Vale Q2 Earnings Review: Lower Iron Ore Prices Negatively Impact Results

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Vale (NYSE:VALE) released its second quarter earnings results and conducted a conference call with analysts on Thursday, July 30. [1] As expected, the sharp decline in iron ore prices over the course of the last year negatively impacted the company’s results. However, a boost in quarterly iron ore shipments driven by record Q2 production levels, in addition to the company’s cost reduction efforts, partially offset the impact of a fall in prices on the company’s margins. Despite a sharp 40% year-over-year decline in realized prices for Vale’s shipments of iron ore fines, the decline in the company’s adjusted EBITDA margin was far more gradual. [2] Vale’s adjusted EBITDA margin stood at 31.8% in Q2 2015, as compared to 41.5% in the corresponding period of 2014. [2] The company’s net operating revenues for Q2 2015 stood at $6.97 billion, sharply lower as compared to the figure of $9.90 billion reported in the corresponding period of 2014, primarily due to the decline in iron ore prices. [2] In this article, we will take a closer look at Vale’s Q2 earnings results.

Iron Ore Prices

The average realized price for Vale’s iron ore fines stood at $50.62 per ton in Q2 2015, nearly 40% lower than the average realized price for Q2 2014, which stood at $84.60 per ton. [3] The sale of iron ore fines and pellets collectively accounted for around 63% of Vale’s net operating revenues in Q2 2015. [2] Thus, the decline in iron ore prices was primarily responsible for Vale’s poor quarterly results.

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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. Benchmark 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. [4] Chinese steel demand growth is expected to decline by 0.5% in 2015, following on from a similar decline in 2014. [5] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, an expansion in production by major iron ore mining companies such as Vale, Rio Tinto, and BHP Billiton has created an oversupply situation. [6] 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. [7] A combination of weak demand and oversupply is likely to result in weak iron ore prices in the near term. The following chart illustrates the trajectory of iron ore prices over the last twelve months.

Iron Ore Prices, Source: Y Charts

 

Costs

In response to the weak iron ore pricing environment, Vale has adopted a strategy of cost reduction and disciplined capital allocation. In Q2 2015, the company’s costs and expenses declined by 14% to $5.9 billion, as compared to figures for the corresponding period of last year. ((Vale’s Q2 2015 Earnings Release, SEC))

Vale has actively sought to reduce expenses such as SG&A and R&D, both of which declined by more than 25% year-over-year. [2] In addition, the company’s margins were boosted by the sharp increase in iron ore production volumes and the company’s cost reduction initiatives. The company’s cost reduction initiatives were augmented by the depreciation of the Brazilian Real versus the U.S. Dollar, which reduced costs in Dollar terms. Iron ore production in Q2 2015 rose to 85.3 million tons, which was 7.4% higher than in the corresponding period of 2014. [8] The increase in iron ore production was primarily due to the ramp-up of production at the Itabira and Minas Centrais mines, where production rose 11.4% and 18.5%, respectively, year-over-year. [8] 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. As a result of the company’s efforts to reduce production costs, as well as economies of scale arising from the sharp increase in iron ore production volumes, unit cash costs have declined over the course of 2015 from $18.30 per ton in Q1, to $15.80 per ton in Q2. ((Vale’s Q2 2015 Production Report, Vale Website))

The reduction in costs realized by Vale helped offset some of the negative impact of the sharp fall in iron ore prices on the company’s results in Q2. Given the prevailing weakness in iron ore prices, Vale’s cost reduction efforts will stand the company in good stead over the course of 2015 and beyond.

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Notes:
  1. Vale announces dates for reporting of 2Q15 performance, Vale News Release []
  2. Vale’s Q2 2015 Earnings Release, SEC [] [] [] [] []
  3. Vale’s Q2 2015 Earnings Call Transcript, Seeking Alpha []
  4. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  5. Short Range Outlook 2015-2016, World Steel Association []
  6. BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb []
  7. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  8. Vale’s Q2 2015 Production Report, Vale Website [] []