Investors looking for bargains in this down market surely have oil & gas firms at the top of their shortlists. With Royal Dutch Shell (LSE: RDSB) shares down 35% over the past 18 months, is the company a bear market bargain or a value trap? Shell’s ills are obviously a symptom of plummeting oil prices, but the larger worry is that the £35bn acquisition of BG Group will be an anchor on the company for years to come.
The BG deal was certainly struck at a rich valuation and its success remains predicated on crude prices recovering to at least $60/bbl. While proponents of the shale revolution in the US maintain fracking will make $60/bbl a ceiling on crude prices rather than a floor, oil prices have bounced back from innumerable challenges in the past. If oil does return to this level, the BG deal begins to make a great deal of sense. BG brings with it some of the world’s lowest-cost production assets in Brazil, will make Shell the largest global supplier of LNG, and is materially accretive to Shell’s dividend payments once oil hits $40/bbl.
After being beaten down over the past year, Shell shares are trading at a very reasonable 13 times forecast earnings and boast a 7.7% dividend. Given this attractive valuation and strong growth prospects once crude prices pick up, I believe Shell could be the epitome of a bear market bargain.
Toothpaste and cough drops
Pharmaceutical giant GlaxoSmithKline (LSE: GSK) is another blue chip that has seen share prices fall over the past year. The reason in this case is an increased focus on selling consumer health goods and vaccines. After swapping significant assets with Novartis, GSK now books only 59% of sales from prescription drugs. While hedge fund managers such as Neil Woodford have called for management to return to a narrow focus on developing drugs, I believe this diversified approach has considerable merit.
Selling toothpaste and cough drops to growing middle classes in emerging markets is a much less risky revenue source than spending billions on acquisitions in the hopes of discovering a new blockbuster drug. GSK is still spending significant sums on developing these drugs, but consumer goods revenue has allowed it to stay on the sidelines as competitors such as Shire and AstraZeneca dish out tens of billions on smaller competitors. This business model will certainly constrain runaway growth, but it will also allow steady returns for shareholders. Priced at 16 times forward earnings, the shares aren’t a stellar bargain but they do offer steady growth and a solid 5.8% yielding dividend.
Between a rock and a hard place
While GSK’s dividend is covered twice by earnings, the dividend at TalkTalk Telecom (LSE: TALK) hasn’t been covered for two years. Furthermore, the fallout from last years hacking scandal continues, with full costs now topping £55m and subscriber growth slowing considerably. While this may prove a temporary stumble, I remain unconvinced of the company’s long-term potential. The telecoms industry is highly competitive and TalkTalk lacks the fixed infrastructure of BT or the media offerings of Sky. Its main advantage is dirt-cheap prices, but it’s very vulnerable to price hikes on its rented broadband and wireless lines. If the competitors it rents these assets from raise prices, TalkTalk will be between a rock and a hard place. It could either eat the loss or pass on the rising costs to customers, thereby eroding its competitive advantage.
