(Bloomberg Gadfly) -- Don't show, tell. Royal Dutch Shell Plc is proud that it has generated sufficient cash to cover its investment and dividend commitments for five consecutive quarters. Yet it is still cautiously paying part of its dividend in its own shares. Even a decent set of quarterly numbers can't hide why Shell is having to run a tight ship.
The Anglo-Dutch oil major made $4.1 billion of net profit in the third quarter, far better than expected. Refining and retail were particularly strong, although the uplift was broad-based.
Yet progress on Shell's key challenge -- cutting the mountain of borrowings amassed in the $64 billion acquisition of BG Group Plc last year -- remains a constant struggle. Net debt actually rose $1.3 billion to $68 billion from the second quarter.
Free cash flow of $3.7 billion didn't quite cover $3.1 billion of cash dividends and interest of $860 million. That left disposal proceeds carrying the debt-reduction burden, but these were relatively light in the period. To compound the problem, a stronger euro inflated the value of some of Shell's liabilities. Gearing didn't budge from the second quarter, at 25 percent.
Shell has a self-imposed gearing target of 20 percent and it needs to show a credible path to getting there before it moves to an all-cash dividend.
That could come from a step-up in the operating performance twinned with more disposals. There's not much sign of momentum in free cash flow generation. Organic free cash flow was $16 billion in the 12 months to Sept. 30, roughly where it was at June 30.
The outlook for disposals is more encouraging. Shell has completed $20 billion of a $30 billion divestment program. Finishing this would go a long way to hitting the gearing target, and given that it has plenty in the works, it's nearly there.
The payment of a full cash dividend, when it comes, won't mark Shell's full rehabilitation. Return on capital employed stands at 4.6 percent, against a targeted 10 percent. A more efficient capital base will help, but Shell still needs to deliver an even stronger operating performance.
For now, Shell's investors can rest assured the dividend is affordable. A stronger balance sheet and adequate returns are going to have to wait.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.
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