The first half of 2013 has not been favorable for the Brazil based World's largest iron ore mining company, Vale S.A. (NYSE:VALE). It observed an 84% year-over-year decline in earnings in the second quarter. This was due to more than 26% decline of iron ore prices from February 2013 to July 2013. We believe if this phenomenon continues, Vale could report its lowest year-over-year earnings since iron ore business contributes approximately 70% of its total revenue. Recently, the stock was in the spotlight because of its ongoing legal battle with the Brazilian government to reduce the tax debt on Brazilian companies that own subsidiaries abroad. The regulation approved by the government last week rejects the fines and interest if companies pay their debts in one installment.
The tax debt from Vale is around $13.8 billion, and if Vale pays the debt in one installment, then the debt will be reduced to 20% of the amount. We expect Vale will be able to save approximately $11 billion in costs, which it can invest in future growth initiatives.
Sale of stake will trigger growth initiatives
Vale agreed to sell 35.9% stake in its cargo logistics unit, Vale Logistic Integrada, or VLI, to Japan's Mitsui (OTCPK:MITSY) and a Brazilian government fund managed by Caixa Economica Federal bank for $1.2 billion. It is also planning and negotiating to sell another 26% stake in VLI to Brookfield Asset Management (NYSE:BAM), which would cut Vale's share of VLI to 38.1%. Vale's VLI unit consists of its general cargo operations, or operations indirectly related to the transport of its iron ore output and other minerals. The company is selling the stake to focus on its more profitable iron ore business to recover profit margins that have been lower due to the falling iron ore prices. Before the stake sale, Vale was Brazil's largest rail operator, with more than 6,200 miles of railroads in Brazil, and largest private operator of ports and terminals.
Despite of the stake sale, Vale's iron ore stock, locomotives, and approximately 100 clients will not be affected in terms of transportation capacity. They will still have access to Vale's Carajas and Vitoria-Minas railway systems situated in Brazil, which have a combined capacity to move Vale's annual output of around 300 tons. On the other hand, VLI will have access to Vale's ports and warehousing facilities in Brazil. Going forward, the company will invest over $4 billion in VLI over the next five years to enhance its railroad system. We believe that the company will leverage from the investment by transporting its iron ore output from the mines to the port. This will also help Vale increase emphasis on its iron ore business; the cash from the VLI stake sale would help fund the company's growth prospects without weighing on the balance sheet.
New project will further ascertain growth
Along with the stake sale of its logistic business, Vale is currently investing $19.6 billion in the S11D iron ore project to strengthen its iron ore business further. This project includes construction of a railway line, port, and a processing plant in Brazil. According to the company, the S11D project is the largest single iron-ore project in history, and it will produce 90 million tons of iron ore every year. We expect this increase in capacity will help Vale meet additional demand. The company is already experiencing heavy demand from China, its biggest market outside Brazil. In July this year, the imports from China rose 17% to 73.14 million metric tons in comparison to June. The demand for iron ore from China is expected to reach 1.13 billion tons by 2015. We believe the company will benefit from the rising demand and post strong numbers in the next two years.
To meet the rising demand, Vale will take advantage of the increased logistics capacity, which will be 230 million tons per year for its Carajas mine. Iron ore production from the constructed plant is expected to start in the second half of 2016 and should reach full capacity in 2018. We believe the S11D performance has been impressive, as Vale has observed $450 million in procurement related cost savings with more left to achieve. The company saved $1.6 billion in cost during the first half of this year, and it expects 2013 to finish at over double the first half achievement. In our view, the savings are permanent and present a great source of value generation. Additionally, it can also benefit from the weaker Brazilian currency 'Real' against foreign currencies. For instance, every 0.10 cent depreciation in Brazilian Real against USD, it generates around $700 million in cost savings and EBITDA. It will observe an overall cost savings of over $2 billion in the second half of this year.
The stake sale and its investment in the S11D project are essential to its future success. This will help it compete with other mega iron companies including Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP). Both these players from the iron ore industry also supply iron ore to China. These two companies are also looking forward to focus on iron ore production with expansion projects through low cost iron ore operations to meet the rising demand from China. We believe that these companies, which are considered to be the 'Big Three' of the iron ore industry, have potential to profit from the growing iron ore demand.
Together with the initiatives these companies are taking, let's have a look at the valuation metrics that will support these companies moving forward.
Source: Yahoo! Finance
As illustrated in the table above, Vale is stronger in terms of the valuation metrics when compared to the iron ore giants. While considering the EV/Revenue metric, Vale is placed at a considerable position, but BHP Billiton has a stronger future sales prospect. Rio Tinto and Vale have strong P/E ratios, and investors can expect growth in the coming quarters. Moreover, Vale's trailing P/E is expected to drop to 8.01, which depicts that the investors can expect a strong 2014. When compared to the 'Industrial Metals and Minerals' industry, Vale seems to be highly undervalued as the industry has a high trailing P/E ratio of 60.9 times.
We believe that Vale isn't dominating the industry but does have solid potential to outnumber its peers. The stake sale and expansion project will bolster its revenue in the next year. Based on these initiatives to capitalize on iron ore, we expect the stock to go beyond its current trading level in the coming quarters.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Madhu Dube, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.