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Shell needs to do more to close the valuation gap with US peers


At its first capital markets day in two years, Shell’s [LON:SHEL] new CEO Wael Sawan and his team sent the right message – that returns would take priority over growth — but it was likely found wanting by investors.

“Although, we believe the key actions accompanying the message — reduced spending and increased distributions — are a positive and crucial step, they are unlikely to be enough to close the valuation gap with US peers,” said Allen Good, Director of Equity Research at Morningstar.

Furthermore, the long-term outlook remains uncertain with most guidance items only covering through 2025. “We believe the new team has Shell heading in the right direction and places the company as one of the more compelling options among European integrated oils,” Good added. “Incorporating the updated items into our model, leaves our fair value estimate and moat rating unchanged.”

Shell shares are trading at a modest discount

Shell shares are only trading at a modest discount, but they are supported by a relatively high shareholder yield. The tone set by Sawan and his team were likely the most important element of the update.

“We have previously argued the Shell and other European integrated oils’ discount to US peers Exxon [NYSE:XOM] and Chevron [NYSE:CVX] was a result of several factors, but differences in capital allocation and energy transition strategies were the most relevant and addressable,” Good said. “By stressing that all projects, most notably low carbon power, must compete for capital and earn adequate returns, Sawan and his team sought to address this issue.”

Shell is not completely abandoning power, but it certainly is trimming its sails. Capital spending will fall to $22 billion-$25 billion in 2024 and 2025 from $23 billion-$27 billion in 2023, with the bulk of reductions coming from marketing and renewables and energy solutions. The planned $10 billion-$15 billion in low-carbon spending from 2023 to 2025 will focus on industry and transport.

Shell is getting out of retail power

Furthermore, Shell is planning to divest its European retail power assets, which should reduce capital spending by a further $1 billion-$2 billion. The divestment will also contribute to the announced $2 billion-$3 billion structural cost-reductions Shell plans to achieve by end-2025 while delivering over 10% annual growth in free cash flow per share.

The spending reductions will bring the portion of spending marked for upstream and integrated gas more in line with U.S. peers. However, Shell will lack their absolute volume growth. While it abandoned its prior plans to reduce oil production by 1%-2% annually through 2030 given declines already achieved through divestment, it will only hold current oil production stable at about 1.4 million barrels a day, not increase it.

Also, while the addition of 11 million tons per annum of liquid natural gas production by 2030 will lift LNG volumes over 25% by 2030, total hydrocarbon production by then will still be at about 2022 levels given divestments. Investors were likely looking for more of an about-face from Shell that would result in higher overall volumes, especially oil.

To further enforce capital discipline and satisfy investors, Shell increased its pay-out ratio to 30%-40% of operating cash flow, from 30% previously, while increasing its dividend 15% and committing to a minimum of $5 billion in repurchases during the second half of 2023. The higher pay-out rate matches peer TotalEnergies [Euronext:TTE], which was leading the group with a 35%-40% pay-out commitment.

Shell expects to maintain the dividend down to $40/bbl while still repurchasing shares at $50/bbl. Meanwhile, its prior guidance of 4% annual dividend growth remains intact.

Shell management need to prove themselves

Sawan called the updated strategy and guidance through 2025 a “sprint” for management and Shell’s organisation to prove themselves during the next two years while getting a better sense of the macroeconomic environment. As such, financial guidance beyond 2025 was lacking aside from 6% annual growth in free cash flow to about $30 billion by 2030, assuming $65/bbl. This may leave some investors wary that Shell could revert to its spendthrift ways in pursuit of its unchanged long-term emission-reduction targets (for example, net-zero emissions by 2050 plan).

“Despite a history of reversing course, we do not think that is the case here,” said Good at Morningstar. “Shell is unlikely to ever match the hydrocarbon-focused strategy of ExxonMobil and Chevron, but there is plenty of room to improve returns and address low-return investments while offering an appealing energy transition alternative among integrated oils.”

By reigning in its low-carbon power ambitions, stemming the declines in its oil production, and emphasising the value of its LNG and trading organization, Shell could be that option. As such, Morningstar view the update positively and believe it will begin to change investors’ perceptions, making Shell the preferred option among European integrated oils, even if it is not enough to earn a US type of multiple.

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This article does not constitute investment advice. Do your own research or consult a professional advisor.

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