CUHRIG/E+ via Getty Images
CUHRIG/E+ via Getty Images
In the first quarter of 2022, Vale's (NYSE:VALE ) net debt increased by US$3Bn to partially fund the US$5.3Bn shareholder returns. Yet, this did not stop the company from announcing a massive share buyback program which should reduce the number of outstanding shares by 10 percent. With iron ore prices on a decline and this buyback program in place, the dividend will likely be lowered. Investors should expect to be exposed to the cyclical nature of this company and accept lower returns in the short term.
Vale is one of the largest mining companies in the world. The company is a leading producer of iron ore, pellets and nickel, but also has major operations in logistics and energy generation. To visualize the global presence, production figures and sales, reference is made to figure 1.
Figure 1 - Infographic manufactured capital (vale.com)
Figure 1 - Infographic manufactured capital (vale.com)
Two main business segments are present in the company:
The Ferrous minerals segment deals with iron ore, iron ore pellets and manganese amongst others. This business line accounts for approximately 90% of EBITDA. The Base metals segment mainly evolves around the production of nickel and copper.
For Vale earnings are closely tied to the price of iron ore (SCO:COM). Figure 2 shows a sensitivity analysis which correlates EBITDA to sales volumes and the ore price. At first glance it appears earnings are less sensitive to sales volumes than ore price. However, comparing the actual differences in percentages rather than absolute figures, a different picture emerges.
For example the difference between the lower and upper end sales volumes is approximately 5% whereas the difference in boundaries of the ore price is 20%. The key takeaway of this table is that the production is relatively constant and predictable whereas the iron ore price is volatile and unpredictable in comparison.
Figure 2 - EBITDA sensitivity analysis (vale.com)
Figure 2 - EBITDA sensitivity analysis (vale.com)
To get a handle on EBITDA as a function of ore price, both have been plotted in figure 3. For clarity, the non-GAAP metric 'adjusted EBITDA' is shown as management uses this for decision making. The adjusted EBITDA has been taken from the annual reports for the respective years, apart for the values prior 2015. The values prior to 2015 have either been taken from the 2015 annual report, or have been re-calculated based on the method described in the 2015 AR.
Figure 3 – Adjusted EBITDA and stock price versus iron ore price (investing.com, vale.com, yahoo finance; chart by author)
Figure 3 – Adjusted EBITDA and stock price versus iron ore price (investing.com, vale.com, yahoo finance; chart by author)
The adjusted EBITDA clearly follows the trend of the ore price as expected. It also shows the ore price can be rather volatile or cyclical which also holds for earnings and the stock price. The correlation between ore, earnings and the stock price is strong save for the year 2019. This disconnect is attributed to the Brumadinho dam disaster.
When it comes to shareholder returns, it is more interesting to understand how the dividend is tied to the ore price. In this article the same approach is used as described in my coverage of Rio Tinto (RIO).
Figure 4 shows the annual dividend versus the iron ore price. In the case of Vale the correlation between the ore price and dividend is less evident as for RIO. This is explained by the fact the dividend pay-outs have been affected by the financial implications following the dam disasters. On the upside however, prior 2019 Vale clearly demonstrated the dividend did follow the ore price. This indicates management is focused on the interests of shareholders.
Figure 4 - Annual dividends versus iron ore price, red bar indicates only the first of the semi-annual dividend (investing.com, vale.com; chart by author)
Figure 4 - Annual dividends versus iron ore price, red bar indicates only the first of the semi-annual dividend (investing.com, vale.com; chart by author)
Although Vale is a very shareholder friendly company as management will endeavor to return substantial amounts of cash whenever possible, it is less straightforward to indicate what the expected dividend will be. Two factors are at play here.
The first is the poor correlation for the data after 2019, the dividend was either substantially lower or higher in comparison to the trendline. Both in the years of the Brumadinho disaster and the corona pandemic, the dividend was way lower than could have been expected based on the performance since 2011. On the contrary, the 2021 dividend appears to have been used as a compensation for the subdued dividends in the years prior.
The second factor making it harder to estimate the magnitude of future dividends is the share buyback program which was started in April 2021.
In April 2022, Vale announced a massive share buyback program which should reduce the number of outstanding shares by 10 percent. This program is already the third one since April 2021, see figure 5. Working with the current price of US$17.5 per share, this equates to a program of US$8.8Bn for the next 18 months or US$5.8Bn per annum.
