Vale - The Risks Are Overblown

| About: Vale S.A. (VALE)

Summary

Vale has seen its stock price drop by more than 80% from the commodity cycle highs in 2011.

The company has strong earnings potential and has managed to keep its volumes growing. A rapid recovery in iron ore prices from increasing demand should help Vale's earnings.

The Brazil fears of corruption in Vale are overblown. These corruption allegations are widespread among all Brazilian companies but shouldn't hurt Vale's earnings.

Introduction

Vale (NYSE: VALE) is a Brazilian multinational company and one of the largest mining companies in the world. The company has a market cap of $25 billion and has seen its stock price fall by more than 80% since the peak of the commodity cycle in 2011, a market cap drop of more than $100 billion. The company is one of the world's largest iron ore and nickel producers.

Vale Logo - Sulphuric Acid

However, Vale has had a difficult time. The joint difficulties of crashing commodity prices and difficulties in the Brazilian economy have resulted in a rapidly dropping share price. Despite this, the company has strong potential. The company has been focused on increasing its production and earnings while managing its debt pile. At the same time, once commodity prices recover, this will combine with increasing production to help Vale's earnings.

Production Volumes

Now that we have an overview of Vale and the general idea behind the things that will help the company's long-term earnings, it is time to dive in by discussing the company's production volumes.

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Vale Production Volumes - Vale Investor Presentation

It is important to keep track of how strong Vale's production growth has been over the past two years. The company's gold production has almost doubled and it is now annualizing at roughly $0.5 billion per year. The company's copper production has also been increasing rapidly and based on its first-quarter results is annualizing at $2.0 billion per year.

However, there is a downside to be seen. The company is one of the largest iron ore and nickel producers in the world. Its iron ore production took a hit in first quarter 2016, but the first quarter tends to be a lower production quarter and the company's first-quarter production has increased year over year. The company's iron ore production seems to be annualizing at just under 350 million tons per year. Iron ore prices have increased by 25% since the start of the year and the company's production for the year should bring $17 billion in revenue.

Nickel production has also been continuing to increase year over year and is currently annualizing at roughly 300 kilotons per year. Based on current nickel prices that means annual revenue of just under $3 billion. As we can see, iron ore makes up the bulk of Vale's annual revenue. However, the other thing we can see is that Vale has been consistently increasing production year over year. That is important to the company's long-term earnings growth.

Earnings

Now that we have discussed Vale's production volume, it is now time to discuss the company's earnings.

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Vale Earnings Changes - Vale Investor Presentation

The above image shows Vale's adjusted EBITDA along with its EBITDA margin. The scale of the company's improvements is visible from how its EBITDA margins have increased since third quarter 2014. In early 2014, before the start of the oil crash which resulted in an increased downturn in commodity prices, Vale's EBITDA margin was more than 40%. However, since then Vale's EBITDA margin dropped to the mid-20s. However, since then Vale has shown stunning growth and has managed to increase its EBITDA margin to the mid-30s for the most recent quarter. That represents impressive growth which should help the company's earnings.

The company's EBITDA has also remained strong in the face of rapidly falling iron ore prices. Iron ore prices have fallen from $120 per ton before the most recent quarter to less than $50 per ton in the most recent quarter. That represents a drop of 60% in iron ore prices. At the same time, the company's EBITDA has decreased by roughly 50% showing an ability for the company to keep its margins strong. Vale's first-quarter EBITDA annualizes at $8.0 billion and with a $25 billion market cap that is an incredibly low market cap/EBITDA ratio of just over 3.

That shows how the company's earnings have remained strong in the face of decreasing ore prices. It also shows how cheap Vale's stock is in comparison to its earnings.

Long-Term Potential

Now that we have discussed Vale's production values and earnings, it is now time to discuss the company's long-term potential. To start, Vale is a Brazilian company and that means that its stock price has been dragged down by the corruption allegations from Brazil. Vale is currently under the spotlight for a number of corruption claims.

However, despite these difficulties, Vale is a strong company. And corruption allegations don't hurt Vale's production nor its long-term earnings potential. As a result, these allegations will eventually pass and Vale will once again be able to take advantage of its strong production to increase its earnings.

Brazilian GDP Growth - The Coming Depression

And despite some difficulties, Brazil's economy remains strong with mid-single digit GDP growth in the past, growth that is expected to continue. Vale, as the largest mineral producer in Brazil, will be the supplier of choice for new infrastructure projects. This demand for Vale's raw materials, compounded with the company's close proximity to major regions, should help boost the company's earnings and profitability.

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Vale Capex Changes - Vale Investor Presentation

More so, during the current market downcycle, Vale has been decreasing its capex expenses. The company's combined capex dropped by almost 35% from the first quarter 2015 to the first quarter 2015 saving the company almost $1 billion. However, most importantly, the company is keeping growth capex strong with much of this capex drop coming from sustaining capex. That means the company is continuing to grow its production while minimizing its costs.

Worldwide Iron Ore Consumption - Business Case Studies

And worldwide iron ore consumption has been growing and is expected to continue growing. In fact, from 2002 to 2010, world iron ore consumption increased by more than 50%, a growth trajectory that is expected to continue. This continued growth in demand should help to boost iron ore prices which should provide a nice support to Vale's earnings, the majority of which are derived from its iron mines.

Conclusion

Vale, like all other commodity companies, has had a difficult time recently. The company's difficulties have been compounded by its central reliance on iron ore prices which have dropped from almost $200 per ton in 2011 to recent lows of less than $50 per ton. That represents drops of more than 75%, a significant production drop that has hurt the company's earnings. That drop in price has cost Vale tens of billions of dollars.

However, despite this, Vale remains a strong company with significant future potential. The company's shares have been punished by fears of Brazil corruption despite this not hurting its production. More importantly, the company's production has remained strong and is continuing to grow. Worldwide iron ore demand is also expected to continue growing. This combination should help Vale's long-term earnings.

As a result, after the cycle lows from January 2016, I recommend higher risk investors take advantage of the current downturn to invest in Vale.

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.