Arch Resources(NYSE: ARCH) produces coal used for steelmaking and power generation. Along with third-quarter earnings, it announced a dividend of $1.13 per share, down from $3.97 in Q2. That's a huge dividend cut, but there's more to unpack here before you make any decisions.
Some dividends are meant to change
As with some oil producers, Arch has adopted a variable-dividend policy. The dividend is, effectively, tied to the coal producer's financial performance. That, in turn, is heavily influenced by the prices of thermal and metallurgical coal. The coal used in power plants (thermal coal) and the coal used in steelmaking (metallurgical coal) can see big spikes and valleys. So Arch's performance can move around quite a bit. Using a variable-dividend policy is a fairly direct way to ensure that investors benefit from the good times, though it also means accepting dividend cuts during lean times.
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From a big-picture perspective, pushing more cash to shareholders when commodity prices are high makes it more difficult for management to use a cash windfall for questionable capital investments. Don't underestimate the value of restraining management; at one point, utilities with strong regulated businesses moved aggressively into the far more volatile merchant-power space. Poor results in merchant power have led most utilities back to their regulated roots. So while a variable-dividend policy may not be for every investor, there are reasons why they can make sense.
And it is also worth noting that Arch Resources is what came out of Arch Coal, a company that ended up filing for bankruptcy in 2016. An important factor in that bankruptcy was a debt-funded acquisition that didn't work out as well as hoped amid an industry downturn. In other words, making sure that management is focused on execution (which can be aided by keeping cash on hand to a minimum) and not on inorganic expansion is probably something that at least a few investors will appreciate, given the history here.
That's a big change in a short period of time
So there's a backstory that investors need to understand when looking at the Q3 dividend cut. And still the drop from $3.97 per share to $1.13 per share in just one quarter is pretty large. If you own this stock, you should be asking if it is reasonable to think that the coal market fell out of bed like that. The truth is that it can, but in this case the sales price per ton of metallurgical coal rose slightly, while the price of thermal coal fell, leading to an overall modest improvement in the company's cash margin per ton to $54.70 in Q3 from $53.73 in Q2.
That said, if you go back two quarters, the numbers look vastly different. In Q1 of 2023, the cash margin per ton was $121.59, up from $93.15 in Q4 of 2022. Higher thermal and metallurgical coal prices were both a key factor. But it is clear that Arch Resources is, indeed, experiencing a shift in the coal market. So a dividend cut isn't outlandish, but there's still a bit more to the cut that you need to understand, and that requires even more digging.
In Q3, the company changed its variable policy, going from distributing 50% of discretionary cash flow down to 25%. And that is probably the most important thing that investors need to know because it is a fundamental shift in the way the dividend is paid. Cash preservation and stock buybacks are the focus for the cash not being paid out as dividends, with the hope of being more opportunistic when buying back stock. Still, that means that cash might end up piling up on the balance sheet at times, and investors have to trust that it will eventually get used to buy back stock.
Dig in and understand what's going on
There's nothing you can do to control a dividend cut, since the board of directors makes that decision. But it is important that you understand what is behind the cut before a knee-jerk reaction leads you to make an investment misstep. Or, in this case, you simply accept the cut because of a variable-dividend policy. When it comes to dividend cuts, you should always find out what caused the cut and then figure out if your investment thesis remains intact. If the thesis isn't the same anymore, which may be the case here given the change in policy, you may want to sell the stock.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Arch Resources. The Motley Fool has a disclosure policy.
