What 2014 has in Store for Vale S.A. (VALE) – The Biggest Producer of Iron Ore

Based in Rio de Janeiro, Brazil, Vale S.A. is one of the biggest mining companies in the world. It is the largest producer of iron ore and the second largest producer of nickel. The company also produces other minerals such as copper, aluminum, coal, and fertilizers. While the iron ore prices remain the key driver of Vale’s share price, there are a few other important factors that could affect the company’s share price in 2014, including seasonality, emerging market equity outflows, iron ore quality premiums, and finally non-core assets re-rating.

Vale’s share price, similar to its iron ore peers, has fallen every year in the second quarter since 2010. This is a seasonal trend, as Chinese steel mills end the 1Q re-stocking phase and supply starts to pick up after weather disruptions. Given a consensus view in the market that iron ore will again be weakest in 2Q, this is a concern for Vale’s share price in early 2014. The market pre-empted this seasonal trend in 2013 and this was reflected in Vale’s weaker performance in 1Q13. 2014 poses the same seasonal risk, as the latest inventory data shows rising inventory of iron ore at Chinese ports and Chinese steel mills.

Emerging markets (EMs) bearish outlook is another consideration for Vale in 2014. EMs have witnessed outflow of capital lately as investors invest more in the developed market equities. Brazil is also suffering from the same problem. Investors remain bearish on Brazil. Vale suffers from Latin America equity outflows, however, the company benefits relatively vs. domestic stocks. Brazil goes to the polls in 2014; the country will be holding its 25th presidential elections in 2014. The elections hold significant value for Vale, given that the former Brazilian environment minister Marina Silva, who’s known as a strong environmentalist, has agreed to run for the vice president on the presidential ticket of Eduardo Campos. One possible risk to Vale would be a surge in support for Ms. Silva’s ticket.

Iron ore quality premiums are another theme that represents a potential upside for Vale’s share price in 2014. Due to various factors including low steel utilization rates, lower coking coal prices, weak steel mill margins, iron ore premiums have declined significantly in 2012 and 2013. The weakening quality premiums have cost Vale $12 per ton in pricing power. However, due to tighter environmental regulations in China, these premiums rebounded slightly in the last quarter of 2013. Depending on the Chinese authorities, this trend could continue in 2014 and Vale investors have a relatively free option on this potential upside, as Vale sells premium ores averaging ~66% Fe content, 4% better than IODEX 62% benchmark.

As mentioned in the beginning of the article, Vale is the largest producer of iron ore in the world. The segment generates 70% of the company’s revenues and 90% of reported EBITDA. However, when we look at the assets of the company, iron ore assets represent only 45% of the total with $50 billion of assets in base metals, fertilizers and coal. One of the biggest potential upsides in the company’s share price in 2014 could be a possible re-rating of these assets. Out of all these assets, base metals with $35 billion of book value have the most valuation upside for Vale. The company is targeting $4.0-$6.0 billion of EBITDA by 2016 and if Salobo I/II, VNC and Onca Puma can all reach close to their name-plate capacity, the target should be achievable. Analysts are expecting an improvement of more than $2.0 billion in 2014, possibly higher if Indonesia bans exports of unprocessed nickel ores.

The management has also expressed its intentions to seek minority investors for the company’s non-core assets, specifically in coal, fertilizers and energy. Other than the company’s energy assets, which it recently restructured, coal is the most near-term candidate. Vale’s coal business generated negative EBITDA in 2013 and is likely not rated in Vale’s share price. Therefore, any deal at close to 1x book value should generate upside to the current market price.

Vale recently announced that it has signed agreements with Cemig to create two companies, Alianca Norte Energia (ANE) and Alianca Geracao de Energia (AGE), which will incorporate energy generating assets of both companies. Vale will incorporate its 9% stake in the Belo Monte hydropower plant consortia into ANE and will subsequently divest 49% of its stake in ANE to Cemig in return for R$206 million. With the proposed sale, VALE would retain a 4.41% stake in Belo Monte, while Cemig would increase its stake in the project to 11.87% from 7.28%. I think this proposed sale is positive for Vale, given that the company will be able to reduce future capital / debt guarantees into this major project ($14 billion total capex). AGE, on the other hand, has been created to incorporate the stakes that both Vale and Cemig have in Porto Estrela, Igarapava, Funil, Capim Branco I /II, Aimorés and Candonga power plants, which together have attributable capacity of 1,158MW and 625MW in assured energy. Vale will hold 55% and Cemig 45% of AGE.

The restructuring of the energy business is consistent with Vale’s strategy to reduce future capex requirements, divest non-core assets, and re-focus on core assets. The company’s next step in this strategy should be selling half of its 70% stake in the $4.4 billion Nacala corridor project. An announcement in this regard is expected in first half of 2014.

Conclusion

Iron ore prices remain the biggest driver of Vale’s share price and the market remains largely cautious on the iron ore prices outlook. However, the long-term iron ore prices could exceed consensus expectations. Vale’s attractive iron ore growth projects should also support growth in earnings and cash flows. The company, relative to the industry, also benefits from a low production cost. Vale’s low-cost operations especially in iron ore and nickel result in above-average operating margins and cash flow generation. Finally, the re-rating of Vale’s non-core assets represents possibly the biggest potential upside in Vale’s share price in 2014.

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