Vale Shares Take A Hit, But Could Bounce Back

About: Vale S.A. (VALE)
by: Nolan Thompson

Vale share price dropped to a 52 week low, yet the company increased its free cash flow by 2% in Q3.

$1.5B invested into the production of copper and nickel.

Conservative president of Brazil could create a deregulated environment for the mining company.

Investment Thesis

Recent headlines have caused a massive selloff of Vale (NYSE:VALE) shares dropping the price to a 52 week low. In addition, industry forecasts show an increase in demand for iron ore in China and India. Plus, a new president elected into office, looking to bring American capitalism to Brazil, may create an environment that will allow the company to expand its mining operations at a faster pace. Recent investments made into Vale’s copper and nickel mines may increase future revenues as well. With high free cash flow and undervalued P/E and Forward P/E ratios, Vale is an attractive value opportunity to gain exposure in the Materials sector within the growing economy of Brazil.

Vale Has a Dam Problem

Two major dams have collapsed in the last three years, which are owned by Vale. In 2015, the Marina dam collapsed and killed 19 people and destroyed the surrounding environment. Vale and its partner were forced to pay more than $6B to the Brazilian authorities. The most recent dam collapsed in January 2019 where more than 60 people died and hundreds are still missing. As of January 26, 2019, Brazilian authorities have blocked $1.3B from being released to the company. Also, the company has been fined $66M by Brazil’s Environment agency Ibama for the dam break. Since the accident is still recent, the financial impact that this will have on Vale is uncertain; however, it may not be as much as the total fines the company faced in 2015.

In addition, Vale has been put on CreditWatch by S&P because the company may face fines and the possible loss of license to operate in the area affected by the accident. This possibility of financial loss has been made a reality by the recent class action lawsuits filed by various law firms. The lawsuits claim that Vale violated the federal securities laws under the Securities Exchange Act of 1934. The complaint is that the company provided false and misleading statements concerning its safety protocols and compliance with applicable mining regulations. Plaintiffs involved in the class action lawsuit are looking to recover compensable damages caused by Vale's violations of the securities laws.

Overall, Vale has a few legal and financial headwinds that could affect the share price in the near term. There has not been a ruling on the most recent dam collapse, but the company is in the cross hairs of environmental and other governmental agencies. The dam collapse in 2015 was supposed to push the company to use safer practices and inspect the other operating dams to look for any issues to prevent an accident from happening again. Now, Vale has a great deal of issues that may impact the performance of the company in 2019. This uncertainty in the future of Vale should be considered before making an investment decision.

Major Growth in Q3

During the Q3 2018, Vale performed very well in comparison to Q2. Total net operating revenue for Q3 was $9.54B, which was a 10.8% increase from the previous quarter. All revenue segments under Ferrous Minerals experienced growth besides Manganese and ferrous minerals labeled Others. Iron Ore had the most significant increase in net operating revenue from Q2 to Q3 of 22.4% in 2018. Revenue from Copper and Nickel had a slight decrease in net revenues from the previous quarter. With investments into Nickel and Copper, the company aims to increase the production of these two revenue segments to add to the total revenue growth which the Iron Ore segment has been experiencing. Continued revenue growth seems obtainable with the optimism surrounding the increase in the price of steel.

In addition, Vale has been able to increase its gross profit from around 19% in 2015 to above 30% in 2016 and 2017. Based on the trailing twelve month income data, it is expected that the company is going to continue this trend of generating a gross profit of over 30%. Vale has remained profitable since 2016, and the company should obtain its EBITDA projection of $16.9B for 2018. The company had and increase in free cash flow of 2% which totaled to $3.1B for Q3 which will allow the company to continue paying off its total debt. The company is using free cash flows to get its debt down to $10B. Vale is expected to release earnings soon which should align with the projections the company forecast throughout Q4.

Investments & Demand for Steel Create Opportunity

Steel Prices Rise After Dam Collapses

After the dam collapsed in January 2019, Vale announced that it would decommission all of its upstream units which could impact the production of 40 million tons of iron ore. This news pushed up the prices of the steel-making raw material globally to its highest since 2014, and it is expected to increase steel prices even further. For example, Shanghai Steel prices rose by as much as 12% in January after the decommissioning news was announced. Indian steel prices have also shown a recovery in February. Demand is expected to rise for steel, which is going to benefit Vale because the company generates most of its revenue from the sale of steel-making raw materials. The company’s outlook for iron production is still continued to rise into 2020 where it expects production to be 400 million tons; however, since iron ore supply will be lower, Vale will be able to increase its prices to keep up with demand. In addition, the company has been able to lower iron ore costs for the year.

