Last month, for the first time since its 1989 IPO, PotashCorp (NYSE:POT) cut its dividend, slashing the payout by roughly 34% to $0.25 a share. While the move was meant to better match its outsized dividend to lower earnings, don't be surprised if the latest cut is a sign of more trouble to come.
A slowing China is a big problem
Deteriorating earnings power is largely to blame for the dividend cut. The biggest factor: lower selling prices. From 1980 to 2000, producing and selling potash, a major form of fertilizer, was a fairly stable business, with selling prices stuck at around $150 a ton for over two decades.
Around 2005, that all changed. Over the next 10 years, China would grow its economy by over 600%, jumping from the fifth largest economy in the world to the second. To fuel this economic growth, along with an explosion in population, China needed to import a wide range of commodities ranging from oil to scrap metal. By 2015, China was the largest potash consumer in the world, with prices averaging between $300 and $500 a ton since 2008.
Lately, however, the markets have roiled over the collapse of what many analysts have coined the "commodity supercycle." Slowing Chinese demand has pushed the Bloomberg Commodities Index down to levels not seen since 1998. Many fear that global commodity demand will be permanently impaired as China focuses on transitioning toward a service-based economy. This is having severe impacts on PotashCorp's business.
This year, China is expected to demand only 14 million tons of potash, down from an already depressed level of 16 million tons last year. The Chinese market for potash is bigger than the entire North American market combined, along with Latin America and India as well. With China being the biggest consumer of potash in the world by far, permanently slower growth could upend the entire market for years to come.
In the past, 70% of global production was controlled by two large cartels (of which PotashCorp was a member of one), so pricing drops were avoided by coordinated supply responses. Last year, though, Russia's Uralkali quit one of those cartels, effectively ending the its power. With markets now setting prices, slowing demand and foreign competition has free-reign to influence PotashCorp's profitability.
How likely is another dividend cut?
PotashCorp management is forecasting 2016 earnings to be $0.90-1.20 per share, potentially making it the smallest profit in over a decade. The recently reduced dividend meanwhile totals $1.00 a share, so things don't have to deteriorate much for it to be in danger again.
On a cash flow basis, things look a bit better, but not much. Last year, the company generated roughly $2.4 billion in operating cash flow. After $1.3 billion in capital expenditures, it ended the year with about $1.1 billion in free cash flow. With the previous dividend costing the company $1.2 billion in 2015, PotashCorp ended the year with a cash deficit. Two things should help it this year. First, capital expenditures are being rolled back to $800-900 million. Second, the dividend cut should save the company about $400 million annually. In total, cash outlays should be reduced by around $850 million this year.
The question however is how much pressure operating cash flows will feel. China it seems may be just one of the major headwinds this year. The biggest decline in sales volume for 2015 actually came in North America. Growing foreign imports are providing strong competition at cheaper prices, while high crop inventories and collapsing selling prices are limiting farmers' fertilizer budgets. This helped the company's average realized price for potash collapse to $238 per ton, down from $284 per ton in 2014.
There's no reason to believe that prices don't have further to fall, either. Over 95% of the industry has production costs of under $180 a ton. Only then might we get the real supply response necessary to balance shifting demand.
PotashCorp looks like it's already ceding market share to lower cost producers too. Its estimate for global potash volumes remains similar to last year (59 million to 62 million tons), but its own volumes are expected to fall to just 8.3 million to 9.1 million tons. There's a good chance prices continue to slide until an industrywide supply response is formed. Until then, faith in PotashCorp's 6% dividend should be for the bold.