Is Vale SA's Dividend Safe?

By Markets Fool.com

Vale SA is one of the largest iron ore producers in the world. A few years ago, that was a great business; but iron ore prices have been falling since early 2011. That's led Vale's share price and earnings lower, too. It's dividend yield, meanwhile, based on its two semi-annual payments in 2014, is around 9.5%. Can Vale keep paying that kind of a dividend without an iron ore upturn?

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Saying the right things
During Vale's early December investor meeting, the company pointed out that, "2015 is a challenging year," noting that the "speed of iron ore price recovery is uncertain." But that didn't change its dividend stance: "Nonetheless, we are positive about paying healthy dividends without additional debt." In fact, Vale stated that, "cash flow and dividends will reach unprecedented levels and debt will reduce gradually" through 2018.

Being that the presentation was in English, and Vale is based out of Brazil, the word "unprecedented" here probably means that Vale hopes to achieve the highest levels of cash flow and dividend disbursements in its history. But just because a company says it want's to pay dividends doesn't mean it can. That leads to the question: With iron ore prices lingering at low levels, can Vale continue to pay shareholders like it has?

Checking the books
A quick look at the company's third quarter gives a glimpse of what it can, and can't, do. One of the first places to look for dividend security is the payout ratio, or dividends as a percentage of earnings. Vale lost $0.28 a share in the third quarter, but that was mostly due to dramatic currency exchange shifts. Backing that out, the miner would probably have been about breakeven.

Iron Ore Spot Price (Any Origin) Chart

Iron Ore Spot Price (Any Origin) data by YCharts.

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The company's iron ore production is at record levels, so it's doing all it can operationally. But low commodity prices for a product that accounts for nearly two-thirds of the top is clearly taking its toll on the bottom line. Luckily, dividends aren't paid out of earnings; they are paid out of cash flow. While the earnings trend is troublesome, it doesn't mean Vale can't pay its dividend.

Cash flow from operations over the trailing 12 months through September, which brings back in non-cash charges like depreciation, was roughly $13 billion. The company's growth initiatives, like building new mines, ate up roughly $12 billion of cash flow.Part of that spending was covered by selling investmentsand other actions, so investing activities only used a total of about $8.4 billionof cash flow over the period. In other words, the company's cash flow is going largely toward investing in its future. That's not a bad thing.

Dividend payments over the trailing 12 months, however, totaled about $4.2 billion. While Vale has been trimming back its spending to just a few high-profile investments, there's not a lot of room to support dividends at current levels without continuing to add debt. In fact, it would have come up short if it hadn't issued new debt and sold investments it owned.

Source: Glasbruch2007, via Wikimedia Commons.

Can't get around it
The big problem is iron ore. For example, the company's operating profit -- before the impact of exchange rates -- was less than half of what it was a year ago. This suggests that Vale can't keep paying out as handsomely as it has without cutting spending more sharply than it has, taking on new debt, or seeing an iron ore price rebound resuscitate its top line.

Vale openly admits that 2015 will be a tough year, so it may be willing to take somewhat drastic actions to support its dividend over the near term. But at this point, only aggressive income investors should buy Vale for income alone. The real opportunity here is the recovery potential of Vale's shares when the iron ore market's supply/demand situation balances out, and iron ore prices head higher again.

The article Is Vale SA's Dividend Safe? originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.