2023-03-22 11:00:00 ET
Summary
- Vale is executing the last part of its ‘bold buyback program’.
- To fund this program, cash levels dropped from US$13.5Bn in 2020 to a current level of US$4.8Bn.
- Secondly, net debt quadrupled in 2022 and the company revised the concept of ‘expanded net debt’ to stay within its target range.
- Thirdly, the company decided to divest 10% of its base metals unit to shore up cash for the buybacks.
- Even so, Vale will still be able to generate a decent dividend yield that may appeal to investors.
Vale (VALE) has been treating shareholders exceptionally well over the last two years. Even as the outsized returns may come to an end, Vale will be able to generate a decent 7% dividend yield for investors.
2022 recap
In 2022 Vale posted solid results, see figure 1. The results came in lower than the exceptional results posted in 2021, but this was expected given the realized ore price was lower as well. Nevertheless the company earned a decent amount of money and shared the wealth with its shareholders.
Figure 1 - Vale FY22 results (vale.com)
In spite of decent earnings, net debt quadrupled while capex remained flat. In other words, debt was increased not to invest in the business, but rather to fund the 'bold buyback programs', a term introduced at the 2022 Vale investor day. At the time, the company announced to buyback approximately 20% of outstanding shares. Considering the returns depicted in figure 2, the program was bold indeed.
Figure 2 - Shareholder remuneration, FY22 results presentation (vale.com)
In 2021 nearly all free cash flow was returned to shareholders, but in 2022 the company actually returned more than twice the FCF. The ability to do so lies in the fact Vale had amassed large amounts of cash in 2020 and 2021, but also revised the definition of 'expanded net debt'. In brief, management allowed debt to increase and simultaneously brought cash levels down significantly.
Expanded net debt development
The company uses a metric called 'expanded net debt' which, in addition to regular net debt, accounts for a tax renegotiating program and dam de-characterization costs.
After the first quarter of 2022, it turned out Vale was operating beyond its own target for the 'expanded net debt'. Therefore, in 1Q22 the Board of Directors made the decision to increase the self-imposed debt ceiling, to wit:
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.
As the company raised the high-end of the optimal leverage to US$20Bn when the actual number was already US$19.4Bn, this information led me to believe Vale would significantly cut the dividend in order to fund the share buyback program.
As explained in the previous section the company didn't, instead it chose to distribute a generous dividend in addition to the buybacks. And the Expanded net debt? Well, the concept was simply changed, see the next excerpt taken from the 3Q22 investor presentation:
Vale revised the Expanded Net Debt concept, seeking to be more aligned with market practices and have an indicator that better informs management on capital allocation decisions. The revised Expanded Net Debt now encompasses: (i) net debt, lease (IFRS 16) and currency swaps, and (ii) the provisions for the reparation of Brumadinho and Mariana, whose annual cash commitments are more concentrated in the early years. Operating and regulatory commitments previously included, such as the Refis tax renegotiation program and the upstream dam de-characterization provision are now excluded from the Expanded Net Debt concept. Those commitments are expected to have a more stable and longer annual cash outlays. The Expanded Net Debt target range of US$ 10 billion to US$ 20 billion remains unchanged.
This revision basically lowered 'expanded net debt' by US$6Bn. For reference one can compare the 4Q21 result given in figure 3 against the data in my previous coverage of Vale.
The effect of the revision is shown in figure 3. The expanded net debt lands comfortable in the middle of the US$10-20Bn range while net debt increased by approximately US$6Bn in 2022, mainly due to a significant reduction in cash.
Figure 3 - Expanded net debt, FY22 results (vale.com)
Cash levels
Over the course of 2022 the total amount spend on dividends and buybacks was US$12.6Bn as noted before. The generous returns in 2022 were in part funded by a US$7.1Bn reduction in cash.
Actually, if a long term view is taken, it becomes clear how much cash the company has generated, but also how swiftly this has been distributed, see figure 4.
Figure 4 - Dividend per share and cash versus ore price (vale.com, seekingalpha.com; chart by author)
The company has historically operated with a cash level of US$4-5Bn. In 2019 this level started to rise as the company halted dividends following the Brumadinho disaster. In 2020 dividend was resumed albeit at a low level given the pandemic the world was facing.
