If you want to see a stock that's on top of the world, look no further than Royal Dutch Shell (NYSE: RDS-A)(NYSE: RDS-B). The integrated oil major is paying a dividend of nearly 6%, and its share price is up 11% so far this year, in marked contrast to some of its peers -- I'm looking at you, ExxonMobil (XOM +3.47%).
But sometimes stocks that start out on top of the world don't stay up there long. Depending on Shell's Q3 results, which it reports on Thursday, Nov. 2, it could be one of them. Here's what to look out for in Shell's quarterly earnings report.
Oil and gas industry bigwig Royal Dutch Shell is poised for another quarter of outperformance. Image source: Getty Images.
Cash is king
Shell is coming off a strong second quarter, in which the company generated plenty of cash. During the quarter, it spit out $11.3 billion in operating cash flow. That brought Shell's 12-month operating cash flow (Q3 2016 through Q2 2017) to $38 billion, which was more than enough to cover the company's cash dividend in each of those quarters.
Now, the company is admittedly giving shareholders the option of receiving a scrip dividend, in which the dividend is paid out in additional shares instead of cash, but that's only an option -- and, for shareholders who would reinvest the dividends anyway, it's a perfectly reasonable one. It does help Shell boast that it can cover its dividend, though, when the entire dividend doesn't need cash coverage.
Shell was able to generate that kind of cash even at an average oil price of less than $50 a barrel, which is undeniably impressive. In Q3, though, Brent crude prices were above $50, so expect Shell to continue to be able to generate gobs and gobs of cash from operations and be able to cover its dividend again. If it can't, for some reason, then we have a problem.
The debt load
Shell went into heavy debt to acquire BG Group for just north of $50 billion in February 2016. That ballooned its net total long-term debt load from under $30 billion in 2015 to about $75 billion. Compare that with conservative ExxonMobil, whose net total long-term debt has never exceeded $40 billion.
However, Shell has made some progress in paying down its long-term debt, using some of the cash it has earned from recent asset sales. The rest of that cash is still on the books, which offsets the long-term debt, pushing down the net total. Shell repaid about $3.3 billion of its debt in Q2, and investors should look to see how much progress it has made in Q3.
Many happy returns
Shell CEO Ben van Beurden and his management team should certainly take credit for the work they've done in transforming Shell from a notoriously low-margin behemoth to a more profitable enterprise. However, one area in which all of the oil majors have fallen short recently is returns on capital, which can generally be seen as a measure of management's effectiveness:
RDS.B Return on Capital Employed (TTM) data by YCharts
However, you'll notice that Shell's returns began noticeably ticking upward after the BG Group acquisition. In fact, according to CFO Jessica Uhl, some of Shell's business units -- downstream and chemicals, in particular -- were earning returns on average capital employed of 15% to 20% during the second quarter.
Management's target for the company for return on average capital employed is 10%, and the company seems to be heading slowly in that direction. We'll see if Q3 represents a leap forward or a step back in that regard.
Investor takeaway
Shell has been performing admirably for several consecutive quarters in a low-oil-price environment, and there's no reason to think the company is going to stop now. However, if warning signs were to appear, they would probably appear in the form of lower-than-expected earnings or cash flows, production hiccups, or sagging returns. That's why investors should keep an eye on these metrics when Shell reports its Q3 earnings next week.
But I anticipate that Shell is likely to continue its trend of outperformance.
