Vale: Forget The Noise And Think Long Term
- The S11D project is a game changer for Vale.
- BRL depreciation will have a favorable impact on both Capex and Opex.
- 2015 will be very difficult in terms of FCF but long-term prospects are intact.
- Focus on the fundamentals and on the underlying business and forget about the noise.
Vale SA (NYSE:VALE) shareholders are among the worst off in these last 5 years. Market Cap has shrunk almost 82% since April 2010 amid declining iron ore prices and concerns about VALE’s balance sheet and cash flow. Iron ore prices tanked, from a high of almost $190/metric ton to less than $56 last week. Commodity prices are expected to keep sliding with record production from the three mining giants (VALE, RIO and BHP) and slower growth in China.
I bought my shares at around $12, and therefore have seen my capital shrink by more or less 50%, taking into consideration dividends received. While I did expect turmoil in the horizon, the stock performed a lot worse than I had anticipated. However, I’m not panicking and will certainly hold on to my shares. I’ll try to outline my reasons in the next few paragraphs.
There’s a lot of noise surrounding VALE. Every week an analyst cuts the stock rating, which is surprising since the stock has tanked in the last 12 months. It’s interesting how rating cuts almost always happen ex post facto. Last week, an analyst even suggested that VALE ought to sell a stake in its Carajás complex. This would be a red flag if management were to even think about it. I personally believe the idea to be preposterous. VALE has options on hand to fund its cash flow gap in 2015 and 2016. There are several divestiture options, along with a complete dividend cut, which would save approximately $2B. An IPO of the base metals division could generate around $ 6B. Other options are outlined below.
Free cash flow in 2015-2016 is one of the major concerns for shareholders. VALE expects to disburse $10B in 2015 alone. 2015 is the critical year for capex management.
From 2016 onwards Capex will start to decrease and, with that, FCF should rapidly improve.
It’s important to understand that we are in the middle of a harsh business cycle. Low iron prices will eventually drive out smaller producers and thus condensate production in the hands of the Big Three. Getting rid of all the noise is the most important thing for shareholders right now. If I could sum up my thesis in one figure, the one below would be it.
S11D is VALE’s crown jewel project. The mines are located in Carajás in the state of Pará. Initial capex of $ 19.7B has decreased approximately $4B due to an advantageous forex scenario. Total production out of the high quality iron ore mines in Carajás will mount up to 230 Mt from the current 110 Mt when the project is finished. After S11D completion in 2H2016, VALE will be even more competitive, with lower cash costs and improved truckless logistics. Keep in mind that the forecast above provided by VALE in December 2014 uses an exchange rate of 2.60, while the current rate is close to 3.24. This translates to significantly lower capex and opex. S11D is expected to contribute with 90Mt of the prospected overall 450Mt by 2018.
As a commodity producer, there are basically three main concerns for VALE: cash costs at the mine, logistics costs and royalties. There is too much confusion going around and little is being said about VALE’s efforts in cost reduction and freight optimization. With inland rail transportation and the ban lift on the Valemax ships, further cost reduction is a reality. The figure below, a forecast for the market cost curve in 2015, demonstrates the large portion of unprofitable supply in the market. With prices below $60/t the range of profitable suppliers narrows even more.
The current scenario is the definition of ‘blood in the streets’. VALE is expanding production and focusing on cost reduction exactly when it should. Eventually, the market will balance itself, even if it takes years. While iron ore demand won’t grow exponentially, VALE is positioning itself to be the best producer in terms of costs and logistics, not to mention the premium quality high Fe content that comes out of the Carajás mines.
2015 and 2016 will be tough on shareholders and the stock will probably behave in an unpredictable manner. I will accumulate on further softness (if below $5) and follow each quarter closely. The next quarterly report will be an excellent opportunity to see the results of a depreciated Real and to follow up on the progress of the expansion projects.
Of course there are risks attached to an investment in the Brazilian giant. Royalty increases and government interference through VALEPAR (owned in part by the largest government-controlled pension fund in Latin America) are things to look for. Investing in emerging markets is risky and that’s why there are discounted stocks up for grabs throughout Latin America.