Shell stock price of $55 per share, this means that 17.3 million new shares of Shell get created through each quarterly scrip dividend payment.
Despite all of this talk of dilution, the effect isn’t all that substantial. Over the course of a year, 69.2 million new shares get created via scrip. That amounts to annual dilution of about 1.7% of the shareholder base. It is not something that Shell shareholders should get excited about, but it is a tolerable maneuver during a down cycle when profits are lower and debt financing carries an interest rate between 3-6% depending on the length until the note’s maturity.
For the most part, I am agnostic regarding the differences. A lot of investors that I respect tend to highly favor cash dividends because they are real, represent a portion of existing cash flows because it is money actually withdrawn from a corporation’s treasury, and don’t dilute the existing ownership base during a time when the RDS stock is being given away for less than it’s worth.
My view is that scrip dividends are capable of being rational for all parties involved—the company’s management team, the existing shareholder base, and the portion of the existing shareholder base that is receiving new shares.
If you own 10,000 shares of Shell, you have the right to receive $9,400 in cash when the Board of Directors declares a $0.94 dividend. The person opting for the scrip dividend is entitled to something of the same value, and shares at the current market price worth $9,400 seems like a fair way to transfer that value. If you think it is so terribly dilutive and such a good deal for those electing to receive scrip, you can always switch from receiving Shell dividends as cash and instead join the program. A good way to test whether you actually believe what you’re saying when you claim something is “rigged” is to self-examine your decision-making to see if you are taking steps to put yourself on the side that benefits from the rigging. My hunch is that most investors don’t think the company is being given away via scrip, otherwise you’d see more than 25% of the shareholder base participate in the program.
Is A Scrip Dividend Common?
Usually, you will see scrip dividend payments among companies that are known as income stocks and experience fluctuations in their earnings (making it difficult to keep the payout flowing during the lean years). It is largely a European phenomenon, with banks and oil companies being the big players.
Oil companies like Total SA, Royal Dutch Shell, and BP add a scrip payment option when the price of the commodity is low and they want to prop up the price of the stock by maintaining the dividend. The theory is that if they don’t issue a scrip dividend, they may have to cut the dividend which would lower the market capitalization of the stock and raise the borrowing costs for their capital expenditures that are necessary to fund new drilling sites or improvements.
European banks didn’t really find religion with scrip dividends until after the financial crisis when they needed to improve their Tier 1 Capital. Giving investors a chance to accept scrip dividends in lieu of cash payments was useful for giving investors an incentive to come back to bank stocks while also letting some capital build up so all of the profits didn’t have to go out the door as dividends.
So why don’t smaller companies issue scrip dividends? Because the investor community needs to have confidence in the quality of the shares being issued. If a start-up oil company tried to pay shareholders in scrip, no one would take them up on the option and there might even be a shareholder revolt because there is not an asset base of sufficient size to withstand the dilution.
When it is clear that the assets underlying a stock represent enormous productive value, you can get away with a lot of corporate acts that wouldn’t be tolerated from smaller businesses trying to gain footing and establish themselves. When you produce 1.5 million barrels of oil per day, you get to enjoy some financing perks that a Texas wildcatter buying 10,000 acres of oil-rich property doesn’t.
Do You Want More Shell Shares?
This is the fundamental question that you should ask yourself when deciding whether you want to receive a Shell dividend as a scrip payment in lieu of a cash dividend or whether the cold hard cash is preferable.
Personally, I think the answer to that question is yes. While it is true that companies tend to broadcast the scrip option when their cash flows have been a bit compromised, there is an upshot for investors that reinvest. Usually, the stock is trading at a discount price due to this distress and it means you are getting a decent chunk of ownership for not accepting a cash payment.
Let’s do the math. Shell brought back the scrip dividend payment option in the first quarter of 2015. Since then, there has been $7.52 in dividend declarations that have been eligible for scrip participation. The average Shell price of value received has been $47.32. Each share has made 0.15 shares of Scrip payments. The figure is 0.21 if you happened to do this throughout the entire two years and benefitted from a rising Shell share count at the time of each scrip payment.
If you did nothing but sit back and collect scrip for the past two years, every 100 shares would have grown into 121 Shell shares. Those 21 pieces of ownership funded by Scrip now have a market value of $55 per share. Those shares can now be sold for a cash value of $1,155.
Furthermore, the scrip dividend that pays out from the Royal Dutch Shell A shares is not taxed in some countries, giving investors in eligible countries a strategy tax advantage over
This topic has been well-covered on my website before, so I’ll be brief in saying it again: If you really want to ratchet up your passive income compared to the amount that you initially have to invest, oil shares are a smart place to look.
Especially when they are distressed and people are worrying about a RDS dividend cut. Even if these European oil giants cut their dividend in half, you’re still collecting over a 3% dividend yield which is superior to what you can get from most American multinationals. And if there is no dividend cut, your share count rises enormously. The upside of cheap oil is that you can get your hands on cheap Shell shares—investors have been able to add 15-21% to their existing share count over the past two years which just wouldn’t be possible a few years back when the share price crossed $80 per share.
