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

DBRS has confirmed the rating of Labrador Iron Ore Royalty Income Fund (Labrador or the Fund) at STA-3 (low). This action removes the Fund from Under Review with Developing Implications, where it was placed on November 1, 2006, when the Federal Government announced significant changes to the way in which Canadian income trusts will be taxed in the future. The confirmation of the Fund’s stability rating follows DBRS’s expectations of minimal changes to the Fund’s business strategy and financial plans over the near term, despite the proposed changes in legislation to tax income funds beginning in 2011.

The performance of the Fund remains on track. The non-operating, royalty structure of the Fund and its strong balance sheet have allowed it to maintain a higher rating than most of the commodity-based, non-royalty funds rated by DBRS, which are generally in the STA-4 to STA-6 range. The Fund has been able to maintain a stable distribution history. In addition to making its regular quarterly distributions, in the last three quarters of 2006 the Fund declared special dividends, after setting aside funds to reduce debt.

The Fund receives its royalty stream based on the revenue of Iron Ore Company of Canada (IOC) through Labrador Mining Company Limited, with revenue much more stable than earnings. IOC is majority owned (58.72%) by Rio Tinto Group (rated AA (low) by DBRS), 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. Furthermore, access to low cost power from Newfoundland and Labrador Hydro helps cement its favourable cost structure (second quartile on the cost curve). DBRS sees minimal risk in IOC ceasing operations, so the royalty is well protected.

IOC faced a labour disruption when the United Steel Workers of America went on strike on March 9, 2007. A five-year collective agreement was announced on April 26, 2007. During the work stoppage, IOC continued to ship iron ore pellets and the seven-week strike did not affect royalty payments. However, the suspension of operations led to a depletion of inventory and this will affect royalty payments to the company in the second quarter of 2007.

IOC enjoys a secure place in world markets as there is a limited supply of iron ore for record levels of demand; conditions that are expected to continue for the foreseeable future. The Fund remains essentially debt free and has maintained (but not used) the ability to temporarily cover its distributions through borrowings (bank lines are in place out to 2009) should the royalty stream be affected by one-time events. Because of the non-operating nature of the Fund, it has no capital expenditures to finance.

The main issues facing the Fund are its reliance on IOC, which itself is a highly concentrated one-operation business, and a high exposure to the Canadian dollar. 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. Despite these issues, the Fund can maintain its STA-3 rating category given the sustainability of its distributions, which are underpinned by its royalty stream, and the long-life iron ore reserves at Labrador City. Even during the last cyclical downturn, the Fund was able to essentially keep its payout ratio near 100% exclusive of one-off events such as special dividends.