Where Next for Royal Dutch Shell's Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Royal Dutch Shell (RDSB) (RDS.B).

Does Shell have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at Shell's cash flow from the last five years:

Source: Royal Dutch Shell company reports.*A value of >1 means the dividend was covered by free cash flow.

A rollercoaster ride
Shell's business requires billions of dollars of capital investment each year, often with long lead times before projects start to deliver income. At the same time, its operating income is affected heavily by the prices of oil and gas, which can be volatile. After peaking in 2008, oil prices crashed dramatically, falling by more than 60% in just a few months. Oil prices have since recovered steadily, and these changes are reflected in Shell's free cash flow figures.

Shell's free cash flow failed to cover its dividend payments in 2009 and 2010, but has recovered strongly since and was a healthy two-times dividend payments in 2011. It's interesting to note that if you average Shell's free cash flow to dividend ratio over five years, it comes out at 1.1, indicating that on average, Shell's generous dividends are covered by genuine free cash flow. This is good news for shareholders like me, who appreciate its high dividend yield, which currently stands at 4.9% -- and is forecast to rise to 5.1% next year.

Is Shell's dividend safe?
Shell's production and earnings are split, approximately equally, between oil and gas, most of which is sold as liquefied natural gas (LNG). Since 2010, oil prices have remained at historically high levels, and this looks likely to continue -- not least because many new discoveries have higher extraction costs than the historical norm. These costs, coupled with firm global demand for oil, suggest that a prolonged spell of low oil prices looks unlikely -- although it's never possible to predict commodity prices with certainty, due to the wide range of factors that can cause disruption to the markets.

Similarly, although the U.S. shale gas boom has depressed gas prices in North America, at present there is limited scope to export this gas, meaning that gas prices in Europe and Asia have remained much higher. Shell is one of the biggest players in the global LNG industry and earned $9 billion from its gas business last year -- a figure the company expects to rise steadily over the next decade, thanks to strong demand growth throughout the world.

Looking at the broader picture and taking into account Shell's dominant position as one of the world's five biggest oil and gas companies, I think that Shell's dividend looks very safe, and expect it to continue to grow steadily over the next couple of years.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Mr. Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had £21 billion of private investors' funds under management -- more than any other City fund manager.

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