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Vale (NYSE:VALE) accepted Brazilian government's offer and has agreed to pay $9.61 billion in taxes on profit from overseas operations. The company has 15 years' time to pay this debt, but it has to give $2.56 billion as upfront payment this month. Brazil's tax authority has claimed that Vale owes around $14 billion in unpaid taxes on the profit it earned on foreign subsidiary sales from 1996 to 2008, and this has been a long drawn legal battle for Vale, which was also impacting Vale's stock price.

This upfront payment could be one of the reasons for Vale's recent divestment. It has sold assets worth more than $3 billion this year.

Following are the assets from which Vale has divested this year:

Month

Asset Sold

Acquirer

Worth

November 2013

20% stakes in two natural gas exploration blocks, which are located in Parnaiba Basin, Brazil

French company GDF Suez SA (OTCPK:GDFZY)

Undisclosed

November 2013

all shares of Norway based aluminium company Norsk Hydro (OTCQX:NHYDY) (OTCPK:NHYKF)

N. A.

$1.82 billion

September 2013

35% stake of its cargo unit VLI

20% to Japan's Mitsui & Co. (OTCPK:MITSY)

15% to Brazilian government fund

$1.2 billion

In pipeline

Another 26% stake of VLI

Brookfield Asset Management (NYSE:BAM)

$0.86 billion (2 billion reais)

As Vale has accepted this offer, it will remove prevailing uncertainty among the investors, and the company won't have to generate previously estimated $14 billion. Secondly, it will improve the company's relationship with the government, which is very much required as Vale requires various government licenses to expand its domestic production.

Valemax returns in dragon's land

China consumes about 60% of the global iron ore and is the key market for three major iron ore exporters, Rio Tinto (NYSE:RIO), BHP Billiton (BHP), and Vale. At present, iron ore demand is more than supply, and the trend is expected to remain same next year as well. To capitalize on this opportunity, these companies are ramping up their production. Rio Tinto and BHP have ramped up their production in the Pilbara region of Western Australia. For next year, Rio Tinto and BHP have projected their annual production capacity of 292 million metric tons and 212 million metric tons respectively. Vale will also increase its annual production capacity from 306 million metric tons to 346 metric tons by ramping up its production in the Carazas region by 40 million metric tons in 2014.

The iron ore supplied by Vale has more iron content and contains fewer impurities than the ore exported by its rivals. However, the greater distance between Brazil and China increases the shipping cost for Vale. At present, it costs Vale $10 more per metric ton to ship from Brazil to China compared to Rio Tinto and BHP, as their mines are located in Australia. Due to much shorter and cheaper routes to Chinese ports, Rio Tinto and BHP have been taking market share from Vale. China imports about 50% of its iron ore from Australia and only 17% from Brazil.

To cut its shipping cost, Vale developed the world's largest freight ships "Valemax Vessels," weighing 400,000 dead-weight metric tons. These ships were launched in July 2011 to transport ores to China but were banned in the same year under the Chinese Government's "big boat ban." Chinese Government has blocked large foreign freighters from anchoring in Chinese harbors.

However, Vale has found a solution to this problem. On October 31, 2013, it signed a comprehensive strategic cooperation agreement worth $500 million with the Chinese company Shandong Shipping Corp. Under this deal, Shandong will operate Vale's four Valemax Vessels, through which Vale can deliver its iron ore directly to Chinese ports. It will help the company cut its shipping cost by 33% and will make the company more competitive with BHP Billiton and Rio Tinto's transport cost.

Shipment route

Cost/Metric ton

Australia to China for BHP, and RIO

$7

Brazil to China for VALE (Normal)

$17

Brazil to China for VALE (By using Valemax)

Approx. $11

Expected Cost reduction

Vale's Average quarterly iron ore export to China

34990,000 metric tons

Remark: Average of previous 3 quarters

(Source: Company's reports)

Shipping cost reduction if Valemax is used to deliver

Approx. $6/ metric ton

Difference of $17 and $11

Savings

Approx. $210 million

Shipping cost is the major factor that makes Chinese steel companies choose Australian iron ore over Brazil. However, by transporting its cargo by using Valemax, Vale can minimize this gap. Chinese companies have also shown a positive outlook about this deal. Therefore, I expect Vale's iron ore export to China will increase and will also improve its margin.

Stock Valuation

Valuation measures

Vale SA

BHP Billiton

Rio Tinto

Forward P/E

7.66

13.70

9.85

EV/EBITDA

5.34

8.02

6.93

If I compare Vale's stock with its rivals on the valuation front, it looks attractive. Its forward price to earnings ratio is less than BHP and Rio Tinto. Now that Vale should be able to anchor its Valemax cargo ships in the Chinese harbor, the resulting reduced cost of its cargo is expected to make its iron ore shipments more competitive. Considering the future prospect, Vale looks undervalued at the moment.

Conclusion

In its third quarter, Vale has shown outstanding results, and I expect the trend to continue in the coming quarters as well, as demand of iron ore is high in China, the biggest iron ore consumer. If Valemax gains direct entry into China, Vale's shipping cost will reduce significantly, which will help it receive more orders. The only thing that overshadowed these positives was the uncertainty surrounding the Brazil tax settlement dispute, which has also come to an end. My recommendation is investors should make an investing position in this stock.

Source: Vale: Beyond The Brazilian Tax Dispute And Making Headway In China