Vale's Future Looks Promising

| About: Vale S.A. (VALE)


Increasing high quality iron demand will benefit Vale.

Despite decrease in iron ore price, Vale will generate a healthy profit.

Vale also has a committed management looking to reduce costs and improve profitability.

Attractive for dividend investors.

Vale (NYSE:VALE), the world's largest iron ore miner, is trading at lows not seen since 2009. So, many investors are convinced that now is the best time to invest in the company. For the year to date, the stock plunged more than 15%, having recently touched a new 52-week low of $12.39. However, it is not only Vale that has seen depreciation in share price all the major iron ore miners, including BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO) and Cliff Natural Resources (CLF), have seen depreciation in their share price.

Future growth of Vale is heavily reliant on Chinese iron ore demand. The company generates 70% of its revenue and 90% of reported EBITDA from iron ore. China is the world's biggest buyer of iron ore, accounting for 63% of global imports last year. Demand for iron ore was relatively strong in 2013. China's steel industry is active, and the housing market is quite strong as well. Both industries depend on iron ore, and as a result, iron ore demand will continue to rise going forward, impacting Vale's sales favorably. China's own iron ore is very costly as well as of low quality, as a result, it will remain dependent on imported iron ore. The country's cost of producing its own iron ore is $75 a ton compared with $30 to $60 a ton for imported ore.

Worldwide, 98% of all iron ore mined is used in the manufacturing of steel. In 2014, crude-steel output in China is expected to rise 3% to 815 million tons. Iron-ore imports are forecast to rise to a record 870 million metric tons this year, up 6% from last year. Brazil projected to increase its iron ore export volume this year by 9.1% to 352 million tons.

China's major steel mills in the province of Hebei and Jiangsu are under pressure to lower emissions and comply with new air pollution standards following smog crises last year in several major cities. This resulted in an increase in demand for high-quality iron ore. Vale is poised to take full advantage of increasing high quality iron ore demand, as the Brazilian ore that the company produce is the highest quality in the world and is purer than Australian ore, which its main competitors mine. Increasing high quality iron ore demand is also drawing up a premium in the Chinese market. The premium for a 62% iron content ore is now $17-$18.6/metric ton, six months ago the premium was $8. Pellets with 65% iron ore content are trading at a $40-$42/metric ton premium, up $10 in the last six months.

Even though Vale is heavily dependent on China for growth, it also has strong demand from within Brazil and South America. With Brazil's high import taxes, many auto and industrial manufacturers choose to produce in Brazil. Therefore, steel manufactures that supply these auto and industrial manufacturers in Brazil can rely on Vale to supply iron ore at the best price and most convenience.

In the fourth quarter of 2013, Vale reported a net loss of $6.45 billion, up from $2.62 billion a year earlier. But the loss includes charge of $9.36 billion, incurred because the company had settled tax-related disputes with the Brazilian government over profits from a foreign business unit. Additionally, the company has also recorded an impairment charge of $2.3 billion this quarter, which further extended its loss. Both charges are one-time expense. Impairment is also a non-cash flow item. Excluding both charges, its net loss would turn into a profit of nearly $5 billion. Vale's adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), a measure of the company's ability to generate cash from operations, rose 50% in the quarter to $6.64 billion.

Vale's profitability is largely dependent on iron ore prices. Iron ore prices decreased in the last three months and is expected to decrease further in the coming months. The price averaged $134.86/ton in the fourth quarter of 2013. Analysts are forecasting iron ore to average $100-$119 in 2014. The company will still earn a healthy profit, as its cost of mining is about $21/tons (excluding transport costs).

Vale is undertaking several measures to improve its profitability. Its management is serious and committed to reducing costs. Credit Suisse estimates that the company will cut its costs by $400 million in 2014. The company is making efforts to cut transport costs, which are higher than its main competitors, Australia's BHP Billiton and Rio Tinto. BHP and Rio have a competitive advantage over Vale, as their mines are closer to China. Vale is developing a new marine terminal in Malaysia, which is expected to be operational by October of this year. Current transportation cost of Vale is around $22/ton and should fall by $4-$5/ton for shipments to China after Malaysia opens. Reduction in transportation costs will also improve the company's bottom line.

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These ratios indicate that Vale is potentially more profitable than the average firm in its competing industry. Its profit margins are much higher than the industry average. In addition, having a ROE that is greater than the industry ROE, the company has a greater prospect for generating abnormal earnings. It is expected that Vale will be able to deliver 16% return on equity in 2014 against 9% in 2013.

Vale is also an attractive investment for dividend investors. It has the best dividend yield of 6.9% among all major global miners. In 2013, the company paid dividends of $4.5 billion, and commitment to a minimum dividend of $4.2 billion in 2014. With $5.3 billion in cash, it has the ability to pay dividends for at least three years.

Bottom Line

China's iron ore demand will remain strong due to growing steel demand. China has good relations with Brazil, and as a result, Vale is well positioned to benefit from growing iron ore demand. The company is making significant efforts to reduce costs and improve profitability. It is also attractive for dividend investors. The stock may see little depreciation in the short term, but has a bright long-term future. In my opinion, Vale is a great long-term investment.

Disclosure: I 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.

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