Dividend Report Card: Royal Dutch Shell

Does the oil giant's dividend pass the test?

In the dividend report card series, we analyse financial metrics to begin answering the following questions about a company's dividend:

1. Over time, has this company steadily increased its payouts?

2. How sustainable is the dividend?

3. Does the company have room to further increase the dividend?

For a full explanation of each category, click here for a tutorial.

Today's pupil is Royal Dutch Shell (LSE: RDSB), which has a prospective 6.8% yield, according to Company REFS.

Dividend history

^{Source: Capital IQ, as of August 27, 2010.}

In sterling terms, Shell has raised its dividend at a good clip over the past five years despite changing its declared dividend currency from euros to dollars in 2007. Unfortunately, we can't say the same thing about earnings growth over the same period. Still, the recent dividend growth has been impressive, so it scores a 5 of 5 in this category.

Sustainability

^{Source: Capital IQ, as of August 27. 2010.}

This is where Shell's dividend story becomes a bit shaky. Its balance sheet, with £8 billion in cash is certainly strong enough to pay its creditors and maintain the annual dividend commitment of £6.9 billion. And on an earnings basis, there's enough cover for the dividend, but it's the lack of free cash flow generation that has me concerned.

At present, Shell pays out more in dividends than it's generating in free cash flow and has had to raise debt to make up the difference. On the other hand, Shell has been ramping up its capital investments as a percentage of sales, from 5.2% in 2005 to 7.7% over the past twelve months. As long as those investments pan out, the lack of cash flow cover could be a temporary event.

Even so, a major shock to Shell's business -- a multi-year drop in oil prices or a natural disaster of some kind -- could call the current dividend into question.

Growth

A repeat of Shell's 11.7% dividend growth rate of the past five years is unlikely and analyst consensus, as measured by Company REFS, expects just 2.9% and 2.3% dividend growth over the next two years, respectively. Given its lack of free cash flow cover and low sustainable growth rate, it's easy to see why this could well be the case.

On the other hand, a higher growth rate could resume if oil prices return to 2008 levels. Also, if the US dollar strengthens versus sterling, British investors could realize higher dividend growth

Competitors

An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against its direct competitors. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

^{* All trailing yields}

With BP's (LSE: BP) dividend currently suspended, Shell is an intriguing name for income-thirsty investors to consider. However, the average major integrated oil and gas company dividend yield is just 3.7% and cash is a precious thing to oil companies that have significant and ongoing capital expenditure costs. As a result, there could be some internal or external pressure to keep Shell's dividend from growing at a meaningful rate.

Pencils down!

With all the numbers in, here's how Royal Dutch Shell's dividend scored:

It's best to be careful here. Shell's dividend yield is impressive, but it's not without risk, so if you're going to hold it in a high yield portfolio, be sure to complement it with a diversified group of shares.

Read more dividend report cards:

• Tesco
• BHP Billiton
• Marks & Spencer
• Diageo

> Todd does not own shares of any company mentioned.

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