Digging Deeper Into Vale SA's Dividend Update

| About: Vale S.A. (VALE)

Summary

Vale SA wants to change its dividend policy, two months after it suggested cutting the minimum payout level to zero.

For Vale, a dividend cut has been pretty much on the cards.

The company also does not seem confident about the sustainability of recent rally in iron ore prices.

But let’s not forget, the biggest players of this industry – Vale, BHP Billiton and Rio Tinto – actually exacerbated the downturn by growing production.

Vale SA (NYSE:VALE), the world's largest iron ore producer, wants to change its dividend policy. In a statement released on Wednesday, the Rio de Janeiro-based company said that it would propose changing the dividend policy that currently focuses on promising a minimum annual payout to one that aligns shareholder returns with cash generation.

In other words, the company will abandon its practice of suggesting a minimum dividend payment at the start of each year. Instead, it now wants to propose dividends only after analyzing its financial health and ability to generate future cash flows. Moreover, the company, which pays first dividend in April and the second in October, also wants to make the first payment in April followed by second in October, next year.

Less than two months ago, Vale said that it would propose reducing the minimum dividend for 2016 to zero. That showed the management's intention to scrap the dividend until the market environment improves. The miner will put these proposals before the shareholders at a meeting on April 25.

For Vale, a dividend cut has been pretty much on the cards. The company has recently posted a record annual loss of $12.13 billion for last year, driven in large part by massive write downs of $9.37 billion. It has also been reducing dividends that peaked at $9 billion in 2011, dropping to $4.2 billion in 2014 and $1.5 billion last year. The miner needed to preserve cash in order to fund its operations, including completion of the $14.5 billion, 90 million tonnes per year S11D project, the largest of its kind in the iron ore industry, amid slumping prices. Last year's deadly dam breach on a joint-venture Brazilian project could also turn out to be a major overhang on its future cash flows. In this backdrop, Vale's decision to curtail payouts is a step in the right direction.

Interestingly, iron ore prices have been rising, particularly this month when the steelmaking ingredient posted record single day gain of 20% on March 7. On a year-to-date basis, iron ore is up roughly 29%. But analysts and industry experts, including BHP Billiton (NYSE:BHP)'s CFO Peter Beaven remain cautious, fearing the gains might not last. Vale's latest update also conveys a similar message.

But let's not forget, the biggest players of this industry - Vale, BHP Billiton and Rio Tinto (NYSE:RIO) - actually exacerbated the downturn by growing production.

Vale, for instance, managed to post 2.9% year-over-year increase in iron ore production to 85.4 Mt in the fourth quarter of 2015, thanks to record output from Carajás. For the full year, the company's iron-ore production reached record levels of 333.4 Mt. The completion of S11D by the end of the year will ensure Vale remains as the world's top iron-ore producer in 2016-17. But by increasing output in the face of a supply glut, the major miners, who are all low-cost producers with strong balance sheets, hoped to force the exit of high-cost miners. The closure of these relatively smaller miners could, theoretically, have a positive impact on the Big Three's market share and pricing power.

However, it is still debatable whether this strategy has actually worked. We haven't really seen massive mine closures in the iron ore sector, especially from China. A large chunk of the global supply comes from Chinese mines who may continue to operate with losses, given some of them are supported by large steel mills while others are backed by the Chinese government. Most of the high-cost miners were "hanging by their fingernails", according to Rio Tinto's outgoing CEO Sam Walsh, but still hanging nonetheless. Eventually, the low price will force their exit, but nobody knows how long this might take.

But what we can say with certainty is that the Big Three are also feeling the pain. Vale's peers have also been busy slashing payouts as iron ore prices plunged from an average of north of $130 per tonne in 2011-14 to just $37 in late-2015. Last month, BHP Billiton reduced dividends by 74%, ending its longtime progressive dividend policy, after it reported first net loss in more than 16 years. Rio Tinto, which has also recently abandoned its progressive dividend policy,plans to slash dividends by around 50% this year.

The largest miners have been forced to revise their dividends and payout policies. If prices fail to improve in the near term, then even the big boys may have to meaningfully alter their future production plans.

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