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My buy recommendation for Vale SA (NYSE:VALE) still holds, and I believe there is still a lot of juice left in this one even after almost 100% appreciation since I last recommended it. The basis for my bullish stance is that the iron ore prices are going to remain strong and Vale SA has made a number of internal improvements which are going to help it operate even more efficiently in the next few quarters. The progress made in the last four months has also resulted in improving the company's fundamentals and financial position. As a result, I have added some key financial and credit metrics in this article. First, I will talk about the fundamentals.
Calculations by the author. Data sourced from SEC filings
The table shows the profitability as well as credit metrics in the last four years. This time frame is ideal for our analysis because in January 2013, iron ore prices were at the highest level in the last five years. And from there, it kept falling consistently for the next three years. In January 2016, iron ore prices bottomed at around $40 per metric ton. The rally has been strong as the price has doubled to $80 in the last year. Operating and net margins are negative in the last two years due to the iron ore prices falling down to the lowest levels in the last nine years. Depressed commodity prices resulted in massive impairment charges which caused these margins to fall below zero. As you can see in the lower part of the table that adjusted operating income (adjusted EBIT) is positive, meaning the operating margin was positive after the adjustments for impairments and write-downs. The graph below will make it visually easier to understand the trend.
Please pay attention to gross margin and see how it has started an upward movement. It should now look like an inverted bell-shaped curve if the iron ore prices continue to remain strong.
Despite a considerable decrease in adjusted EBITDA, credit metrics remain in healthy shape. I have adjusted gross debt for the impact from the newest note issue. At the height of the commodity price crisis, Vale's leverage went up to 4.1x. It was the highest figure for the company during the last four years. Due to the improvement in EBITDA and commodity prices, it has now come down to 3.6x. I am expecting it to come down further as the fourth-quarter earnings are still to come. Since September, iron ore price has gone up by more than $23 per metric ton, an increase of over 40%. This should have a favorable impact on EBITDA and operating income. The last row shows EBITDA margin, which has stayed in double digits despite the company going through one of the worst commodity crisis in the last 10 years. EBITDA margin in the last 12 months is now above 2013 figures.
Rating agencies are happy with the credit metrics of the company. As I have said in the past that the company's low cost base, tight financial controls and the sale of some of its assets will enhance its credit profile. It has now been acknowledged by Moody's. It is expecting the leverage to come down further in the current year (its iron ore price range assumption of $45/65 per metric ton is on the conservative side). If the iron ore prices hold over $80, then we will see a sharp decline in leverage and might result in an upgrade from the rating agencies. Miners were having trouble managing their credit metrics, but Vale has navigated this storm wisely.
Ore sale from S11D project will start during 1Q2017, which means that the cost base will go down further. At the time of full ramp-up (2020), this project will have the capacity to produce 90 million tons of iron ore annually. It should give a lift to gross margin due to the low-cost operations at S11D. Most of the players in the market are now bullish about iron ore prices. My bullish view about iron and copper was mainly based on the infrastructural investments in the emerging economies from Asia-Pacific, Chinese investments in the region, and China's own encouraging industrial manufacturing numbers. Rio Tinto (NYSE:RIO) CFO has declared that iron ore prices will not fall off a cliff. The reason behind the optimism is an increase in demand from China. Chinese millers are looking for higher-grade imported iron ore, which is likely to continue pushing the prices higher.
Although the best time to buy this stock was four months ago, I believe it is still a good choice for the next 2-3 years. The turnaround is not complete yet. We are going to see some key transactions complete in the current year (sale of fertilizer business, coal assets), and we will also see the benefits of S11D project. Growing profitability, stronger credit metrics and a possible upgrade from the credit rating agencies can be a few catalysts in the next 12 months. This stock still has a long way to go.
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.