Vale's Results Will Benefit From Higher Iron Ore Prices

| About: Vale S.A. (VALE)

Vale (NYSE:VALE), the world's largest iron ore mining company, will announce its third quarter earnings results on Wednesday, November 6, after markets close. We expect higher iron ore prices to have a significantly positive impact on its year-over-year earnings since iron ore constitutes the majority of its business. Iron ore prices were higher than expected in the third quarter due to the resilience of the Chinese economy which defied slowdown expectations.

In the third quarter, Vale struck a deal to divest 36% of its stake in its logistics subsidiary VLI for approximately $1.2 billion. The company's decision to reduce its stake in VLI is part of its strategy to get rid of non-core assets in order to reduce future capital expenditures on them and instead concentrate on its core operations.

This quarter, the company hasn't released its production report ahead of its earnings results otherwise we would have had greater clarity about the company's expected performance.

We have a Trefis price estimate for Vale of $17, which is nearly the same as the current market price. We will update our price estimate once the third quarter earnings results are out.

Iron Ore Prices

Iron ore prices in the third quarter were higher than expected because the sentiment about China's economy was buoyant, defying previous expectations. The production of steel surged due to the stimulus aimed at stabilizing the country's economy. Since inventories of iron ore were low, increased demand from the steel industry triggered a rise in demand for iron ore. (Iron Ore Spot Price Chart, YCharts)

However, once the stocking cycle is over and more supplies of iron ore hit the market, prices are likely to go down. According to the Bureau for Resources and Energy Economics, the official Australian commodities forecasting agency, iron ore exports from Australia are expected to grow at an annual rate of 8% between 2014-2018. The rise in demand is not expected to be commensurate with the rise in supply. Vale expects its ambitious S11D project in Brazil to start iron ore production in 2016 and will likely face the brunt of falling prices even as its production volume surges. [1]

In fact, low operating costs are likely responsible for the mining giants' decision to go ahead with a production surge despite the inevitable fall in prices they would have to face. They may be banking on pushing the high cost miners out of the market in an environment of falling prices and capturing their business. [2]

The VLI Stake Sale

In the third quarter, Vale struck deals to sell a 36% stake in its logistics unit VLI, a 100% subsidiary, to Japan's Mitsui & Company Ltd. and Brazil's worker compensation and retirement fund FGTS. While Mitsui will pay $667 million for a 20% stake, FGTS will pay nearly $573 million for a 15.9% stake. [3]

At the time of announcing these deals, Vale was also in discussion with Brookfield Asset Management to sell a further 26% stake in VLI. While the deals with Mitsui and FGTS, when concluded, will bring Vale's stake in VLI to 64.1%, a potential deal with Brookfield will bring it down to nearly 38%. Even with less than a 40% stake, Vale will retain management control of VLI. [4]

Why Vale Is Selling Stake In VLI

In Q2 2013, Vale reported a net quarterly profit of $424 million compared with a profit of $2.64 billion in Q2 2012. The previous year's results included $1.24 billion in the reversal of deferred income tax while this year net income plunged due to a surprise $2.78 billion hit from foreign exchange losses on currency derivatives and debt. The Brazilian currency real depreciated significantly against the U.S. dollar. Excluding these items, net profit stood at $3.24 billion. Net operating revenue fell to $11.03 billion from $12.47 billion in the previous year's comparable quarter, mainly due to lower iron ore prices. [5]

Vale is looking to cut down on capital expenditures on non-core businesses in order to fund its iron ore growth projects. Hence, selling a stake in VLI is a prudent move by the company to bring in equity partners to share its burden. In its 2012 annual report, Vale had expressed its desire to bring in equity partners in VLI to fund its capital requirements. Therefore, the stake sale is'n't surprising for the market. [6]

Vale will retain management control of VLI even if its stake falls to less than 40%. In recent years, the Brazilian government has pushed Vale to set up and maintain freight operations, even as its own efforts in the area have faltered due to high costs, bureaucratic obstacles and political conditions. Therefore, the stake sale in VLI will reduce Vale's burden to some extent. Vale is even considering a public listing for VLI going forward, which will help it raise more money and reduce its own commitment. We think it would allow Vale to better compete with global mining rivals such as Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), which are also reducing non-core assets to focus on their bread-and-butter iron ore business.

There have been no further updates from Vale regarding the final outcome of discussions with Brookfield or the timeline for conclusion of the transactions with Mitsui and FGTS. We will look out for any announcements in this regard in the earnings conference call. We would also like to know what the management's view on China's economic growth prospects in the next few years as it would be a major driver of Vale's business going forward.

Disclosure: No positions.