Many investors believe that dividends are an implicit promise between management and shareholders that a company will make enough money in good times to cover its dividend payments throughout the business cycle.
Because of this belief, very few companies cut their dividends, as the action implies that management is not allocating capital across the business cycle correctly. The companies that do cut their dividend often see significant share price weakness as income investors reallocate their portfolios away from those companies and other would-be investors avoid them.
Every cloud has a silver lining, however. A dividend cut can be a positive in that a proactive cut could mean the difference between a company that suffers significant share dilution and a company that doesn't.
So with that said, should Cliffs Natural Resources (NYSE:CLF) cut its dividend?
Cliffs Natural Resources is currently in a tough spot. Iron ore prices have fallen by a third this year to below $100/ton , making Cliffs Natural Resources a marginal producer. Because of the falling prices, Cliffs Natural Resources is bleeding -- Wells Fargo estimates that the company is burning cash at a $220 million a year pace. With China's economy still weak, Cliffs Natural Resources needs as much liquidity as it can get to make it through the cycle.
Cutting the dividend to one cent a share would save Cliffs Natural Resources approximately $85 million a year, providing the company with valuable runway space. That extra runway could help the company stave off dilution or forced asset sales in the future.
A dividend cut may not make much difference for the stock price either. Too many people expect a dividend cut, as the writing has been on the wall for a while. Wells Fargo, for example, has said that Cliffs Natural Resources' dividend is only sustainable if iron ore prices remain above $100 . Other investment banks have pretty much iterated the same thing. In the stock market, if too many people expect an event, the impact of the event will not be as significant as most expect because the market has already discounted it.
In the face of declining iron ore prices, most investors agree that Cliffs Natural Resources' best course of action is to cut costs as much as possible. Cliffs Natural Resources' production costs are simply too high versus that of lower cost producers such as Rio Tinto plc (NYSE:RIO) and BHP Billiton Limited (NYSE:BHP), which have actually been adding production capacity over the past year.
While the company has reduced capital expenditures from $862 million last year to between $275 million and $325 million this year, the cuts may not be enough. With its stock price trading near 52-week lows and off over 40% this year, the market is implying that Cliffs Natural Resources needs to do more to stop the fall.
A dividend cut is something that Cliffs Natural Resources can still do. While it may be bad news for income investors, a dividend cut will provide the company with more runway and flexibility. As long as it is accompanied by fiscal discipline, a dividend cut could be a good thing for Cliffs Natural Resources in the long term.
Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.