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Why Won't the Market Shell Out for Shell?

We don't think the integrated oil company gets credit for its improvement.

Royal Dutch Shell RDS.A/RDS.B posted an impressive first quarter with earnings growth across all operating segments and continued strong cash flow generation. These results stand out from the relatively weak reports of other integrated oil companies and demonstrate the value of Shell’s integrated model while supporting our thesis of continued earnings and free cash flow growth for the next several years. As such, our fair value estimate and narrow economic moat rating are unchanged. We continue to think that Shell’s improvement is underappreciated by the market, leaving the shares trading a wide discount to our fair value estimate.

Adjusted earnings slipped to $5.4 billion from $5.5 billion in the year-ago quarter as improved performance in the operating segments was offset by higher corporate charges due to the absence of tax credits and changes related to IFRS 16 implementation. Integrated gas segment earnings increased to $2.5 billion from $2.4 billion as higher realized prices and increased contributions from liquefied natural gas portfolio optimization offset lower production and sales volumes. Upstream earnings improved to $1.7 billion from $1.6 billion last year as reduced operating expenses and higher volumes outweighed the impact of lower oil prices. Production across the entire portfolio, including upstream and integrated gas, fell 2% to 3.75 million barrels of oil equivalent a day from 3.84 mmboe/d the year before, largely due to divestments and maintenance activity. Volumes are expected to bounce back in the second quarter thanks to new project ramp-ups and lower maintenance activity.

In contrast to many peers, Shell reported an increase in downstream earnings to $1.82 billion from $1.77 billion. Strong results from crude oil and products trading offset weakness in refined products and chemical margins.

Operating cash flow increased to $11.3 billion, excluding working capital and the positive impact of IFRS 16 implementation, from $10.4 billion last year thanks in part to greater contribution from high-cash-margin barrels in the Gulf of Mexico, demonstrating the portfolio upgrading that has occurred in recent years. During the quarter, Shell repurchased $2.3 billion in shares, bringing the total to $6.75 billion since the launch of its program to buy back $25 billion by year-end 2020. It plans to repurchase another $2.75 billion by the end of July.

Return on capital employed improved to 8.4% from 7.1% last year, increasing our confidence that Shell can achieve its 2020 goal of 10%.

Reducing Costs and Avoiding Mistakes With the restoration of its cash dividend, Shell has demonstrated that it has taken the necessary steps to remain competitive in a world of $60/barrel oil. Like the rest of the integrated group, Shell has reduced its cost base, which had become bloated, in part by reducing head count and improving its supply chain. Furthermore, the addition of BG's low-cost production reduces Shell's per-barrel operating cost, which had ranked among the highest in its peer group. Shell has already reduced operating costs by 20% from 2014 levels and believes potential further reductions are possible in later years.

At the same time, Shell plans to avoid the mistakes of the past, when rising commodity prices resulted in ever-increasing capital budgets, by keeping yearly capital spending at $25 billion-$30 billion through 2020, a 40% reduction from the nearly $50 billion it spent in 2014. The sharp decrease should improve capital efficiency but not completely sacrifice growth. While the reduction in spending is in part a function of canceled marginal projects that are no longer economical, it also results from cost deflation, improved performance, and design standardization, which have meaningfully improved potential returns and reduced total project spending.

The impact is most notable in Shell’s future deep-water projects in the Gulf of Mexico and Brazil, where break-even levels have fallen to $45/barrel. The improved economics of deep-water projects--combined with projects nearing completion, high-return conventional reinvestment opportunities, and a large liquefied natural gas portfolio (which does not decline)--mean Shell can deliver modest production growth at a reduced level of spending.

As a result of its collective efforts, including divestiture of capital-intensive, low-return upstream and downstream assets, Shell should boost margins and improve returns by 2020, leaving it in a better competitive position. While we think it might fall just short of its goal of a 10% return on capital, we expect it can realize its target of $25 billion in free cash flow with oil at $65/barrel.

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