Vale Worth $26 Despite Iron Ore, Political Pressures

Vale (NYSE:VALE), the world’s largest iron ore miner, has faced many hurdles in recent quarters – mainly related to China, the world’s largest consumer of iron ore and copper. In January, China stopped the company’s giant “Valemax” ships from docking at its ports. Meanwhile, Chinese steel companies forced Vale to change its iron ore contract pricing mechanism and launched their own iron ore trading platform. Then China’s reduction of its GDP target growth rate raised demand concerns. These issues, in addition to heavy rains in Brazil, weighed on the company’s first quarter earnings. Vale‘s huge dependence on iron ore make it more sensitive to pricing fluctuations than competitors Freeport McMoRan (NYSE:FCX), and Rio Tinto (NYSE:RIO).

We have revised our price estimate for Vale to $26, which is about 20% above the current market price. We have updated our model to eliminate the sold aluminum division and have updated our forecasts for shipments, pricing, and capital expenditures over the next 2-3 years to reflect the company’s near-term outlook.

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Iron ore prices, production weigh on earnings

In the first quarter  the company’s revenues totaled $11.3 billion, down 16% on a year-over-year basis and 23% sequentially, as a result of lower average realized prices for iron ore and pellets as well as lower shipments. Rising raw material costs and lower prices translated into an overall decline in operating margins as EBITDA fell significantly to $4.9 billion. Heavy rains in Brazil also contributed to the margin pressure as they resulted in higher transportation costs.

Dull outlook for iron ore prices, shipments to rise

After two years of spectacular growth on the back of skyrocketing iron ore prices, Vale is now feeling a pinch as iron ore prices come under pressure. Construction activity in China has slowed, leading to a piling up of inventories and a resulting decline in demand, as iron ore is primarily used in steel production. We expect iron ore prices to remain weak in the near-term due to additional capacity expected to come online over the next two years. However we do still expect China to be the primary growth driver for iron ore demand.

Vale is developing new mines and plans to invest about 50% of its total capital expenditures on this business. The company spent nearly $4 billion in capex in Q1, up significantly from the prior year’s quarter. We forecast Vale’s iron ore shipments growing moderately as the company’s construction of giant “Valemax” vessels and a distribution center in Malaysia with a capacity of 30 million tons per annum (expected to be operational in 2014) should help it tap the Asia Pacific market, where mining behemoths Rio Tinto and BHP Billiton have a proximity advantage over Vale.

Fertilizer presents a promising opportunity

Agriculture, a sector that is largely immune to recessions, is the fastest growing industry in Brazil. It grew by 3.9% in 2011, compared to the country’s GDP growth of 2.7%. ^[1] To hedge against any economic uncertainty and tap the underlying growth potential, Vale is betting on fertilizer. The company has increased its stake in its own fertilizer production company Vale Fertilizantes SA. Further, the company intends to invest around 10% of its $21 billion planned capital expenditures on the fertilizers business in 2012. ((Vale Pays $1.1 Billion to Increase Fertilizer Unit Stake, Bloomberg, Dec 13 2011))

Rising input costs remain an issue

We expect ferrous minerals, nickel, copper and other base metal margins to decline gradually mainly due to rising energy, labor and other input costs. Ferrous minerals will likely be the most affected due to falling iron ore prices. Vale has taken various measures to combat this, including the construction of its Valemax vessels, which could significantly reduce the company’s shipping costs for iron ore as they each have a capacity of 400,000 deadweight tons. However, the plan has not yet come to fruition as China has refused to allow these ships to dock at its ports in order to protect its domestic freight industry. The company may have to wait until 2014 for the completion of its distribution center in Malaysia to fully use those vessels.

We expect margins to improve in the company’s other businesses mainly on the back of economies of scale and the company’s efforts to improve operational efficiency.

Taxes could increase

The Brazilian government is mulling an increase in taxes on the mining sector, while the Brazilian state of Para – from which Vale produces a third of its total iron ore output – has introduced a new mining tax. This move could prompt other states to take similar steps as they seek to increase their revenue from the nation’s huge mineral wealth. ((Vale’s Biggest Mine Faces New Brazilian State Tax in Para, Bloomberg, March 23 2012))

Vale well-positioned to withstand near-term pressures

Mining companies have always been susceptible to macroeconomic and political risks. Being one of the largest mining companies in the world, Vale cannot remain insulated from such issues. However, we believe that the aforementioned issues won’t hamper the company’s long-term prospects and believe its long-term outlook is strong.

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1. Brazil’s GDP up 2.7% in 2011, ChinaDaily USA [↩]