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Summary

  • China's iron ore imports are expected to increase this year.
  • Although iron ore prices are expected to decline, Vale has potential to generate healthy profits.
  • Cost-cutting efforts and sale of non-core assets will help to improve its bottom line and strengthen the balance sheet.

2013 was a challenging year for Vale S.A (NYSE:VALE). Its share price dropped 29% last year, from $21.49 per share to $15.25 per share. Year-to-date, the stock lost more than 16%. Nevertheless, the stock still has a great upside potential.

Vale is involved in the production and sale of iron ore and pellets, nickel, fertilizer, copper, coal, manganese, ferroalloys, cobalt, platinum group metals, and precious metals. The company is the largest iron ore producer in the world, and has been since 1974. This gives it a significant advantage both in economies of scale, as well as in negotiating prices. Iron ore is its core business, as iron ore and pellets accounted for 73% of the company's revenues last year.

The growth of Vale is heavily dependent on Chinese iron ore demand. China is the world's largest steel producer, and uses much of the iron ore in that process. Last year, the company generated 40.5% of its revenue from sales to customers in China. Due to increasing steel production, China's iron ore imports are expected to rise this year. China imported a total of 819 million tonnes of iron ore in 2013, an increase of 10.2% from a year ago. Steel production in the country will rise 3% to 815 million tons this year. As a result, its iron ore imports are projected to reach a record 870 million metric tons this year, up 6% from last year.

Brazil's iron ore exports to China have been increasing in the past five years, and this trend is expected to continue in the future. Brazil, the second-largest exporter of the commodity, exported 170.1 million tons of iron ore to China in 2013, up 4% from a year earlier. The country accounted for 20.8% of China's iron ore imports in 2011 and 22.09% in 2012. In the first four months of 2014, Brazil exported 55.7 million tons of iron ore to China, up 10% from a year ago. Brazil's iron ore exports are estimated to grow 9.1% to 352 million tons this year. The increase will benefit Vale, as it accounts for more than 80% of the country's total iron ore exports. The company projected that it would export about 1.1 billion tons of iron ore to China over the next six years.

Profitability of Vale is heavily dependent on the iron ore price. Recently, the price of iron ore slipped below $100/tonne for the first time in 20 months. The price is expected to average $120 this year and $115 next year, sliding to $105 in 2016 and $98 in 2017. Although depreciation in iron ore price could put pressure on the company's bottom line, but it still has the ability to generate a reasonable profit. Vale is a low-cost iron ore producer. Its iron ore cash production cost is $21.6/tonne, excluding iron ore acquired from third-parties. However, after adjusting depreciation and freight costs, the company's production cost nearly double. Assuming a cost of $43 per ton, Vale can easily generate a healthy profit, despite a decline in iron ore price. Analysts are expecting the company will report EPS of $1.99 in 2014 and $1.95 in 2015.

Vale is working hard to reduce its costs and improve profitability. In the first quarter of 2014, the company reduced its selling, general and administrative expenses by 20.1%, research and development expenses by 15.2%, and pre-operating and stoppage expenses by 33.1%. Vale expects that its stoppage costs will fall 50% in 2014. Credit Suisse estimates that the company will cut its costs by $400 million in 2014. Vale has also been reducing its capital expenditure over the past few years. For 2014, Vale has approved a capital expenditure budget of $14.8 billion, with 80% going to develop new iron ore projects and for logistics. The company's 2013 budget was $16.3 billion. Reduction in capital expenditure will improve its cash figure, and thereby increase shareholders' returns.

Vale is also selling its underperforming assets to control costs and boost profit. It sold $6 billion in non-core assets during 2013. The company plans to continue this trend in the future. Recently, Vale has completed the sale of 35.9% stake in its logistics unit, VLI, for $1.2 billion. It also completed the sale of its entire 22% stake in Norsk Hydro ASA (OTCQX:NHYDY) for $1.82 billion last year. Divesting from its VLI and Norsk Hydro businesses will result in reduction of costs and improvement in the balance sheet. Vale is using the cash generated from the sale of assets to expand its iron ore business.

Bottom Line

The future of Vale looks bright. China's iron ore demand will remain strong this year. Despite an expected decrease in iron ore price, Vale will be able to generate profit. The company's cost reduction efforts and selling of underperforming assets will improve its cash position and help to increase returns to shareholders. Its current decline presents a good opportunity to buy the stock. In my opinion, Vale is an attractive investment for long-term investors.

Source: Vale S.A.: A Buy Or A Sell?