Even In Hard Times, You Can Still Be Sure Of Shell

The City can be hard to please, as Jeroen van der Veer, the chief executive of Shell, will doubtless tell you.

Yesterday’s second-quarter profits of nearly $7.6 billion (£3.7 billion) were the best produced by the Anglo-Dutch oil major to date, and $1.5 billion more than those unveiled two days previously by BP. Yet the overwhelming reaction from analysts and investors was disappointment.

They pointed out that over the past seven years Shell has beaten forecasts by an average of 4.6 per cent. Once $660 million of one-off gains are stripped out of yesterday’s numbers, Shell has beaten forecasts by only a modest 2 per cent.

True, Shell has benefited from a sector-wide surge in refining margins – caused, ironically, by BP’s refining shutdowns in the US. The more capacity BP has been forced to take off the market, the more petrol prices have climbed. But Shell also disappointed on production, and continuing turmoil in Nigeria – where it has yet to give a date on when it will restart operations – means the group may reach only the bottom of its targeted output range of 3.3 million barrels a day this year.

Of course, shareholders always look forward. But it is important to remember where Shell has come from. Just three years ago, it was mired in the reserves scandal that catapulted Mr Van der Veer to power. He has since increased Shell’s exploration budget to $2 billion a year, and invested far more in new technologies. The company is better placed than BP on liquefied natural gas (LNG) and has a leading position in oil sands – a division whose results it will henceforth report on a standalone basis.

That is not to ignore the hole in its production pipeline – Shell’s output is 600,000 barrels a day less than BP – it needs to fill. But if Shell’s profits underwhelmed, that is also because of higher write-offs in its exploration expenditure during the past six months. It has made four big discoveries in that time, one of which – Prelude off Australia’s northwest coast, adjacent to Total’s Icthys gas project – carries high hopes.

Like other “super-majors”, Shell’s shares continue to suffer from a conglomerate discount. But the scope for the company to step up its share buyback programme, and the premium that should attach to its lead in LNG, provide support. At £19.72, or 10.5 times current-year earnings, Shell is worth holding.

Rolls-Royce

The £10 billion engine maker is the corporate embodiment of British reserve. It does not do flashy. It just quietly gets on with building world-class aircraft engines, nuclear reactors and power plants for ships. With similar unobtrusiveness, it yesterday turned in a set of record first-half results. Sales increased by 10 per cent to £3.6 billion and underlying profits were up 17 per cent to an above-forecast £380 million. Its order book now stands at £35.1 billion and its balance sheet is flush with £755 million of cash. The rocky period after September 11, 2001, when orders dried up but debt remained onerously high, is long over.

The side-effect of success is that shareholders have started to ask why Rolls is not returning surplus cash to them. Yesterday’s 10 per cent increase in the interim dividend is welcome but with the company’s order book bulging and substantial cash flowing in – notwithstanding a £100 million working capital outflow related to factory openings – there is an argument that investors should be receiving greater reward. But demands for such redistribution ignore the enormous R&D costs involved in building aircraft engines. Rolls does not have access to the reserves of its rival GE, and it needs a cushion to finance new projects. This will become even more important in the next couple of years as Boeing and Airbus and their airline customers push for more environmentally friendly aircraft.

To satisfy restive investors, Rolls is planning a financial review next year once it reduces its pension deficit. But their impatience, together with profit-taking after an 18 per cent gain this year, saw the shares fall back more than 6 per cent yesterday. At 13.4 times 2008 earnings they are not expensive, but may struggle to make progress until Rolls’s new capital structure becomes clearer. Hold.

Legal & General

After two months of record rainfall, the life insurer’s logo – a multicoloured umbrella pitched at a jaunty angle – has seldom seemed more appropriate.

But it failed to protect Legal & General from a savage sell-off which sent its shares down more than 8 per cent, wiping more than £800 million from its stock market value.

The adverse weather has not helped. L&G reported a higher than expected loss of £38 million in its general insurance division in the six months to June 30, against a £2 million profit last time. This month’s floods are likely to cost at least another £30 million.

There was also disappointment that the share buyback confirmed by Tim Breedon, chief executive, was not bigger than the previously flagged £1 billion. But, falling stock markets aside – to which L&G is exposed through its extensive equity holdings – it was the 8 per cent fall in new business profits that did the most damage.

L&G is not performing badly. Across the world, its life and pensions sales rose 22 per cent, to £5 billion. In the UK, that figure was 24 per cent higher at £4.5 billion. The problem is that growth at L&G has been in lower-margin areas such as pensions and savings. Sales of protection products have fallen, reflecting the tougher mortgage market and strains on house prices. Sales of new unit-linked bonds have also dropped. Of greater comfort was the strong performance of investment management. L&G is not expensive on most measures, but, amid the volatility, is best avoided for now.

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