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Credit FAQ: How Would Brazilian-Based Vale Fare With Iron Ore Prices Below $100/Ton?

Publication date: 20-Sep-2012 09:33:12 EDT

Iron ore prices have declined by as much as 30% since July, to below $90 per ton, before recovering to $100-$110 per ton. This comes on the heels of mining companies reporting weaker operating results for the first half of 2012. Whenever there is strong volatility in iron ore prices-–especially if they're going down-–Standard & Poor's Ratings Services receives many questions on the impact of the lower prices on Brazil-based Vale S.A. (A-/Stable/--), one of the largest mining companies in the world. Here, we provide our answers to those questions.

Frequently Asked Questions

Is the rating on Vale under pressure?

We expect our rating on Vale to remain stable over the next 12-18 months, as indicated by the stable outlook. Price volatility is an inherent risk for commodity producers, and we incorporate it into our evaluation of these companies' business risk profiles. Our ratings on Vale also reflect its strong credit ratios and our expectation that the company will maintain both its prudent growth strategy and its disciplined approach to shareholder returns. Vale's total adjusted net debt to EBITDA was 1.1x and FFO to total debt was 69% for the 12 months ended June 30, 2012.

While we expect that Vale will invest aggressively in the next three years, around $15 billion to $20 billion per year, we also believe that the company can-–and would be willing--to adjust capital expenditures and dividends amid slower global economic growth and subdued commodity prices.

What are your expectations for Vale's earnings in 2012 and 2013?

We have revised our EBITDA expectation for Vale to $22 billion to $23 billion in 2012 from $25 billion to $29 billion previously, assuming that average prices for iron ore have dropped to close to $100 per ton in September from an average of $140 in the first half of 2012 (62% Fe CFR China benchmark). Our reduced EBITDA expectation is mostly a result of weaker average prices for iron ore (see chart 1), 20% lower than we previously expected, since volume should remain constant at 300 million tons of iron ore and pellets sold in the year. Considering also that the depreciation of the Brazilian real means lower cash costs for Vale's production in Brazil, we believe that EBITDA margins, although lower, would only fall to 45% to 48% in 2012 and 2013 vs. 55% in 2011.

Longer term, for the next 18 to 24 months, we still believe that market fundamentals for iron ore remain relatively positive and will allow Vale to post strong cash flow generation.

Chart 1

What is the impact of iron ore prices below $100/ton on Vale's credit ratios?

Assuming Vale's average sales price for iron ore of $100/ton in 2012 and $90/ton in 2013 and 100% of its capital expenditures, including all projects approved and undergoing, we expect Vale to maintain comfortable credit metrics for the rating category--such as total adjusted net debt to EBITDA below 1.5x in the next two years. Our base-case scenario already incorporates long-term market prices of $90/ton without a major impact to Vale's leverage ratios (see table).

However, if Vale's prices decrease below $80/ton and remain there for the next year or two, during the peak of Vale's capital expenditures, and--assuming no reductions in spending--we could see Vale's total debt to EBITDA approach 2x. But this wouldn't necessarily trigger a downgrade, given our current assessment of Vale's "strong" business risk profile based on the company's global market position and its low production cash costs relative to those of peers. Even during a distressed year such as 2009, Vale realized average iron ore prices of $56/ton and posted EBITDA margin of almost 40%. (To estimate Vale's average sales price, we use the benchmark 62% Fe CFR China and we factor in freight costs [$10/ton-$15/ton] as well as premium paid for higher ore grades [65%-67% of Vale's sales] and produced pellets [20% of Vale's sales].)

Vale's Ratios And Iron Ore Prices
Iron ore prices ($/ton, 62% Fe CFR China) 90.0 100.0 110.0 120.0
2013 Total debt/EBITDA (x) 1.9 1.7 1.5 1.3
2014 Total debt/EBITDA (x) 1.7 1.4 1.3 1.0
Source: Standard & Poor’s.
Do you think Vale will adjust its capital expenditure plans?

Yes. Vale has yet to announce any downward revisions to its investment plans, but we expect the company's capital expenditures to be lower by at least 10% in 2012. Our assumption is based on:

  • A devaluation of the real vis-à-vis the U.S. dollar of around 20% since the announcement of the capital expenditure plans in November 2011, which should affect most of the expenses denominated in reais (such as local equipment, labor costs, and research and development); and
  • The delay in some projects, given lengthy administrative processes to obtain licenses and secure equipment and labor.

