We work hard for our money. That's why when we choose to invest our excess we want it working just as hard, if not harder, on our behalf. The sad reality is not all companies and the management teams that we entrust with our hard-earned money have our best interests in mind. Because of this we need to dig deeper to find the companies and management teams that are truly effective in earning a strong return on our behalf.
This goes deeper than the dividend, which most investors see as a tangible return. That's why we won't even look at the dividend yield of Royal Dutch Shell plc (NYSE:RDS-A)(NYSE:RDS-B) in our consideration, even though it's a full point higher than ConocoPhillips' (NYSE:COP). Instead, we're going to take a deeper look at return on equity, or ROE, as an indicator of how well a company is earning money for its investors. However, we're going to do so with a twist by using what's known as the DuPont model.
Laying the groundwork
Before we go too far we need to know what ROE is, why it matters, and what its limitations are. Basically, ROE is how well a company does at reinvesting its income to generate earnings growth. It's equal to net income before stock dividends divided by total shareholder equity. At its core, this is the return a company is earning for every dollar investors have entrusted with its management to grow.
So, let's see how our two big oil giants are doing in creating wealth for their investors:
As the above comparison shows, ConocoPhillips is beating the stuffing out of Royal Dutch Shell, as its ROE is 17.33% while Shell's is just 8.98%. However, those numbers only tell part of the story.
To get the full story we'll use a five-step DuPont model, which breaks down the ROE into its five factors.
What we will be looking for are areas that could skew ConocoPhillips' ROE higher or have a negative impact on Royal Dutch Shell's ratio. Here's the comparison of the two oil giants:
In this head-to-head competition of big oil giants, we see ConocoPhillips coming out with much better pre-interest, pre-tax margins as well as having better tax efficiency. Meanwhile, Royal Dutch Shell has a better asset turnover ratio, a higher equity multiplier, and a better interest burden. So, let's take a closer look at what these numbers imply.
What does this tell us?
At first glance the numbers might imply that Shell is doing a better job than it would appear; however, there is one thing we need to consider. While both companies are among the largest oil companies in the world, they are not necessarily equal peers. ConocoPhillips is an independent oil and gas company, while Royal Dutch Shell is an integrated oil and gas company. The key difference between the two is that while both companies are involved in upstream oil and gas production (the wells in the ground) Royal Dutch Shell's operations span further as its operations also include midstream (pipelines and processing plants) and downstream (refineries, gas stations, petrochemical plants). ConocoPhillips shed its midstream and downstream assets a few years ago when it spun off Phillips 66 (NYSE:PSX), and it did so because the margins, especially in refining, were dragging its overall returns.
Because it's no longer integrated, ConocoPhillips' margins are much higher than Royal Dutch Shell. Further, the company is purposefully focusing its investments in oil and gas wells that will push its margins even higher in the future. Its goal is to grow both its production and margins by 3%-5% per year, which will grow its cash flow by 6%-10% per year.
One top of that, sales at refineries tend to be enormous, but margins are low. For example, Phillips 66's sales last year were $171 billion while its EBIT was $5.8 billion. Meanwhile, ConocoPhillips' sales were $56 billion, while its EBIT was $15 billion. This is one reason why Royal Dutch Shell's asset turnover is so much higher, but its margins are not as wide.
Bottom line, this deeper look at the numbers confirms that ConocoPhillips is truly earning its investors a higher return, as Shell's return is at least partially depressed by its integrated business model. We can directly credit this higher return to ConocoPhillips' management team's decision to shed its lower margin assets. The decision was the right one as the company is now earning its investors a better return today thanks to steady oil prices. However, that might not always be the case as refining assets tend to act as a natural hedge against falling oil prices. So, what's working today might not always work, but for now ConocoPhillips comes out on top.
Matt DiLallo owns shares of ConocoPhillips and Phillips 66. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.