Investments in Copper & Nickel Could Boost Revenues

Recently, Vale has been making plans to invest heavily into its Nickel and Copper production, since the company generated massive revenues selling iron ore to China. First, the company is close to approving a $1B copper expansion. This expansion is said to have started at the end of October 2018 in Brazil at the Salobo copper mine based on articles released in October. This expansion will take about three years to complete and add about 50,000 tons to capacity at the mine. The company currently produces about 200,000 tons at the Salobo mine. The reason why Vale has decided to make an investment into copper is because global copper stockpiles fell, while a growing concern of a deficit to the copper market will happen next year.

In addition, Vale will be investing $500M into its New Caledonia nickel mine from 2019 to 2022. The reason why the company is making this investment is because it is aware of the expected surge in electric vehicle sales. This metal is a key input for most types of lithium-ion batteries which are used in electric cars. Investments into the production of these metals produced by Vale may lead to higher earnings in the future.

Industry Outlook

The forecast for iron ore prices are expected to be slightly lower, but there is a limited downside. Producers of iron ore believed to be able to continue to generate cash, which will increase capital returns and improve the balance sheets. However, as the new supply of iron ore continues to add to the surplus, while China decreases its construction and demand for the metal, the prices may decline over the next year.

Source: Bloomberg Terminal

The chart above shows that Iron Ore Major Producers have been outperforming both the MSCI World Index and Iron Ore Equities throughout January 2, 2018. Companies with more diversified product offerings showed stronger performance during the same period.

Source: Bloomberg Terminal

In addition, China’s pig iron production will likely be flat to down over the next four years. The chart above forecasts the decline of production to 209 million tons by 2022 as costs rise and mines go underground. Smaller mines have already started to shut down in China, so this domestic production in the country will determine the future demand from iron ore producers in other parts of the world.

New President Could Benefit Vale

Brazil recently elected a new conservative president, Jair Bolsonaro, on October 28, 2018. His goal is to adopt a more American style of capitalism for Brazil, which may move the country towards a free market. Business owners and other members of the public are optimistic for the future of Brazil’s economy. This optimism could lead to more business owners taking on debt to pay for new employees to help with the demand of future business brought on by the president’s new reforms. Bolsonaro’s reforms include increasing the retirement age for the pension system, streamlining the tax regime, and opening up the economy by lowering tariffs. His goal is to build a relationship with other major economies, such as China and the United States, so that Brazil can become a global player.

In addition, Bolsonaro’s incoming foreign minister, Ernesto Araújo, is seeking to change the Liberal diplomacy left behind by the past president. In Brazil, there is a cyclical recovery in the works because inflation is low and credit is recuperating. This new wave of political beliefs has led economists to believe that Brazil’s GDP will experience positive growth, even surpassing Mexico’s GDP growth. Vale is headquartered in Brazil, so the company will most likely be able to take advantage of these new reforms to increase the profits of the company.

Source: Financial Times

Financial Analysis/ Valuation

Source: Chart Created by Author Using Data from FinViz

Some of the leaders in the Iron Ore industry have attractive P/E ratios compared to the current S&P 500 P/E ratio of 21.01x. The chart above shows that these companies are trading at a discount relative to the S&P 500. Vale stands out the most among its competitors based on its Forward P/E ratio of 6.84x. This low Forward P/E ratio for Vale indicates that analysts expect the company’s earnings to increase.

Source: Chart Created by Author Using Data from FinViz

Vale also pays a 4% dividend which creates more value when purchasing shares of this company. Other competitors have dividend yields around the same amount, but the value of the shares are at a much higher price. With limited upside to be gained by investing in the higher priced companies that may be overvalued, Vale looks like an attractive company to invest in based on the indicators showing the company is still undervalued.

Additional Risk

China' Economic Slowdown May Be Problematic

In addition to the risk to reputation because of the dam that collapsed, China is experiencing a slowdown within its economy, which is could be a problem for Vale. The revenue generated by China accounts for 40% of the total revenue. If the company’s largest contributor to its revenue starts to do less business in the future, then Vale will have a difficult time increasing its revenue year-over-year. It will be important to monitor the global economic conditions to see how much of an impact China’s deteriorating economic growth will be to Vale.

Investor Takeaway

Vale is a leader in the iron-ore mining industry, but the company has dealt with a negative event that will have a short-term impact it. This event has led to a decrease in the amount of iron ore available, which is increasing the price of available steel-making materials on the market. Even though Vale is losing a large amount of its inventory, the company is investing over $1.5B into the production of its other revenue segments: Copper & Nickel. This new investment may offset the losses caused by the shortage in inventory.

Negative headlines are in the news about Vale, which has caused the current share price has dropped to a value near its 52 week low; however, with growing free cash flows and ratios indicating an undervalued security, Vale may present a unique opportunity for a value play.

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.