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By Ishtiaq Ahmed

Vale S.A. is one of the largest mining companies in the world. The company focuses on production, exploration and sale of basic metals in Brazil and internationally. Vale is also engaged in logistics, fertilizers and steel businesses. Its Bulk Material segment focuses on the mining of iron ore and pellet production, along with the operation of Brazilian southern and northern transportation systems, including ports, railroads and terminals connected to mining operations. This division also includes manganese ore mining and ferroalloys activities. Vale S.A. (NYSE:VALE) is the second largest mining company in the world, as well as the largest producer of iron ore and pellets.

At the moment, the company has a dividend yield of just above 6%, and an annual dividend of $1.153. The company has a payout ratio of 72%. In my previous article, I talked about the ability of the company to maintain its current high levels of dividend disbursements. I looked at the earnings potential, cash flows and the debt of the company. However, in this article, I go deeper in my analysis of the cash flows and debt coverage of the company, and through some metrics, try to ascertain the strong financial position of the company.

Free Cash Flows:

 

Free Cash Flows

 
 

2011

2010

2009

Net Income

$22,885

$17,264

$5,349

Depreciation and Amortization

$4,122

$3,260

$2,722

Funds from Operations (FFO)

$27,007

$20,524

$8,071

change in noncash current assets

$1,416

$614

$439

change in noncash current liabilities

$1,095

$727

$496

Operating Cash flows

$24,496

$19,183

$7,136

Capital Expenditures

$16,075

$12,647

$8,096

Free Operating Cash Flow

$8,421

$6,536

-$960

Long Term Debt

$21,538

$21,591

$19,898

Source: SEC filings

In the previous three years, net income of the company has quadrupled. At the end of 2009, net income stood at just $5.3 billion, which jumped up to $22.8 billion by the end of 2011. Along the same lines, the funds from operations of the company have more than tripled in the previous three years. From $8 billion in 2009, the FFO has gone up to $27 billion at the end of 2011. The cash flows from operations stood at significantly improved levels in 2011 as compared to 2009. The firm has been able to convert most of its sales into cash flows indicating high quality of earnings. At the end of 2011, cash flows from operations stood at $24.49 billion as compared to $7.1 billion at the end of 2009.

However, heavy capital expenditures resulted in negative free cash flows at the end of 2009. In the following years, the capital expenditures kept rising, but the cash flows from operations grew at a higher pace than the capital expenditures. As a result, the company had impressive cash flows during the past two years. At the end of 2011, the free cash flows for Vale SA stood at over $8.4 billion.

Essential Ratios:

 

Essential Ratios

 
 

2011

2010

2009

Funds from Operations(FFO)/Total Debt

1.25

0.95

0.41

FFO/Capital spending requirements

1.68

1.62

1.00

Free Operating Cash Flow + interest expense/ Interest expense

4.42

3.47

0.38

Debt Service coverage

2.75

1.68

0.13

For my analysis, I have used four ratios. The first ratio indicates that the debt of the company is adequately covered with the FFO. In fact, the ratio has increased significantly over the period being analyzed. The second metric indicates that one of the most important components of the firm is easily covered with the FFO of the company. As I mentioned, capital expenditures are an integral cash outflow for Vale, and the analysis shows that the firm should be able to meet its capital spending requirements through its internally generated funds.

The last two metrics in the table indicate that the firm is able to meet its interest and debt payments sufficiently. The interest payment for the company was around $2.5 billion a year. The interest coverage ratio indicates that the firm should not have any trouble meeting its interest obligations. In addition, the debt service coverage ratio has improved massively, indicating a stronger financial position of the company.

Summary:

According to my analysis, the firm should not have any trouble in meeting its dividend payments. The company has impressive cash flows and strong business prospects. As I mentioned in my previous article, the growth in the Chinese market will further boost the earnings of the company. Vale generates about 53% of its revenues from Asian markets; however, it is at a disadvantage as compared to its competitors BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) as its mines are far from Asia. However, the company has received encouraging reports about its "Valemax" vessels.

Valemax ships are known as the world's largest iron ore vessels with a capacity of 400,000 deadweight tons. Once deployed, those ships can carry massive amounts of iron from Brazil to China. Currently, Chinese government refused to allow these giant vessels to be docked at Chinese ports. However, the ban is likely to be removed soon due to the increased iron demand by Chinese manufacturers. The Chinese authorities face immense pressure from the local manufacturers to remove this ban. Once these vessels are free to transport iron ores, this will drastically reduce the shipment costs and substantially improve the profit margins margin.

The company hopes that it will soon be able to receive permission to dock "Valemax" in China. The company has ordered 35 "Valemax" ships, but the company will not own the ships and try to leaseback some of the ships. The new fleet will bring the cost down by almost 20%. At the moment, the company is unloading its mega ships in Philippines and Malaysia.

I believe the dividends of the firm are safe, and there are healthy growth prospects for Vale. The company is already generating substantial cash flows from Brazilian operations. The business prospects in Asia also look promising.

Source: Vale: A Cash Spring