Vale Results Leave Much To Be Desired - and Explained

Companhio Vale do Rio Dolce (RIO)'s recent results leave much to be desired, and explained.

• The Goro nickel mine project in New Caledonia is not given much thought by investors who do not know where the place is, but Vale is currently pouring $3.2bn into construction there.
• The site has a long and colourful history, too colourful perhaps… it is currently beset by environmental issues with local communities that could, at best delay start-up, and at worst result in mothballing. Investors seem blithely unaware of both possibilities.
• Recent Q1 results coming in under expectations pulled a rug from under the stock.
• The volumes were up on some of the most important product lines (with nickel flat) and yet results were mauled by feckless hedging
• We are not understanding how the nickel price fell so much over the last twelve months and yet the hedging lost money. Surely they had sold forward nickel at the crazy high prices? Or evidently not….
• The failure of the Xstrata (XSRAF.PK) bid has spurred talk of smaller bolt-on deals. Copper is an obvious weakness at Vale. There are still lots of opportunities to buy out there and gazump the Chinese but we suspect the M&A genes are the dominant ones in Vale’s bankerocracy and thus what looks like a practical mid-sized deal (helps one up the learning curve, dontcha know?) doesn’t seem as sexy as throwing around billions chasing Xstrata.

Brazil – gotta love it?!

We have come to expect less than piercing analysis when it comes to all matters to do with Brazil. The perpetual optimism displayed by the locals has a soporific effect on the analysis produced by outsiders that turns a gathering of those dedicated to Brazil into something akin to a Haight-Asbury “love-in” circa 1968.

The Brazilocentric view is carried over into the interpretation of every event. For instance, in a recent note on Vale a Brazilian broker enthuses about new projects (being Fazandao and the Samarco pellet plant) with nary a mention of Goro, the largest new nickel mine in the world over the next four years, that Vale is supposed to launch later this year. The investment sunk in Goro is only $3.2bn. Well they may pass over it for doubts are arising over its timetable and even its very existence. Then again they also failed to mention the Brazil-sited Onca Puma mine that Vale is developing so maybe its only a blind spot for non-sexy metals.

INCO: Dearly departed

We loved INCO in our buyside manifestation. We liked buying it, then selling it, then shorting it then covering it. Vale loved INCO so much it bought it and now is Long the stock 24/7/365. Lucky Vale!

If it hadn’t been for the bid for INCO, then Vale would be very much a regional story and monoline in its product range. Whether the deal was a great help to Vale on the earnings front is not clear (and the most recent quarter was punished by the INCO effect) but it definitely raised its profile. It also established the company’s reputation for financial daring. In the process it managed to gazump a handful for the world’s most long-established and powerful mining groups. To refresh the memory, on August 14, 2006 Vale (then CVRD) extended an all-cash offer to buy Inco for $17 billion. That offer received approval from the Canadian government's investment review agency on October 19, and was accepted by Inco shareholders on October 23. CVRD announced am intention to maintain CVRD Inco as a separate nickel mining division with CVRD’s existing nickel mining projects in Brazil (at Onca Puma and Vermelho) being transferred to Inco's management. These two mines were a result of the preceding year’s takeover of Canico Resources.

INCO launched Vale into a whole new category. Considering the price, it was a good deal. By breaking out of the “emerging market” category it could get itself onto a vastly expanded range of investment radars and this helped in motoring the price of the stock dramatically higher. Whether the addition of nickel to the mix would have been as good a choice as copper, for example, is a matter of debate. The sheer number of ex-INCO execs and geologists and mine managers we find in smaller competitors these days suggests to us that despite relatively benign press post-deal that the “Exit” hatch has been crowded by departing talent.

When it comes down to it, Vale is a diversified Brazilian metals miner but globally, it is still only a nickel player.

Interestingly most of the other majors have eschewed big-time nickel plays (or any nickel plays for that matter). Xstrata snatched up Falconbridge in the 2006 melee over nickel assets, but Rio Tinto and BHPB have largely taken a pass on a metal that has not been enormously rewarding for a long time. The table on the following page shows the upcoming production. As we have noted elsewhere around one third of new production (Onca Puma, Niquelandia and Barro Alto) is coming from Brazil, turning a relatively minor player into a major new source. A table with mines of note coming online in the next few years is on the following page.

Nickel prices are still good but also 40% off their recent highs. They averaged US$41,448/t in 1Q07 compared to US$28,946/t in 1Q08. Missing out on Xstrata was generally a good thing for Vale and Xstrata. Vale felt that getting a grip on Xstrata would have cemented its title as the king of nickel but that would have been a dubious crown indeed if it had ended up too dominant to move prices much while smaller players swarmed around it. Without a new mine, like Goro (which would add around 25% to Vale’s nickel output), the nickel division in the short term is becalmed. Production was down 1% YoY in the first quarter.