Vale's approved capital expenditures for 2012 total $21.4 billion: $12.9 billion for expansion projects, $2.4 billion for research and development (R&D), and $6.1 billion for existing operations. However, the company has only spent $6.4 billion in the first semester (30% of the total budget, not considering opportunistic asset sales). Spending on several new mines, including Serra Sul, Serra Leste, Simandou, and Moatize, was 40% below projected levels as of June 30, 2012. In addition, Vale continued to divest non-core assets: in 2012, it has announced the sale of vessels and manganese ferroalloy operations in Europe, thermal coal assets in Colombia, and the kaolin business in Brazil. We expect Vale to spend $18 billion to $19 billion in 2013 for the main projects in development, and $12 billion to $14 billion in 2014. Longer term, we estimate Vale will spend $8 billion to $9 billion per year to sustain operations and R&D.

How important are Vale's iron ore earnings to its consolidated results?

Most of Vale's cash flows still come from its iron ore business, despite the company's increased diversification into base metals and coal. Moreover, the latter commodities are also facing weak prices in 2012. In the first half of 2012, the iron ore business contributed 90% of Vale's EBITDA (see charts 2 and 3).

Chart 2

Chart 3

What is your view on Vale's product and geographic diversification?

Vale's product diversification is still one of its main weaknesses compared with that of major mining companies: iron ore represents 70% of its revenues (see table). The company has recently increased its investment in fertilizers (potash, phosphates, and nitrogen), through the acquisition of Vale Fertilizantes S.A., with a long-term view of the segment's international growth and aiming to be a top global producer. In terms of destination, Vale's revenues are somewhat dependent on Asia, which accounts for roughly 50% of sales, followed by South America (21%) and Europe (18%).

In contrast, geographically, Vale has a well-diversified portfolio of assets, which reduces its dependence on specific mines or plants. For example, despite its well-known high quality ore, the Carajas mine represents around one third of Vale's total iron ore production. And Vale continues to invest in new projects, with Serra Sul projected to add 90 million tons per year of iron ore capacity beginning in 2016.

What could lead to a lower rating on Vale?

Our rating assumes that Vale will adjust its investments and dividends to maintain a total debt to EBITDA ratio in the 1.0x-2.0x range and a "modest" financial risk profile. If Vale shows a substantial increase in net debt, the rating could come under pressure. For example, if Vale approves higher than expected capital expenditures or chooses the path of growing quickly through acquisitions (which is not our scenario) despite prolonged weak commodity prices, we would likely see deterioration in its credit metrics and consider revising our financial risk assessment and rating. Credit metrics weaker than total debt to EBITDA above 2x and FFO to debt below 45% for a prolonged period would be indicators of a weaker financial profile, in our view.

How does Standard & Poor's account for Vale's tax liabilities dispute and its potential impact on the rating?

Vale faces several legal battles, mainly regarding income taxes in Brazil. It's been widely publicized that the federal government has raised a tax claim of R$30 billion ($15 billion) regarding credits in the settlement of federal income taxes on profits of Vale's non-Brazilian subsidiaries and affiliates. Based on the scenario presented by Vale's attorneys and its auditors, we believe that the loss probability is low. In any event, at this point it is impossible to factor in our rating when these disputes will be resolved and--if the decision is negative to Vale--the amount of this potential liability and the timing of payments. In our view, Vale has the financial and balance sheet flexibility to absorb the risk of losing some of these disputes, but we will monitor these developments and incorporate them in our rating as appropriate.

What is the status of government claims regarding royalties?

Vale is negotiating the payment of additional royalties of R$4.4 billion ($2.2 billion) with the federal government. The administration wants to adjust the CFEM (Compensação Financeira pela Exploração de Recursos Minerais), a local mining royalty, for previous years because it doesn't agree with some discounts Vale applied to its calculation of the amount due. In August 2012, Vale announced it had provisioned R$1.1 billion ($550 million) for this purpose in light of a potential loss. Vale believes that it would not be liable for the remaining R$3 billion ($1.5 billion), given that part of its revenues come from producing pellets, a manufactured product and not a mineral. Looking forward, we incorporate an expected royalty increase of 4%, from the current 2%, in our projections of Vale's future cash flows.

What is Standard & Poor's view regarding the Brazilian government's influence on Vale's management?

We do not see Vale as a government related entity (GRE) and our rating on Vale--two notches higher than the rating on Brazil--is evidence that we don't see the credit quality of Vale as directly tied to that of the country. We also don't see direct interference by the government in Vale's strategic decisions nor in its daily operations. However, as any large mining corporation with great importance in a country's economy (Vale is Brazil's largest exporter, with a 14% share of the country's total exports in 2011), Vale is subject to sovereign risks.

Primary Credit Analyst:Rafaela Vitoria, CFA, Sao Paulo (55) 11-3039-9761;
Secondary Contact:Milena C Zaniboni, Sao Paulo (55) 11-3039-9739;

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