Even at today’s valuation for Shell stock, you are still getting a nearly 7% dividend yield. Provided that continues, you only need 3% earnings per share growth to meet the historical average of 10% annually that seems to be everyone’s goal based on historical averages. Given Shell’s super long-term growth rate is 5-6%, you ought to still beat the market by a point or two if you buy and hold.
So why doesn’t everyone do this?
Because you have to absorb a lot of volatility in the price of RDS stock, you have to see earnings wildly fluctuate, and you have to deal with the threat of a dividend cut. That is the price of admission for higher total returns and high cumulative income.
There are two advantages that the “little guy” has over Wall Street asset managers. You can afford to be patient longer, and you can afford to absorb volatility better. Most of them know that if they underperform the S&P 500 for a year or two, they will lose their jobs. And if they underperform by a large amount, they will get fired quicker.
Buying shares of Shell and holding it for the rest of your life is one way you can participate in the competitive advantage of the investor which, frankly, is a nice secondary benefit when pursuing the primary aim of building high-quality passive cash flows.
Does The Shell Share Price Decline From Scrip Dividends?
I don’t think so. But that is question that requires the examination of three variables: (1) what is the share price when issuing a scrip dividend; (2) what would the share price be if the Shell Board of Directors cut the dividend; and (3) what would the share price be if Shell used debt financing instead of scrip dividends to help meet current obligations.
Taking it in reverse order, Shell has chosen to weaken its balance sheet since 2014 in order to keep its dividend coming even when net profits from its oil and natural gas operations couldn’t organically fund the payout.
Just three years ago, Shell had only $38 billion in debt. Now, it has $97 billion in long-term debt on its balance sheet (though only $27 billion of it comes due before 2023). That is what happens when your profits temporarily evaporate while you keep yourself on the hook for transmitting $15 billion in annual value to your shareholders.
This means that Shell’s borrowing costs are now much higher than they were just a few years ago. Because of the hundreds of billions of dollars in revenue that circulate under the Shell name throughout the year, the oil giant usually gets to borrow at 2-3% rates. But that risk profile changes when your debt approaches $100 billion. This means that Shell now has to borrow at a 4-6% rate if it needs money to meet its current obligations. Issuing new shares of stock at a lower valuation seems to harm the price of the stock less than the debt burden cross $100 billion and permitting interest expenses to cross over the threshold of hundreds of millions of dollars per month.
Then, there is an examination of what would happen if Shell cut its dividend. Of course, corporate acts aren’t all or nothing—it’s not like Shell’s Board has to decide between no payout and a $0.94 payout. It could cut the dividend to $0.50 per share which would only eat up about half of 2017 profits instead of nearly all of it. Plus, you’d still be paying a 3.6% dividend yield, which is still high enough that the existing shareholder base might revolt.
It’s entirely possible that a 50% dividend cut would be better for the long-term interests of Shell’s shareholders than issuing the payment as a scrip. But I do think it is clear that a scrip dividend is a superior option to letting the debt burden cross $100 billion.
And, for perspective, we are only talking about cumulative dilution of about 6% of the shareholder base over a three-year time period here. Facebook practically does that with the shares they issue to Mark Zuckerberg alone over the same time frame (I’m joking, but the truth isn’t as far off as it should be). The scrip dividend plan is a good for Shell to maintain its legacy, keep shareholders happy, and only have to put out about 75% of the cash that they would if they didn’t have the program in place. It may not be optimal, but I respect the pragmatism in their approach of trying to meet the expectations of the Shell long-term shareholder base.
Conclusion: Perspective On RDS Stock
In the past ten years, the profits for Royal Dutch Shell have vacillated between a low of $1.9 billion and a high of $33.1 billion. It is very difficult to develop a coherent dividend payment strategy for Shell shares when the cash flows from the asset fluctuate so wildly. In an ideal world, I’d like to see dividends pegged to something like 40% of earnings so people can feel the ebbs and flows of their holdings and become more aware that they own an actual stake in a real business rather than an electronic blip on a screen. But for psychological reasons triggered by loss aversion, I understand why corporations don’t do this.
Shell has addressed this volatility by pragmatically issuing a cash dividend that can be received in the form of scrip that creates new Shell shares. This reduces the stress of paying out tens of billions of dollars during moments when it doesn’t have those kinds of cash flows coming in.
I think shareholders should take advantage of reinvesting through the scrip dividend program into new shares. In two years alone, an investor has been able to add 21 new shares for every 100 shares of Shell that he initially purchased. This is the kind of thing that lets you double your share count and find yourself collecting 15% in annual income on your investment seven years from now even before factoring in the effect of any Shell dividend growth between now and 2024.
Originally posted 2017-01-06 19:46:24.