But will Goro be a booster to Vale’s revenues or a millstone around its neck?

Goro – a “promising” project!

This might be the point at which we mention the old comment on Brazil that it is the “country of the future and always will be”. We were prompted to this thought also by the history of Goro. While construction of the main mine has only been going on for two years, we would have sworn that we have been hearing about this deposits for ages (and we mean “ages”). A glance at the history shows that Goro was discovered in the 1950s. INCO got involved in the late 1960s! The feasibility study was prepared in 1996 and a pilot plant was launched in 1999. Oops, then in 2002, works were suspended due to overspending. The project has been nothing but trouble, and the trouble goes on. Meanwhile back in international financial markets where Vale trades, the problem is rather blithely ignored. Though nickel market players are not so ignorant of its travails.

Until recently production was slated to begin in late 2008, but now more difficulties have reared their ugly heads. Full production of nickel and cobalt in not scheduled until 2013!

What are the problems at Goro? Being a laterite deposit does not help, being in touchy New Caledonia also adds a layer of complications. However, the biggest problems are environmental and relations with the local population. These should not be overlooked, as they may become a deal-killer. A complication that halts progress at the discovery stage is totally a different matter to one that kills a mine on the verge of it beginning production. Back in 2004 the project had a budget of $1.85bn with a potential for 20% cost overrun. This has blown out to $3.2bn at the latest forecast.

The project is the world’s largest mine under construction. However, eventual operation will not be possible without the ability to dispose of tailings and the plan was to pipe these offshore. According to a recent report on Mineweb, the plant’s opponents say the pipeline will damage an offshore area that is likely to be made a UNESCO World Heritage Site, as well as interfere with local fishing grounds. Meanwhile Vale claims that the tailings will be inert and there will be no damage either from the effluent or in the laying of the tailings pipe.

The company finds itself between a rock and hard place as it originally said it wouldn’t dispose of the tailings offshore and then changed course after local protests blocked it from onshore disposal. The delays from this pipeline issue are now likely to put the startup into next year but a report in the New Caledonian media, that should be ruffling the imperturbable feathers of even the most enthusiastic Vale fans, suggests the project might be suspended altogether.

The Mineweb report indicated that the government of New Caledonia, at both the national and local level might be flagging in its support for what is proving to be a long-drawn out struggle. However, the mine is a great source of jobs during construction and should be a large ongoing employer and export earner.

We are unqualified to comment as to where the local officialdom will jump but “suspension” of the project may be a gambit Vale might need to play to focus minds in the local community. Economic development issues have long been problematic in the Pacific Islands due to the alternative to work driving bulldozers in dusty mines being fishing and sitting under palm trees. Some local inhabitants still feel that is a choice they can afford to make. Suspension would likely trigger accountants into considering whether this might mean a writedown of the investment so far. Delay into 2009 (or beyond) would effect earnings projections for Vale. On the bright side, losing 60,000 tonnes of potential production might light a fire under the nickel price, which has been going nowhere lately.

Results pall and estimates defy reality

So the less than exciting results for Q1 at Vale were attributable to weather, poor nickel prices and forex losses. Hmm, welcome to the world of being a global “major”! Or is it? Wasn’t the idea of diversification to minimize exposure to at least the travails of one metal or another and the weather problems of one particular locale. The first-quarter net profit fell 9% from a year ago to $2.02 billion, reportedly due to a drop in nickel prices and a strong real weighing on revenues. Net revenue rose to over $7.8 billion from around $7.5 billion a year earlier. On the plus side EBITDA rose to $3.7bn from $3.2 bn a year earlier but a big chunk of this was a R$317mn reversal of provisions.

Average estimates from analysts had forecast net profit of around $2.2 billion and EBITDA of $3.6 billion for the first quarter. However there was also a pretty big “miss” on revenues where analysts had forecast a net revenue of $8.1 billion.

Production trends by volume were a mixed bag with:

• Iron ore production up a healthy 10.6% YoY to 74.5 million tonnes, while pellets production edged up 1.9% to 8.7 million tonnes. Virtually none (only R$30mn) of the recent price hike of 65%-71% in February impacted this quarter

• Nickel output slipped 1% to around 60,800 tonnes. The nickel price slid from US$41,448/t in 1Q07 to US$28,946/t in 1Q08. Obviously the hedging was not on the nickel position or badly awry if it was!

• Copper output fell 5.5% to 73,300 tonnes as Vale's Copper Cliff Smelter in Canada was halted for maintenance. This paltry output shows copper is Vale’s distinct weak spot.

