DBRS Confirms Stability Rating of Labrador Iron Ore Royalty Income Fund at STA-3 (low)

DBRS has today confirmed the stability rating of Labrador Iron Ore Royalty Income Fund (Labrador or the Fund) at STA-3 (low) based on the Fund’s long distribution history and its performance remaining on track. The non-operating, royalty-based income structure of the Fund and its lack of leverage have allowed it to maintain a higher stability rating than most of the commodity-based funds that rely on operating profits as a source of income for distributions, which are rated by DBRS generally in the STA-4 to STA-6 range. DBRS notes that it is the Fund’s policy to make distributions to unitholders based on its income from the Iron Ore Company of Canada (IOC), which means that DBRS expects the Fund’s distributions to have some volatility.

The Fund receives the bulk of its income from a 7% gross overriding royalty on the revenue of IOC. Income received by way of revenue is far more stable than earnings. This royalty stream accounts for about 75% (average over the last five years) of the Fund’s operating cash flows with the remaining 25% derived from dividends paid by IOC to the Fund as a result of the Fund’s indirect equity interest in the Company.

IOC is majority owned (58.72%) by Rio Tinto plc, one of the world’s largest mining companies. IOC is the fifth-largest pellet producer worldwide and is well regarded for its high-quality products. As well, access to low-cost power from Newfoundland and Labrador Hydro helps cement its favourable cost structure (second quartile on the cost curve). Further supporting the STA-3 low rating are the long-life iron ore reserves at Labrador City.

The main issues facing the Fund are its reliance on IOC, which itself is a highly concentrated, one-operation business. The Fund receives its royalty stream from IOC in U.S. dollars, so a stronger Canadian dollar will lower the amount of cash available for distribution in Canadian currency. In addition, IOC sells its products in U.S. dollars and most of its costs are in Canadian dollars exposing its net income and its ability to pay dividends to the Fund to foreign exchange risk.

IOC has been a competitive producer in international iron ore markets for decades. The Company has a long-lived reserve base and an established place in international markets amongst steelmakers in North America, Europe and Asia. DBRS sees minimal risk in IOC ceasing operations for an extended period of time, so the Fund’s royalty income is expected to persist subject to volatility of iron ore prices, exchange rates and variances in iron ore sales volumes.

World steel markets have weakened dramatically following the financial crisis of the fall of 2008. With a high level of uncertainty in the world economy, steelmakers have sharply cut back production in the fourth quarter of 2008 and the first quarter of 2009. In response, they have cut back on their demand for steelmaking materials including iron ore. Reduced demand for iron ore has been exacerbated by a de-stocking of supply chain inventories resulting in an outlook for much lower prices in 2009. This stands in stark contrast to iron ore markets in the first three quarters of 2008, which were experiencing supply shortages and record prices.

During the fourth quarter of 2008 and Q1 2009, IOC experienced sharply reduced demand for iron ore and has cut back production to avoid building excessive inventories. DBRS expects the Fund’s royalty income to weaken in the near- to medium-term with reduced iron ore sales by IOC and lower iron ore prices to be partially offset by a weakening Canadian dollar relative to the U.S. dollar. Although contract negotiations have not concluded, DBRS expects that the 2009-2010 contract price for iron ore will be up to 40% lower than the previous contract year. This, in conjunction with IOC’s discretion over dividend payments (which may be limited during 2009), will reduce the Fund’s expected income and its ability to pay distributions at 2008 levels.

The Fund has built up cash reserves in 2008 in anticipation of weak results in 2009 and could support distributions at current levels, despite weakened market conditions. Moreover, the Fund has available credit facilities to support distributions temporarily. If iron ore prices are further depressed, DBRS expects that the Fund is not likely to maintain regular distribution levels of $0.50 per unit per quarter, but we do expect that the Fund should be able to distribute at least $0.35 per unit per quarter in the remainder of 2009, which is consistent with 2007 and 2006 regular distribution levels.

DBRS believes that the commodity markets are likely to stay weak in 2009 and that a subsequent recovery will take hold in 2010 resulting in higher iron ore prices and restoration of sales volumes. As such, DBRS expects that the Fund will be able to support 2010 distributions to unitholders at 2009 levels, at a minimum.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Mining, which can be found on our website under Methodologies.

This is a Corporate rating.