The timing of this program is peculiar as the ore price is under pressure and the interest rate hiking pad projected by the Fed may cause a recession in the short run. On the other hand, the best moment to buy back shares is when these are not trading at highs, while it also sends a strong message of confidence by the management team. Nevertheless, with iron ore prices on a decline and this massive program in place, the question is what amount remains to be spent on dividend.
Figure 5 - Share buyback programs since 2021 (vale.com)
Figure 5 - Share buyback programs since 2021 (vale.com)
In the first quarter of 2022 net debt increased by US$3Bn as the company explained in the 1Q22 Conference Call Presentation. The main drivers for the changes in debt were the US$3.5Bn dividend payment and the US$1.8Bn share buyback.
In spite of the increase in net debt, the overall value of nearly US$5Bn is manageable. Yet, in addition to net debt the company uses a concept called expanded net debt. The conversion from gross/net debt to expanded net debt is shown in figure 6.
Figure 6 - Expanded net debt (vale.com)
Figure 6 - Expanded net debt (vale.com)
Apart from the line items Refis (federal tax settlement) and currency swaps, the difference between net debt and expanded net debt is basically formed by the provisions the company has taken to mitigate the risks posed by tailing dams. For readers who are little acquainted with the history of Vale, reference is made to the Mariana and aforementioned Brumadinho dam disasters which formed the basis for these provisions.
The relevance of the notion expanded net debt in light of this article follows from a decision made by the Board of Directors in 1Q22:
Expanded net debt increased to US$ 19.4 billion (…) During this quarter, we reviewed with our Board of Directors a change in our optimal leverage from US$ 15 billion to a range of US$10 - 20 billion, under the expanded net debt concept.
Comparing this statement to the numbers in figure 6 it follows the expanded net debt nearly doubled over the course of a single year and management actually raised the 'optimal leverage' to do so. Moreover, the company is operating at the high end of the communicated range after management just raised it. The fact that the US$3.5Bn shareholder distribution affected net debt, which in turn pushed expanded net debt to the upper boundary of the new range, implies that there is very little in stock for the second payout of the semi-annual dividend, especially if this is placed in the context of the announced share buybacks.
In all likelihood, investors should expect to be exposed to the cyclical nature of this company and accept lower dividends in the short term.
Ever since the Mariana and Brumadinho dam disasters, the safety of tailing dams has been of the utmost priority for Vale. In spite of this attention the risks posed by these dams do not disappear overnight and require diligent study, engineering and mitigation measures. More colloquially, it needs time.
At the Vale Day in November 2021, the overview in figure 7 was shared. Basically it will take the company another 3 years to eliminate the dams posing the highest risks. Without going deeply into the intricacies of soil mechanics it suffices to say this field of engineering is highly empirical. Up to this day it remains difficult to predict the exact behavior of soil. Add to this the fact that tailing dams typically evolve over their lifetime as they are often raised and an already incomprehensible area of engineering becomes even more complicated. A such, chances are the company will need to book even larger (de-characterization) provisions meaning the expanded net debt will rise, thereby affecting shareholder returns.
Figure 7 - Dam safety (vale.com)
Figure 7 - Dam safety (vale.com)
While dams are within the circle of influence of the company, the policy makers in China surely are not. Policy decisions made in China can be sudden and defiant of Western logic. This makes the effect of Chinese policy on ore prices a highly unpredictable part of the equation. SA's Nathan Allen presented an interesting example in a news article on steel industry production cuts, to wit:
However, taken in aggregate, the timing is puzzling. In 2021, China was happy to import crude oil, refine it, and export diesel at a $5-$10 margin. In 2022, the country is restricting exports when seaborne diesel margins are ~$50 per barrel.
On top of this it remains likely China will continue to enforce strict lockdown measures when the winter season will arrive again. As lockdowns already had an effect on iron futures in May, the effect will be exacerbated in the cold season.
Data shows Vale's dividend has followed the ore price for over a decade. This track record indicates management will raise payouts to investors whenever possible. In light of this, Vale announced a massive share buyback program in April 2022 which should reduce the number of outstanding shares by 10 percent.
In the first quarter of 2022, net debt increased by US$3Bn to partially fund the US$5.3Bn in shareholder returns. Amongst others, these distributions raised the expanded net debt to the allowable upper boundary, implying there is very little in stock for the second payout of the semi-annual dividend in 2022, especially with a hefty buyback program in place.
In all likelihood, investors should expect to be exposed to the cyclical nature of this company and accept lower returns in the short term. Nevertheless, the track record of the company and the ability to distribute huge amounts of money make this company a Hold.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.