In 2016, Shell (LSE: RDSB) is forecast to pay dividends of 123.4p per share and with its shares currently priced at 1,500p each, this equates to a dividend yield of 8.2%. Thats around twice the FTSE 100s yield and indicates that Shell is either being exceptionally generous, or its shares are dirt cheap.
The answer though, is that its a bit of both. On the one hand Shell is expected to pay out almost all of its net profit as a dividend in the current year, with only 4% of earnings expected to be held back by the company. And on the other hand, Shells shares currently trade on a price-to-earnings (P/E) ratio of 11.7, which indicates that theyre exceptionally cheap at the present time.
With dividends being so high relative to profit, theres a real threat that Shells current level of payout will become unaffordable. Although the company recently stated that it will pay at least $1.88 per share in dividends in 2016 and therefore will yield at least 8.2% over the next year, its possible that dividends will be cut in future years.
Thats simply because no company can afford to pay out 96% of profit as a dividend indefinitely, since it means that theres insufficient money being used to fund future growth. And with Shell being a capital-intensive business thatrequires significant spend just to maintain (never mind replace) property, plant and equipment, it seems unlikely that it will be able to keep dividends at their current level beyond this year.
The BG factor
Unless, of course, Shells profitability moves sharply higher. With the BG integration to come, Shell may be able to generate significant synergies and cost savings thatnot only make its financial standing much stronger, but provide it with additional scope to grow its bottom line over the medium-to-long term. By doing so, it could make dividends much more affordable, although the BG deal on its own may not be enough to secure an 8%-plus payout in the long run.
Clearly, theres the scope for Shell to borrow to pay dividends, since it has a very strong balance sheet thatcould accommodate more debt. However, this strategy is unsustainable and would leave Shell in a less sound financial position. Besides, further borrowings are likely to be used to fund additional acquisitions rather than keep shareholders happy.
Looking ahead, the price of oil could rise and alleviate the oil industrys current woes. This would boost Shells profit and allow it to maintain dividends at their current level in 2017 and beyond. Realistically though, the glut of supply is showing little sign of reversing. Therefore, buyers of Shells shares must plan for a dividend cut over the medium term.
Crucially, this wouldnt make it an undesirable income stock, since even a halving of its dividend would keep it at over 4%. But an 8.2% yield may prove to be unaffordable in the coming years.
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Peter Stephens owns shares of Royal Dutch Shell. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
