Is Vale A Buy Or A Sell At 52-Week Lows?

Jul.16.14 | About: Vale S.A. (VALE)

Summary

Vale has taken a beating this year due to weakness in iron ore pricing and demand.

Analysts believe pricing will improve going forward, along with demand, and help Vale execute a turnaround.

Vale faces a threat from Rio Tinto, but its solid valuation and dividend yield should compensate investors for its short-term pains.

It has been a disappointing year for Brazilian mining giant Vale (NYSE:VALE). The company's stock is underperforming the S&P 500, losing almost 9% of its value so far this year. In addition, Vale reported disappointing results for the first quarter with a decline in both operating revenue and net income. Vale is suffering as a result of a decline in the selling price of iron ore. In fact, Vale sold iron ore 25% cheaper than the market reference price, sparking a sell-off. However, will Vale be able to bounce back from this disappointing performance going forward? Let's find out.

A turnaround in the cards

A slowdown in the Chinese economy, which is the biggest market for iron ore, is proving to be a sore point for Vale. However, Citigroup is still positive about Vale's prospects, and expects iron ore pricing to get better. As reported by Reuters:

"Citigroup mining company analysts Alexander Hacking in New York and Thiago Ojea in Sao Paulo wrote on Wednesday that the lower than expected iron ore price Vale received is likely to be temporary and reiterated their "buy" recommendation on the stock.

"The headline result is not as bad as it looks," they wrote. "Effectively, Vale over-estimated prices in the fourth quarter and are backing them out in the first quarter."

Vale suffered because of a decline in its average selling price, while there was a marginal decline in the iron ore index (IODEX) as well, indicating that the industry is under pressure. Yet, pellet premiums were firm, and so were the pellet prices despite weakness in the IODEX.

International iron ore prices are mainly determined by Chinese demand. China is reported to be the largest consumer of iron ore in the world. But, in the recent times, due to tight government and financial policies, many of the steel plants have been shut down. This has led to built-up of inventories at Chinese ports and curtailed imports. As China had accounted for half of Vale's iron ore and iron ore pellet shipments last year, this is no doubt creating a big impact.

Pricing to improve

Going forward, it is expected that iron ore prices will get better. According to a recent Bloomberg report:

"Iron ore prices, which completed a second straight quarterly loss today, will rebound as the daily closure of mines supplying high-cost output in China boosts demand for seaborne shipments, according to Citigroup Inc.

Local suppliers in Asia's largest economy are cutting production even as mills increase steel output on improved margins, according to analyst Ivan Szpakowski. An iron ore mine in China is being shuttered every day, with closures seen in all main producing regions, he said in an interview from Shanghai."

It should be noted that Vale is among the world's largest iron ore producers, and has strong fundamentals. This should help the company put in a better performance going forward as iron ore prices improve. According to Vale's Executive Director for Ferrous and Strategy, Jose Carlos Martins, "While policies put in place by China to curtail monetary expansion are driving recent declines in iron-ore prices, the effect probably will be temporary."

Short-term problems and accompanying solutions

In addition, Vale's production is robust. In fact, the first quarter was the company's best since 2008 for iron ore production. Vale reported strong production levels for nickel and coal as well. But, since production was more than demand, management decided that it will push the remaining products into the supply chain during the upcoming quarters.

Going forward, Vale expects iron ore prices to increase, but it will be quite some time until this turn around happens. This is mainly because of over production by iron ore majors, which has resulted in an oversupply situation in the market. This will keep iron ore prices subdued, at least in the near term.

In the meantime, as iron prices improve, management is undertaking various initiatives to stabilize the business. It has adopted various costs cutting initiatives across all areas of the company, and this is yielding results. Vale saw a considerable decline in its SG&A, R&D, and pre-operating and stoppage expenses last quarter.

Rio Tinto's threat

However, Vale is not the only player in the industry and has to face tough competition from rivals such as Rio Tinto (NYSE:RIO). In fact, to offset the negative impact of lower prices, Rio Tinto has increased its production volume, which will enable it to achieve economies of scale. The company anticipates that iron ore demand will improve in the future, and emerging markets such as China and India will play key roles to fuel the iron ore industry.

In addition, Rio Tinto has sued Vale and BSG Resources. According to reports, Rio Tinto alleges that "they colluded to rob the Anglo-Australian company of a highly prized iron-ore concession in Guinea." The situation currently is very complex, and if Rio wins this legal battle, it could cost billions of dollars to Vale. Although Vale has denied the allegations, only time will reveal who actually wins the legal battle.

Valuation and conclusion

Although Vale faces a big threat due to Rio's legal challenge, it cannot be denied that the company is cheap. Although it does not have a trailing P/E, but its forward P/E is quite cheap at just 8. The stock is trading close to its 52-week low, and it could be a good investment considering the expected bump in iron ore pricing and demand. In addition, Vale's cash flow metrics are quite strong, with operating cash flow over the last twelve months standing at $15 billion.

As such, investors should remain invested in Vale, and enjoy the 6.10% dividend yield that it pays out.

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