S&P Downgrades Vale S.A. (VALE) to 'BBB'; Expects Weakening Credit Metrics

Standard & Poor's Ratings Services said today that it has lowered its ratings on Vale S.A. (NYSE: VALE), including its corporate credit ratings to 'BBB' from 'BBB+' and the ratings on Vale's bonds issued by Vale Canada Ltd., Vale Overseas Ltd., and PT Vale Indonesia Tbk. The outlook is negative. All ratings were removed from CreditWatch, where they were placed with negative implications on April 13, 2015.

At the same time, we affirmed the 'brAAA' Brazilian national scale ratings on the company and its debt.

"The downgrade reflects the significant pressure that the combined effect of lower iron ore prices and sizable investment levels are expected to have on the company's leverage in 2015 and 2016," Standard & Poor's credit analyst Diego Ocampo said. "Even though we continue to expect the leverage to meaningfully drop by 2017 and thereafter, we currently assume lower iron ore prices. Therefore, we foresee weaker credit metrics than before, which prompted our revision of Vale's financial risk profile assessment to "significant" from "intermediate."

The price drops are hurting profitability levels across the industry, affecting the most the lesser diversified producers, such as Vale. We consider those two factors--profit volatility and narrow portfolio diversification—are Vale's main weaknesses compared to other high investment-grade metals and mining companies. Still, we consider Vale's massive scale and industry-leading operating cost position support our business profile assessment of "strong."

The ratings remain under pressure because the company would heavily rely on asset sales and unconventional sources of cash to avoid debt levels from meaningfully rising. The timing and size of those measures are subject to market conditions and therefore hard to predict. However, we believe the company has a reasonable chance to receive substantial cash flows from those sources in the next two years.

The most relevant assumptions under our base case are:

• Exchange rates Brazilian real (R$) 3.10/$1.00 in 2015 and R$3.20/$1.00 in 2016 and 2017.
• Brazilian inflation rates of 7.9% in 2015, 6.6% in 2016 and 2017.
• Iron ore price assumptions of $45 per ton for the rest of 2015, $50 in 2016, and $55 in 2017 (62% iron ore content delivered in China).
• Freight costs at $16 per ton.
• Moisture content discount of 8% of cash cost (including freight).
• Iron ore volumes of 289.5 million tons in 2015, 323 million tons in 2016, and 355 million tons in 2017 (average content of 63.9% gradually increasing to 64.1%).
• Pellet production of 50 million tons in 2015 and 51 million tons in 2016 and 2017.
• Copper volumes of 450,000 tons in 2015 and 2016, and 467,000 in 2017.
• Copper prices of $2.7 per pound.
• Nickel volumes of 301,000 tons in 2015 and 308,000 in 2016 and 2017.
• Nickel prices of $6.5 per pound in 2015 and $7.25 per pound in 2016 and 2017.
• Capital expenditures of $8 billion in 2015, $7 billion in 2016, and $5.6 billion in 2017.
• Dividends of $1 billion in 2015 (already paid out), zero in 2016, and $1 billion in 2016.
• Asset sales/nonrecurring initiatives of $4.5 billion in 2015 mainly consisting of:

-- $900 million on the Salobo II gold transaction, which occurred in first quarter 2015;
-- $450 million from the sale of a 15% stake in Vale Mozambique; and
-- $3 billion from the collection of intercompany loans that Vale had granted to the Nacala corridor group of companies, which would be paid down upon the spin-off of that asset.

• Additional asset sales/nonrecurring initiatives of $4 billion in 2016 consisting of logistic assets, equity raisings in subsidiaries, and/or additional spin-offs of noncore assets.

Those assumptions result in the following credit metrics:

• Adjusted EBITDA generation of about $8 billion in 2015, $9.4 billion in 2016, and $12.4 billion in 2017.
• Adjusted net debt to EBITDA of 4.9x in 2015, 3.9x in 2016, and 2.9x in 2017.
• Adjusted funds from operations (FFO) to debt of about 14% in 2015, 20% in 2016, and 27% in 2017.

We adjust the company's 2014 reported debt figures by about $11.5 billion,
which consist of the following:

• The proportional consolidation of Vale's 50% interest in Samarco S.A., which increases EBITDA and FFO.
• The first Salobo gold stream transaction and the net present value of the deposit received under the second gold transaction on the Salobo mine.
• The balance on derivatives aimed at hedge currency risks on debt.
• Obligations of asset retirement and pension liabilities.
• The tax liability on the REFIS program.
• We also deduct most of the company's cash position as surplus cash in calculating net debt metrics.

We have revised our assessment of Vale's liquidity to "adequate" from "strong." Even though we expect cash sources to exceed uses by more than 50% in the next two years, the headroom under the existing covenant package is smaller than what we would consider for a stronger assessment. So far, our base case excludes a potential breach, and if it would occur, there are no risks of acceleration attached to it. Moreover, the most likely scenario is that the company would pay down most of those debts prior to any potential waiver discussion; total debt under covenant package is manageable. Other qualitative factors are Vale's high standing in credit markets and a solid relationship with banks due to its historically prudent risk management.

Principal Liquidity Sources:

• Cash position of $3.7 billion as of December 2014
• Committed credit lines of $5 billion maturing in 2016 and 2018 (the ones maturing in 2016 are being extended through 2020)
• Expected operating cash flows of $6 billion in 2015
• Asset sales/nonrecurring cash sources totaling $4.5 billion in 2015

Principal Liquidity Uses:

• Scheduled debt amortization of about $1.700 million in 2015 (as of March 31, 2015)
• Capital expenditures of $8 billion in 2015
• Dividend payment of $1 billion in 2015
• REFIS payments of about $420 million in 2015

Mr. Ocampo added: "The negative outlook incorporates the significant pressure from Vale's sizable expansion amid record low iron ore prices. This would require substantial mitigating measures that we believe the company can deliver but that entail uncertainties on timing and impact. In addition, some of them may eventually impair the noncore business units' future cash flow generation. These risks reflect a one-in-three likelihood of a further one-notch downgrade in the next 12-18 months."

We could further downgrade Vale by one notch if prospects to bring adjusted debt to EBITDA below 4x and FFO to debt close to 20% by 2016 become unrealistic.

An upside is less likely at the moment given our current price assumptions, but we could revise the outlook to stable if spot prices rebound to $60 per ton, making the need of asset sales/nonrecurring cash contribution measures less relevant in 2016.

RATING ABOVE THE SOVEREIGN

Our ratings on Vale are one notch above the sovereign foreign currency ratings mainly because we believe it has a "moderate" exposure to country risk. Therefore, it can continue serving its debt obligations under a sovereign stress scenario. In determining Vale's ability to survive a sovereign distress we mainly consider its large export base which accounts for more than 80% of its revenues; its robust cash holdings which are mostly located outside the country; and its committed credit lines for $5 billion contracted with international banks and available in any country the company designates through 2016 ($3 billion) and 2018 ($2 billion). Also, a sovereign's distress would likely involve a severe currency depreciation which would actually improve Vale's profitability.

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