Iron Ore Prices Will Boost Vale’s Underlying Earnings But Tax Dispute Settlement Will Result In Net Loss

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Vale (NYSE:VALE), the world’s largest iron ore mining company, will announce its fourth quarter earnings results on Thursday, February 26 after markets close and hold the earnings conference call on February 27. We believe higher iron ore prices had a significantly positive impact on its year-over-year underlying earnings, since iron ore constitutes the majority of its business. Iron ore prices were higher than expected in the third quarter due to the resilience of the Chinese economy, which defied slowdown expectations.

In the fourth quarter Vale sold 26.5% stake in its logistics unit VLI to Brookfield Asset Management for $2 billion. The sale agreement is subject to approval from relevant authorities. [1]

This quarter, the company hasn’t released its production report ahead of its earnings results.  Otherwise we would have greater clarity about the company’s expected performance ahead of earnings.

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We have a Trefis price estimate for Vale of $15, which will be updated once the fourth quarter earnings results are out.

See Full Analysis of Vale Here

Iron Ore Prices

To the surprise of most observers, the average price of iron ore in the fourth quarter was higher than in Q4 2012, despite a slowdown in China. This will boost Vale’s underlying earnings significantly. Since Vale has not released data on production and sales volumes yet, it is difficult to quantify the impact of higher prices on its underlying earnings.

We think that higher iron ore prices were mainly due to an economically irrational expansion of steelmaking capacity in China, buoyed by state subsidies and encouragement from local government officials. While the central government has belatedly ordered a crackdown by forcing polluting facilities to shut down, the full impact of this move is yet to be observed. Our opinion is that Vale may benefit if low-quality iron ore sources in Chinese steel mills are replaced by iron pellets and lumps, as efforts to control pollution get underway. However, that largely depends on whether the commitment of the central government persists going forward. After all, even in the past, the Chinese government has shied away from harsh measures in the face of economic slowdowns for fear of causing wider unrest. ((Iron Ore Spot Price Chart, YCharts))

Stake Sales In VLI And Norsk Hydro

In addition to selling a 26.5% stake in VLI to Brookfield in the fourth quarter, Vale has previously sold 20% of its stake in it to Mitsui for $667 million and an additional 15.9% to FGTS for $573 million. Considering this, Vale has monetized a significant portion of its holding, bringing its stake in VLI to 37.6%.  However, it will retain management control. [2]

VLI has significant concessions for operating railroads, and also owns port infrastructure and warehouses. Its integrated logistics system enables it to transport cargo for more than 100 clients across the length and breadth of the country. Vale’s decision to reduce its stake in VLI is part of its strategy to get rid of non-core assets in order to reduce future capital expenditure on them, and instead concentrate on its core operations. As a part of the same strategy, Vale also sold its residual 22% stake in the Norwegian aluminum producing company Norsk Hydro ASA in the fourth quarter. While all of the 407 million shares had already been sold for $1.66 billion when the company made the announcement, it had said that if the over-allotment option is exercised in full, the figure would go up to $1.80 billion. [3]

Tax Dispute Settlement Will Hit Profits

Vale opted to settle a long-running tax dispute with the Brazilian government by agreeing to pay $9.6 billion, which is 30% less than the $14 billion the government was demanding. The tax dispute was creating business uncertainty for the company and causing its shares to trade at a lower price in the market. The fine will be funded with operating cash flow, rather that debt.  And it will hit the income statement  as a large non-recurring event. [4]

What We Will Be Watching

We would like to have an insight into the management’s thinking about iron ore prices in the next 2-3 years. Rival companies Rio Tinto and BHP Billiton have accepted that prices are likely to be low going forward due to oversupply. We would like to know if Vale agrees and has a plan to counter this by raising production volume to compensate.

We would also like to know if Vale plans to sell any more non-core assets in 2014. The company’s capital expenditure outlook for 2014 will give us better insight into its business strategy.

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Notes:
  1. Vale signs agreement to sell additional stake in VLI, Vale News Release []
  2. Vale reaches agreement to sell stakes in VLI and negotiates sale of an additional stake, Vale News Release []
  3. Vale prices offer to sell Norsk Hydro shares, Vale News Release []
  4. Vale to pay $9.6bn to end tax dispute, Financial Times []