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

DBRS has today confirmed the rating of Labrador Iron Ore Royalty Income Fund (Labrador or the Fund) at STA-3 (low). 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. DBRS notes that it is the Fund’s policy to make distributions to unitholders based on earnings received from their interests, as such, the distributions can have some volatility.

The Fund receives its royalty stream based on the revenue of Iron Ore Company of Canada (IOC) through Labrador Mining Company Limited (Labmin), with revenue much more stable than earnings. IOC is majority owned (58.72%) by Rio Tinto Group (rated A (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. However, IOC faced a labour disruption when the United Steel Workers of America went on strike on March 9, 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 resulted in reduced royalty payments to the Fund in the second quarter of 2007. Despite this, the Fund was able to make its regular quarterly distributions during 2007, in addition to making debt repayments. A five-year collective agreement was announced on April 26, 2007, resulting in labour stability.

IOC enjoys a secure place in world markets as there is a limited supply of iron ore for record levels of demand (brought on by the tight steel market), 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. In addition, IOC has announced a significant three-year capex program which could impact dividend distributions to the Fund in the coming years; however, this should be offset by the significant increase in royalty revenue to be received due to the considerable surge in iron ore prices (resulting from strong supply and demand fundamentals). IOC has recently settled its iron ore concentrate and pellet contracts for 2008, resulting in an increase of approximately 68% and 86%, respectively, over 2007 prices.

Further supporting the STA-3 low rating are the long-life iron ore reserves at Labrador City and strong market cap.

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