Vale Earnings Preview: Higher Iron Ore Volumes to Partially Offset Effect of Lower Prices on Results

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Vale (NYSE:VALE), the world’s largest iron ore mining company, will announce its second quarter earnings results and conduct a conference call with analysts on Thursday, July 31. We expect lower iron ore prices in the second quarter, as compared to the corresponding period last year, to negatively impact the company’s quarterly results. The company has released its production report ahead of its earnings announcement. Higher iron ore shipment volumes in the second quarter, supported by the ramp-ups of Plant 2 in Carajás and the new Conceição Itabiritos plant, will partially offset the negative impact of lower prices on results.

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Iron Ore Prices

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Iron ore is an important raw material for the steel industry. Thus, demand for iron ore by the steel industry plays a major role in determining its prices. International iron ore prices are largely determined by Chinese demand since China is the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. [1] Flagging demand for iron ore from China in the wake of an economic slowdown earlier on in the year, put downward pressure on iron ore prices. According to data from China’s National Bureau of Statistics, growth in investment, factory output and retail sales slowed to multi-year lows in the first two months of the year. [2] A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, tightening of credit by Chinese banks to steel mills that are not performing well will negatively impact these mills’ prospects. [3] Furthermore, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth to services and consumption led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for steel in the long term. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. [4] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, expansion in production by iron ore majors such as Rio Tinto and BHP Billiton has created an oversupply situation. A combination of weak demand and oversupply is likely to result in lower iron ore prices in the near term. [5] Iron ore spot prices stood at $92.74 per dry metric ton (dmt) at the end of June 2014, about 19.2% lower than a year ago. ((Iron Ore Spot Price Chart, YCharts)) The outlook on iron ore prices remains bleak in the near term, in view of the oversupply situation. Iron ore and iron ore pellets collectively accounted for around 73% of Vale’s net operating revenues in 2013. [6] Weak iron ore prices will certainly have a major impact upon the company’s results.

Production Review

Iron ore production in Q2 2014 rose to 79.4 million tons, which is Vale’s highest ever second quarter production figure. Iron ore production in the second quarter was 12.6% higher than in the corresponding period last year. The increase in iron ore production in the second quarter was due to the ramp-ups of Plant 2 in Carajás and the Conceição Itabiritos plant. [7] The increase in iron ore output is consistent with Vale’s long term plans to boost volumes, capitalizing on its low-cost iron ore deposits. Various projects are expected to result in growth in Vale’s iron ore production from 321 millions tons in 2014 to 453 million tons in 2018. [8]

Nickel production stood at 61,700 tons in Q2 2014, 5.2% lower than the corresponding period a year ago. This fall in production was mainly due to suspension of operations at the Sudbury mining complex as a result of an accident and scheduled maintenance activity. Copper production stood at 81,000 tons, down 11.3% from the corresponding period a year ago, primarily due to scheduled maintenance activity at the Sudbury mining complex. Coal production stood at 2.2 million tons in Q2 2014, up 23.8% sequentially, due to higher output from the Carborough Downs and Moatize operations. ((Vale’s Q2 2014 Production Report, Vale Website))

Other Developments

In view of the weak iron ore pricing environment, Vale has adopted a strategy of cost reduction, disciplined capital allocation and divestment of non-core assets in order to remain competitive. Vale has embarked upon a mission to optimize its portfolio, divesting non-core assets in order to free up capital and invest it in projects that will give better returns. The company sold non-core assets and investments worth $6 billion in 2013. [9] The company continued this strategy in the second quarter with the sale of its stake in FIP Vale Florestar for aorund $92 million. ((Vale Sells Stake In Vale Florestar, Vale Press Release))

In addition, the company has also significantly reduced its capital expenditure. Going forward, it is focusing on a smaller project pipeline that would generate greater value for shareholders. Vale’s capital expenditure reduced from $16.2 billion in 2012 to $14.2 billion in 2013. The company’s capital expenditure budget for 2014 is even lower at $13.8 billion. [6]  The decision to idle its Integra Coal Mine, announced in the second quarter, is consistent with its strategy to allocate capital to projects that will generate better returns. ((Vale Comments On Integra Coal Mine, Vale Press Release))

As a part of its efforts to enhance efficiency and cut costs, Vale generated savings of $2.8 billion in 2013. [9] The company continued to achieve results in its cost reduction efforts with savings of $218 million in Q1 2014, as compared to the corresponding period last year. [10]

Expectations from Conference Call

With iron ore prices likely to remain subdued in the near term, we would like to know what the company’s strategy is in response to the prevailing pricing environment. Specifically, we would like to know if the company management has identified any further opportunities for portfolio optimization or cost reduction. This will throw some light on the road ahead for Vale.

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Notes:
  1. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  2. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters []
  3. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  4. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  5. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb []
  6. Vale’s 2013 20-F, SEC [] []
  7. Vale’s Q2 2014 Production Report, Vale Website []
  8. Vale Day 2013 Presentation, Vale Website []
  9. Vale’s Q4 2013 Earnings Conference Call Transcript, Seeking Alpha [] []
  10. Vale’s Q1 2014 Earnings Conference Call Transcript, Seeking Alpha []