The recent surge in the iron ore prices has sent bullish signals to the market. It seems that the Chinese stimulus might have started to "show its color" on the economy. With the price of iron ore climbing over $130/ton, the stock prices of the iron ore mining companies are witnessing a rally. In this scenario, the question is: Which is the best bet among the mining stocks to benefit from the rebound in the iron ore prices?
I believe that Vale S.A (VALE) is the best-positioned stock among the mining companies to appreciate in 2013. This became clear when the company announced its outlook on the investors' day on 3rd December 2012 (discussed in detail below). Before I state the main reasons why I recommend VALE as a buy, I should briefly touch upon the fact that why iron ore is important for VALE:
- The company is the second largest producer of iron ore in the world.
- The company generates 58% of its total revenues from iron ore. Iron ore also generates the largest share in the bulk material segment accounting for 78% of the segment revenues.
I recommend VALE as a buy because of:
- An improvement in the iron ore spot prices
- The changes brought in Vale's strategy by its management
The improvement in the iron ore spot prices is quite evident given that the price has exceeded $130/ton. This Thursday, the price touched $135/ton which is the highest level it has achieved in the last five and a half months. Given that already many people have written on the topic of the rebound in the iron ore prices, I will not emphasize much on it.
It is the strong strategy that Vale has drafted over the last couple of months that has sent bullish signals to the market. Overall, the mining industry is in the process of adapting to a new business environment which is marked by low growth rates and high level of uncertainty. The companies are cutting CAPEX, prioritizing investments and being more disciplined on capital allocation. Vale has been doing the same as well. The company has already sold $1 billion worth of non-core assets in 2012 and should continue to do so.
In its investors' day on 3rd December 2012, the company announced its future strategy. The key takeaways compelled me to make VALE the top pick among the iron ore players for 2013:
- The capital allocation: The company is not only running after sizeable project but is also working hard to secure contracts with high return. By this I mean that the management is focused on winning world-class projects.
- The preservation of investment grade rating: The management indicated that there should be no material increase in the leverage in 2013. Therefore, the company is trying to match its operating cash flows with its outlays.
- The stabilization of the maintenance CAPEX at lower levels: The maintenance CAPEX is currently stable and is hovering around 5% of the company's asset base. However, the company still sees room for further reductions.
- Pulling the brakes on the R&D expenditures: The management expects the R&D expenditures to decline to levels below $1 billion from 2014 onwards. This has sent bullish signals to the market. Several investors have been deeply concerned about the high level of R&D committed by the company during the past years.
- Cutting the SG&A expenses: Vale is forecasting a reduction in SG&A expenses of 20% in 2013, which is more than what the Street estimated.
- A reduction in the operating expenditures: The company is also taking initiatives to lower its operating expenditures. The company has recently shut down its less profitable mines and plants in different parts of the world (e.g. coal mines in Australia / pellet plants in Brazil).
Looking for partners to mitigate risks:
(1) Potash project with Rio Colorado: Vale is reevaluating the project ("slowing the project down"), and also looking for a partner;
(2) VLI (logistic unit - general cargo unit): Vale plans to sell almost 70% of its stake in the VLI unit. The company has already been approached by several interested parties.
(3) Nacala Corridor: Vale launched the construction of its US $1.1 billion heavy haul freight corridor to the port of Nacala in the start of December this year. Vale is looking to bring in a partner to mitigate risks in the project.
(4) CSP (steel): The Companhia Siderúrgica do Pecém (CSP) steel mill started construction works in July this year. The budget for the project is $4.34 billion. However, in the future, Vale is expected to reduce its participation in the project.
The Tax disputes
The company has achieved success in getting some of its tax issues resolved. However, some of the issues have not yet received a final verdict:
(1) The inspection fee on the mining activity (TFRM): The company has managed to convince the government of Pará and Minas Gerais to reduce the TFRM. The government of Pará reduced the TFRM by 67% to $2.6/ton. The regulators at Minas Gerais have also reduced the rate by 60%.
(2) VAT tax (ICMS): On 19th December 2012, the company announced to adhere to the new legislation on the Value Added tax (VAT) on services and circulation of goods (ICMS) enacted by the Brazilian state of Minas Gerais. Therefore, the existing legal proceedings related to this case will automatically cease.
(3) Foreign profits litigation: The Brazilian Federal Revenue Service (RFB) is pursuing Vale for more than $14.84 billion in taxes for assessments on profits of its foreign subsidiaries carried out between 1996 and 2008. The final decision on Vale's injunctions is still pending in Brazilian Superior Courts (there is no incremental information - but the sell-side is confident on a positive outcome);
(4) CFEM (royalties dispute): Recently, the company announced that the chances of losing an ongoing dispute with the federal government over royalty payments are quite high. The final settlement should be close to the already provisioned value of US $ 400 million. The tax is locally known as the CFEM tax.
The divestments are coming - selling non-core assets:
Vale confirmed that it is considering selling its 22% stake in Norsk Hydro (Norway-based aluminum company. The lock-up period will end next February. The company also disclosed that is very close to selling some of its Oil & Gas assets. I also expect the company to divest its assets in its non-ferrous division.
The stock pays a dividend yield of 6.1%. The company is trading at a cheap forward multiple of 8x. Vale is expected to be trading at a forward EV/EBITDA multiple of 6.5x in 2013. This multiple is expected to be re-rated by the investors as they become more confident about the sustainability of the growth cycle of the company. The following chart shows the forecasted iron ore production of Vale:
The company is a large manufacturer of nickel and copper but 90% of its profits (not revenues) come from the iron ore business. This is larger than its competitors like BHP Billiton (BHP), Cliffs Natural Resources (CLF) and Rio Tinto (RIO). With a recovery of iron ore prices on the horizon, I expect Vale to benefit the most from the situation (in the light of the pointers mentioned above.
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