Can Iron Strengthen Vale's Growth Prospects?

| About: Vale S.A. (VALE)

With a record production of phosphate rock, copper and coal, Vale (NYSE:VALE) reported healthy financials in the last quarter. Low quality ore in China and high extraction costs are good news for this Brazilian corporation as it plans to increase its iron ore production by 31 percent by 2017. Let's have a look at how this can translate into value for investors.

Positive Q3 earnings

Source: EBITDA by Business Area, 10Q

This quarter, net sales rose 11 percent YoY, reaching $12.7 billion, beating the average analysts estimate of $12.5 billion. Net income more than doubled and peaked $3.5 billion showing a 115 percent increase than Q312. Cost of goods sold totaled $6.6 billion in the third quarter, down 3.4% year over year. Selling, general and administrative (SG&A) expenditures were $315.0 million, while Research and Development (R&D) expense was $205.0 million, declining 39.3% and 43.1% year over year respectively.

Vale's efforts to initiate the divestiture of unproductive projects by reducing its geographical presence led to this decline in costs. The expected recovery of iron ore and pellet shipments reached 83.6 million tons this quarter being the third largest in Vale´s history. A higher price of iron sold, and volume, was the main driver of the results achieved in 3Q13.

Moreover, the cash cost of iron ore, including mining, planting and transport, after royalties fell to $22.10 per metric ton from US$24.15 in 2Q13. This combination of high quality products with a low cash cost placed Vale at a leading edge in the global marketplace.

China's love for iron

Iron is the key material for steel production. The fastest growing GDP of China has led to an increasing development in industrial estate and infrastructure. China's hunger for steel is allowing Vale to export 50 percent of its production to China, only. In August, China broke its time period record by importing 13.6 million of iron ore from Brazil, with an estimated growth in demand to increase to 10 percent this year.

For the future, the Executive Director for Vale's Ferrous and Strategy says that the growth in China will continue at a rate between 3 to 7 percent in the coming years. He further added that the iron ore prices are not expected to fall and remain between $100 to $110 levels in the future on a sustainable basis. That leaves Vale in a position to benefit from the falling cost strategy it has been following and the rising iron ore prices. Credit Suisse further expects Vale's costs to fall $400 million by the next year. Hence, it is expected that in the future more gains will flow and investors can expect share value to rise.

Disposing VLI

Vale is involved in focusing on its core operation units and disposing unproductive segments. It is focusing on its iron ore segment, which accounts for more than 90 percent of the company's revenue. Consistent with the company's strategy to minimize exposure to non-core assets, on September 18th Vale announced the signing of agreements to sell 35.9% of the total capital of VLI, a wholly-owned logistics operator of general cargo for $1.2 billion. Moreover, it is under final negotiations with a company for the sale of an additional 26% of VLI capital, ultimately reducing its stake to less than 40%. The divestiture will enable Vale to extract the hidden value not priced into its shares and reallocate capital to its core business.

The sale of unwanted business will allow Vale to keep debts at sustainable levels and prevent paying excessive liabilities arising from the $15 billion foreign subsidy tax dispute it is currently involved in with the Brazilian government.

Expansion projects for high organic growth

Source: Company's financials

Vale has started its $3.5 billion Carajas additional 40 Mtpy project in Brazil as it expands production of the steel making raw material. It is investing $34 billion on iron-ore mining and logistics projects that will boost its output capacity by 50 percent to 450 million metric tons in 2018. The company is also developing the Serra Sul mine and logistics venture in Carajas, the world's largest iron-ore complex which at almost $20 billion is the industry's most expensive project. The $3.5 billion Carajas additional 40 metric ton per year project was 95 percent complete at the beginning of 2013 and started its test production in the second half of 2013. The project consists of the construction of an iron-ore dry processing plant, which will have an estimated nominal output capacity of 40 million metric tons a year.

Shale gas again

If we want to know the one thing that is in lime light in the oil and gas sector at the moment, it is shale gas. The expansion of shale-gas production in the U.S. is creating an opportunity for Vale to sell pellets, a processed form of iron ore, to American steelmakers, Vale's CEO Ferreira said in a presentation at the mining event. Pellets account for the second most selling segment of Vale. He further added that the company is in intensive discussions to supply pellets to U.S. steel mills and its Tubarao VIII project will benefit from rising demand in the country.

Foreign litigation could bring value down

In the latest earning announcement, questions were raised about the tax issues, concerning the subsidiaries, in foreign operations of Vale. The tax litigation going around could cost Vale from $14 billion to $22 billion and can potentially affect Vale's profitability and share value in the future.

Good prospects

Higher iron ore prices and their sustainability are driving profits for Vale. It is expected that the prices will not revert to a dangerously low level in the future. With booming markets, like China at hand, and Vale's ability to provide a better quality iron ore at lower price, it looks like all the fundamentals are in Vale's favor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.