Basically, as operations continued, dam de-characterization costs were spread out in time and dividends were cut, the company started to save. In 2021, when the dividends and buybacks were fully reinstated, exceptionally high ore prices boosted the returns meaning Vale had massive amounts of cash available.
In April 2022 however the company committed itself to a new, large share buyback program , but with ore prices declining throughout the year, this took a toll on the cash position essentially bringing this back to the pre-Brumadinho/Covid level.
Shareholder returns
The announced buyback program was 43% complete when FY22 results were presented in February. This means 213 of the 500 million shares were repurchased at a costs of US$3.4Bn. As the program is supposed to be finalized in 18 months, this implies approximately US$4.5Bn will be spend on buybacks in 2023, all else equal.
Concerning the dividend Vale has a straightforward policy indicating it pays 30% of EBITDA in dividends and may decide to distribute additional extraordinary dividends. As EBITDA highly depends on the ore price, the question basically becomes what to expect from the ore price.
In 2021 Vale realized average ore prices of 141.4 US$/t FOB and posted an EBITDA of nearly US$34Bn, see figure 5. In 2022 realized ore price dropped to 108.1 and EBITDA reduced to US$21Bn. For 2023, my base case is the realized ore price will be less than 100 US$/t, implying EBITDA would reduce further to approximately US$17-18Bn. This estimate leads to a dividend payment of approximately US$5Bn.
Obviously this comparison is ball-park as e.g. differences in volume are not accounted for, yet it gives an indication of potential returns.
Figure 5 - Average realized prices, FY22 results (vale.com)
Adding the dividend and buybacks, my estimate is the company will return US$9.5Bn in 2023. Referring to figure 2, this number means the company will again exceed free cash flow just like in 2022, but this time around there simply isn't sufficient cash available to cover the costs.
The company has already adjusted its concept of expanded net debt to remain within its target range, but fact of the matter is that debt is rising while the company made a clear commitment to shareholders to distribute more cash. In this light I see the announcement of Vale that it 'weighs offers for a stake in its base metal business' as a necessity rather than an opportunity.
Nevertheless, by the time the company has concluded the buyback program, my expectation is there will be approximately 4.1 billion shares outstanding. With an estimated US$5Bn available for dividend, the dividend per share becomes US$1.20 which translates into a yield well above 7 percent. These numbers are ball-park, but essentially I expect Vale will be able to maintain a high dividend yield once the buyback program is concluded.
Risks
One of the largest risks the company still faces concerns the tailing dams. These structures are complex, implying time and money is required to mitigate the effects. As long as there are still high risk dams present, chances of another failure are material. Personally I consider this a red flag, but will not elaborate any further as this risk was discussed in more detail before .
Concerning finances it appears management keeps increasing debt at a time central banks are ending the era of easy money. The bold remuneration program plays a part in this, but especially for a company that is cyclical by nature, this potentially amplifies the cyclicality even further. In that sense it must be questioned if the reduction in shares outstanding is sufficient to maintain a high dividend when ore prices drop to levels lower than assumed in this article.
Management seems to have acted quite rash when it announced the current buyback program. In this context I see the decision to monetize the base metals business as a necessity. The energy transition however offers an opportunity to become less dependent on iron ore, thereby reducing the cyclical nature of the company. One could argue Vale is throwing the baby out with the bathwater.
Conclusion
Vale has presented itself as a shareholder friendly company and committed itself to a share buyback program which requires it to pull out all stops. Instead of turning down the buyback program, the company is burning through cash, revisiting its 'expanded net debt' concept and considers divesting the base metal business. A business which has positive prospects given the energy transition currently taking place.
Be that as it may, the company has the ability to generate a decent dividend yield by the time buybacks are finished. On the other hand, Vale appears to be moving towards a pure-play iron ore miner thereby increasing its dependence on ore rather than diversifying and potentially reducing cyclicality. All in all I consider the company a HOLD.
For further details see:
Vale: Dividend Remains High In Spite Of Rising Debt