This article will cover the exposure of Vale S.A. (VALE) to the present iron ore pricing collapse in the same manner as my previous articles on BHP Billiton Limited (BHP) here, and Rio Tinto plc (RIO) here.
Again, much like Rio Tinto and BHP Billiton, Vale is trying to pursue a strategy of mineral diversification. Still, given iron ore's huge boom, this hasn't made much difference for Vale. Vale is the world's largest iron ore producer and it shows. Using 2011 full-year results, iron ore represented 71.5% of Vale's revenues and 99.5% of its operating income (Source: 2011 annual report).
Average selling price and breakeven
Vale had $43.2 billion in 2011 iron ore revenues and $28.5 billion in iron ore segment operating profit. For an overall production of 299 million tons, this gives us an average selling price of $144.3 per ton, somewhat inflated both by iron ore pellets which command higher pricing, and by its higher quality iron ore - both in grade and lack of impurities - which also commands higher pricing. Taking into account that the segment's operating profit represents a margin of 65.9%, this would mean the underlying earnings' breakeven point for Vale would be $49.2 per ton, only slightly higher than RIO's and BHP's, and probably also influenced by the iron ore pellets.
Vale had net profit of $22.7 billion during 2011, which gives us an EPS of $4.38. At the present quote, $17.01, that's good for a P/E of 3.9, shows us how the market is already punishing Vale for its large iron ore exposure and lack of effective diversification.
Since Vale does not disclose the sensitivity of its operating profit from a move in iron ore, but on the other hand doesn't seem to have hedging activity for iron ore prices, I'll use the sales volume to establish the overall sensitivity, using a 20.7% tax rate to establish the equivalence between the segment operating income impact, and the net profit impact (the tax rate was Vale's for 2011).
With this logic, a $1 drop in realized iron ore prices would mean a $299 million drop in revenues and operating profit. Applying the tax rate, this would translate to a $237 million drop in net earnings.
So, a drop in realized iron ore prices towards $100 would imply a $44 drop in prices, or $10.4 billion drop in net earnings. A drop to $80 would imply a $64 drop in prices, or a $15.2 billion drop in earnings.
These drops would wipe out between 44% and 67% of Vale's earnings. We should, however, keep in mind that these drops imply more price movement than what I estimated for RIO or BHP, because of the likelihood that Vale will continue to realize slightly higher pricing for its ore.
These drops also show that Vale has already discounted the drop to $100 per ton, and even mostly discounted the drop to $80 per ton, which if realized would put its P/E at around 11.7.
Vale is the world's largest iron ore producer, and also one of the companies with the largest iron ore exposure. Basically, we can say that substantially all of Vale's earnings come from iron ore.
The market is already punishing Vale due to this exposure, as can be seen from the much lower valuation multiples the company trades at when compared to BHP or even to RIO. Although it is likely that the newsflow will continue to punish Vale's stock, the present quote is already starting to discount a considerable drop in iron ore pricing. Only a return to the pricing regime that prevailed before 2004 would justify lower stock market quotes. Although such a change might take place in the future, it's not entirely predictable that it will happen right away. Such a pricing regime would imply iron ore prices of $50-$75 per ton on a sustained basis.
One final observation, directly from BHP's presentation, which I also made on BHP's and RIO's article on the same theme:
"Going forward, therefore, those who invest in iron ore should do so in the full knowledge that supply will meet demand in due course and that the scarcity pricing that we have seen over the last 10 years is unlikely to be repeated."