Trends Driving Our $7 Price Estimate For Vale
Vale (NYSE:VALE) is the world’s largest iron ore mining company. The company has been battling a subdued iron ore pricing environment over the past year or so. Benchmark 62% Fe iron ore fines prices stood at $63 per dry metric ton (dmt) at the end of February, around 47% lower on a year-over-year basis [1]. As a result of the fall in iron ore prices, Vale’s adjusted EBITDA margin stood at 24.1% in Q4 2014, as compared to 33.1% in the corresponding period of 2013. [2]
As a result of the persisting weakness in the global economic outlook, as well as in market conditions for iron ore, we have a new $6.77 price estimate for Vale, which is around 14% higher than the market price. In this article, we will look at the trends driving Vale’s business prospects and our valuation of the company’s stock.
See our complete analysis for Vale
Iron Ore Prices
Iron ore is the primary 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. [3] Weak demand for steel in China, has translated into weak demand for iron ore. Chinese steel demand growth is expected to slow to 2.7% in 2015, as compared to 3% in 2014 and 6.1% in 2013, respectively. [4] A slowdown in economic growth has tempered the demand for steel. China’s GDP growth is expected to slow to 6.8% and 6.3% in 2015 and 2016 respectively, from 7.4% in 2014. [5] This is the latest downward revision to expected Chinese GDP growth by the IMF, which has raised question marks about long term demand for iron ore from China. Furthermore, a Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, the tightening of credit by Chinese banks to steel mills that are not performing well, will negatively impact these mills’ prospects. [6] The prevailing weak Chinese economic prospects are captured by the Manufacturing Purchasing Managers’ Index (PMI). The Manufacturing Purchasing Managers Index (PMI) measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, has stood below 50 so far this year. [7] With weak Chinese manufacturing growth, demand for iron ore in the near term is unlikely to grow at rates seen over the last couple of years.
The supply side is characterized by an expansion in production by major iron ore mining companies. Companies such as Vale, Rio Tinto, and BHP Billiton are rapidly ramping up their iron ore production, despite weakness in demand. These companies have low-cost iron ore deposits and are able to operate profitably even at current price levels. [8] These companies are betting on the long-term strength of iron ore demand from China, and the curtailment of high-cost iron ore production capacity, to bring the demand-supply equation back into balance. As per projections by major Wall Street banks, the worldwide surplus of seaborne iron ore supply is expected to rise to 300 million tons in 2017, from an expected surplus of 175 million tons in 2015, and a surplus of 72 million tons and 14 million tons in 2014 and 2013, respectively. [9] [10]
With weak demand compounding a supply glut, average iron ore prices are expected to be significantly lower this year as compared to last year. Prices are likely to remain subdued over the next couple of years, too.
Vale’s Strategy
Despite iron ore prices expected to remain subdued in the near term, the company has adopted a high production volumes strategy. Vale expects to benefit from economies of scale, capitalizing on its low-cost iron ore deposits. In keeping with this strategy, the company’s iron ore production in 2014 rose to 319.2 million tons, around 7% higher than in the corresponding period of 2013. [11] Various projects are expected to result in a growth in Vale’s iron ore production from 331 millions tons in 2014 to 459 million tons in 2019. [12]
However, the drawback of this strategy is that despite the increase in production volumes, Vale may not be able to sell its iron ore output. For example, despite the 7% increase in production volumes, the company’s iron ore shipments rose only around 3% in 2014, partly because of weak demand for the commodity. [13] Thus, the success of the company’s strategy is dependent upon sustained growth in iron ore demand, which may not materialize at the pace envisioned by the company.
Trefis Estimate
In view of the prevailing subdued market conditions for iron ore, we have revised downward our estimates for Vale’s iron ore shipments, realized iron ore prices, and margins. This has led to a downward revision in our price estimate for Vale from $9.04 to $6.77. With the prevailing subdued iron ore pricing environment expected to persist in the near term, prospects look fairly bleak for Vale. Prospects will only improve substantially for the company if there is a significant improvement in market conditions for iron ore. We will be keenly tracking developments at Vale.
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Notes:
- Iron Ore Prices, Y Charts [↩]
- Vale’s Q4 2014 Earnings Release, SEC [↩]
- China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
- Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
- World Economic Outlook January 2015, IMF [↩]
- The Latest Iron Ore Price Slump: Causes and Effects, Forbes [↩]
- China Manufacturing PMI, Trading Economics [↩]
- BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb [↩]
- Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg [↩]
- Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg [↩]
- Vale’s 2014 Production Report, Vale Website [↩]
- Vale Day 2014 Presentation, Vale Website [↩]
- Vale’s 2014 20-F, SEC [↩]