• Manganese production was up 31.9% to 541,000 tonnes after resuming operations at its Azul mine in Carajas.

• Bauxite output jumped by an impressive 42% to 2.5 million tonnes, alumina rose 8.2% to around 1.06 million tonnes. Primary aluminium production fell 3.4% to 132,000 tonnes as Valesul smelter had to save energy due to high spot prices in the electricity market. Don’t underestimate this as a recurring negative going forward as a crunch situation like several years ago is brewing in the Brazilian electricity sector. Aluminium is particularly vulnerable to this.

• Byproduct of nickel production in Vale's mines (cobalt, platinum palladium and gold) rose, while silver output fell 18.8%.

We noted with amusement as one major Brazilian broker was surprised by a R$548mn loss on hedging and says “hopefully non-recurring”. Clearly they haven’t seen the reports of those companies that end up on the wrong side of hedging for successive quarters, if not years. What’s not to say that there could be many quarters of this type of problem? Moreover we would note that “majors” don’t usually get caught by these types of hedges as they generally avoid them.

Conclusion

So the Goro picture is somewhere between bad and very nasty. The best-case scenario appears to be a one or two quarter delay of start-up moving the first production definitively into 2009. The worst-case scenario is very nasty indeed with a possible permanent stalling of the project with the attendant need to provision the sizeable investment made thus far.

Does this matter? What is $3.2bn for Vale? Only one and a half quarter’s net earnings. “Not much” in the market’s view as it doesn’t seem to be factoring this into earnings (not even the slower start to production). The bigger effect is on the credibility as a major player for this is the first non-Brazil project of substance that the company is moving forward with. If it cannot handle this, then how would it deal with Peruvian, Congolese or Mexican local “situations” that might arise for a global major as it evolves. While the monetary effect may be digestible it could give Vale even more pause for thought on international adventures than it has already displayed. We regarded the Xstrata bid as a sign of deficient self- confidence on the part of Vale’s management in its own abilities to do the type of mid-sized deals that built Xstrata, Teck-Cominco or even Lundin.

As for the results, they were no worse than “disappointing” but show that “weather and nickel prices” is not a sufficient excuse for not producing at expected levels. With rather significant strengthening of volumes in most categories, the revenue undershoot needs far better explanation. Because if it can happen on these types of improvements in volumes then it could also mug some of the extremely bullish projections going around for the latter part of 2008 and through FY09. Some of the estimates and comments we have seen, from Brazilian brokers in particular, are exceedingly bullish. This bullishness is almost exclusively based on the iron ore renegotiation and takes little account of other dynamics n the broader portfolio of metals. One wonders if they even know what drives LME prices. Then again, the camp of investors in Vale is divided in two between those who are cursorily glancing over their shoulders at the fundamentals while the other “hot money” crowd whether Brazil- or Greenwich-based don’t care if Vale is a producer of egg cartons as long as it goes up when they are Long and down when they are Short.

Vale is neither expensive nor cheap, so we guess if it’s good enough for Greenwich its good enough for us to trade the hell out of thing and forget the fundamentals.

Disclosure: No positions in this stock.

Comments

[stephenrosenman]

Vale's big driver is iron; everything is far less. Vale did alot of smart things this year that should work out big for them. They achieved a 65% increase in iron prices. RTP and BHP are holding out for more. The world is not caving to RTP and BHP and are buying more from Vale. Vale recently entered a huge deal with 10 year contract with Arcelor Mittal. Iron will drive their bottom line. Eventually nickel will generate better pricing; in the meantime, iron is Vale's key.

[aleron]

There is a mistake in just about every paragraph. So much nonsense in one place. This article tells me more about Hallgarten & Company than about Vale.

[Itsjustal]

I have to concur with Aleron. By the way, you were caught flatfooted today by Brazil's sovereign rating upgrade, weren't you? I guess Brazil just might be stepping into its future beginning today after all....

One more thing: Do you folks even understand emerging markets? Your article suggests not....

[Yuriko777]

Yes, this site is not a good source for information.

[sliman]

Only thing I need to know is RIO is headed to an all time high!!!

[oldfolkdancer]

Mistake in article about majors "eschewed big time nickel plays or any nickel plays" BHPBilliton is developing Ravensthorpe which also suffers from cost overruns. BHPBilliton acquired smaller nickel plays in Australia.
Also with Inco, Vale also got Voisey's Bay which will be producing nickel for the market soon.

[ehabob]

Vale's results were in line until they got to the interest expense section, when they all of a sudden lost $500,000,000.00. Can you say the cost of the line of credit for the failed and ill conceived Xstrata deal. You don't get a $50 Billion line of credit for free, but $500 million wasted on this almost 6 month long quest.... I hate to think what the terms of that deal's financing would have been.