Why Vale Investors Shouldn't Lose Hope

| About: Vale S.A. (VALE)

Summary

Though China’s GDP growth might slow down further this year, the steel PMI is growing due to infrastructure investments in rail and construction, which is good news for Vale.

China consumes 70% of global iron ore and it has started importing more of the commodity and reduced domestic production, creating an opportunity for Vale to increase market share.

Vale is directing its capital expenses toward projects as N5S and the S11D as these carry higher ore content, lower strip ratio, and low haulage costs.

Vale’s S11D Amazon project, where it is investing $17 billion, can push its total costs to less than $10 per ton, which will help it mitigate the price weakness.

A slew of bad news out of China in the beginning of 2016 has weighed heavily on mining companies such as Vale (NYSE:VALE), which are dependent on demand of iron ore from the Middle Kingdom. This is not surprising as China consumes 70% of global iron ore, which is why a slowdown in the country's economy spells trouble for commodities such as iron ore.

In fact, it is estimated that China's GDP growth could slow down further in 2016 after dropping to 25-year lows last year. As a result of the negative news out of China, Vale shares have lost a lot of ground this year, dropping close to 33% in a short span of time. However, a closer look at the iron ore scenario in China indicates that all the negativity surrounding Vale seems overboard. Moreover, Vale itself is trying to improve its balance sheet and cost performance to mitigate a weak pricing environment.

Let's take a look at the reasons why investors should not lose faith in Vale.

Iron ore is making a comeback of sorts

After a steep decline in the last six months of 2015, iron ore prices have made a comeback of sorts this year. In fact, iron ore prices have traded consistently above $40 per ton this year after slumping to as low as $38 per ton in December last year. The stability in iron ore prices this year can be attributed to the rapidly increasing imports of the commodity in China, as the country is now importing iron ore from Brazil and Australia instead of producing it in the domestic market.

For instance, in December, China's iron ore imports were up 17% from the preceding month, while for the full year, imports increased 2.2% to an all-time high. Moreover, recent data suggests that China's steel PMI is moving in the right direction, hitting a nine-month high of 46.7 months in January. In comparison, the index stood at 40.6 points in December, indicating an expansion in orders as product inventory of steel fell to 29 month lows, while new orders were at 18 month highs.

Now, iron ore is a key ingredient in the manufacture of steel, which is why the recent improvement in steel PMI in China has boosted iron ore prices. Looking ahead, China's steel demand could continue increasing due to a variety of factors. For instance, China Railway Corp. has announced that it will spend around $121.5 billion on infrastructure this year, acting as a tailwind for steel demand. Though this is almost identical to the amount spent in the last two years, it indicates that despite a slowdown in the economy, infrastructure investment is continuing at a consistent pace.

On the other hand, an increase in the urbanization rate in China, which currently stands at around 55% as compared to 80% in developed economies, will also propel demand for steel since the metal is used in construction. Hence, the country will need to invest in infrastructure to accommodate more people into cities, which will give rise to the need for more buildings, both residential and non-residential, along with other key facilities such as roads, bridges, etc.

As such, it is not surprising to see that iron ore miners such as Rio Tinto expect China's steel production to exceed a billion tons by 2030, an increase of about 25% from last year's levels.

What Vale is doing to overcome the challenges?

Though the long-term prospects of iron ore look strong on the back of positives in China, the short-term might remain volatile as investors come to term with a normal growth curve in the country as compared to fast growth in earlier years. To mitigate this weak environment, Vale has taken the right steps by focusing on high-quality assets that can deliver better returns in a low-cost environment.

For instance, Vale has made a smart move by investing in the N5S mines. This is because these mines have a lower strip ratio, apart from a short haulage distance that will lead to a reduction in transport costs. Moreover, the iron ore reserve at this mine has iron content of 67.2%, which means that Vale can mine more iron ore with less waste tonnage, therefore leading to lower costs.

On the other hand, Vale's $17 billion investment in the Amazon S11D project is another smart move on its part since it will add 90 million tons of high quality iron ore to the company's portfolio. In fact, this mine can push down Vale's overall cost profile to less than $10 per ton, which is why the company is investing ambitiously in the project.

Conclusion

All in all, Vale is making the right moves by investing in projects that will lower its cost base. This will allow the company to mitigate the short-term weakness in iron ore pricing. Now, as we saw above, the long-term forecast for iron ore in China looks favorable, and this is good news for Vale. Thus, investors should not lose hope as the iron ore mining company is capable of making a comeback in the long run.

Disclosure: I/we 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.