Rescue teams in Brumadinho. Photo: CMB-MG

Since January 25, 2019, Brazilian mining company Vale has been living something approaching an astral hell. On that day, a dam failure in the south-eastern town of Brumadinho caused 251 deaths and brought back investors’ worst flashbacks from the previous tragedy at Mariana, including a wave of legal processes and charges, damages, and sanctions. However, as the dust settles, investors and analysts are beginning to reassess the company and, with the publication of Q3 earnings on the horizon, prospects are less obscure than one might expect.

</p> <p>Vale’s investment thesis can be split into pre- and post-Brumadinho. Boosted by its “<a href="https://brazilian.report/society/2018/11/05/mariana-disaster-2015-tragedy/">Mariana Never Again</a>” slogan, Vale had mitigated its reputational hit from what was at the time the worst environmental disaster in Brazil, and was perceived by the market as being a solid company that generated huge cash flow and was set to pay out some USD 6 billion in dividends in 2019, according to analysts&#8217; <a href="https://economia.estadao.com.br/noticias/geral,vale-deixara-de-pagar-cerca-de-us-6-bi-em-dividendos-neste-ano,70002700850">calculations</a> seen by newspaper<em> Estado de S.Paulo</em>.&nbsp;</p> <p>After the tragedy, the company not only saw BRL 70 billion wiped in a single day, as its shares traded on the São Paulo stock market plummeted 24 percent. It also had to suspend the <a href="http://www.vale.com/brasil/PT/investors/information-market/press-releases/Paginas/Vale-informa-sobre-delibera%C3%A7%C3%B5es-pelo-Conselho-de-Administra%C3%A7%C3%A3o-em-fun%C3%A7%C3%A3o-do-rompimento-da-Barragem-I-da-Mina-do-C%C3%B3rrego-do-.aspx">payment of dividends to shareholders</a> and executives bonuses—more as a reputational precaution rather than an inability to pay. Provisions and damages expenses added up to BRL 23.236 billion by the halfway point of 2019. </p> <p>To make things even worse, there was a fear that neighboring structures at the Brucutu mine might collapse, which interrupted the production of Vale’s largest mine in the state of Minas Gerais, with the capacity to produce 30 million tonnes of iron ore per year.&nbsp;</p> <div class="flourish-embed" data-src="visualisation/792196"></div><script src="https://public.flourish.studio/resources/embed.js"></script> <h2>When life gives you lemons …&nbsp;</h2> <p>Vale is the third-largest mining company in the world, as well as the largest producer of iron ore, meaning that <a href="https://brazilian.report/money/2019/02/18/effects-brazil-vale-mining-disaster/">global supply is linked to the company’s struggles</a>. As a result of the supply cut, benchmark iron ore prices traded in China reached 5-year highs. Even after a slow down, the Dalian Commodity Exchange contract for January has still gained 24 percent this year.&nbsp;</p> <p>Meanwhile, Vale worked to reestablish its facilities in the Southeast and make up for production dips by way of its Carajás mines—the company’s largest, with rocks that contains the highest level of iron ore on the planet (67 percent). In the third quarter, just one of these mines produced 20.4 million tonnes of ore, an all-time record. As a result, iron ore production bounced back to 86.7 million metric tonnes in this year&#8217;s Q3—17.4 percent less than last year, but 34.4 percent more than the previous quarter.&nbsp;</p> <p>As an exporter, Vale’s revenues are pegged in USD. This year, the American currency has gained 13.5 percent in value against the Brazilian Real, leading BTG Pactual analysts to envision the company reversing the losses registered in the first half of 2019, estimating its net income at BRL 1.3 billion.&nbsp;</p> <p>In a note to clients after Vale published its Q3 operational report, analysts from brokerage Mirae Asset explained that even though “Brumadinho’s tragedy will affect the production and sales volume of iron ore and pellets, we still have a positive outlook for the company, as it will continue to have a strong generation of cash flow”, considering the higher prices.</p> <h2>Room to handle problems</h2> <p>As we’ve previously shown in our Daily Briefing newsletter, Vale <a href="https://brazilian.report/money/2019/02/18/effects-brazil-vale-mining-disaster/">recovered its market cap</a> less than one year after the Mariana tragedy, in November 2015. Almost nine months after Brumadinho, it is still lagging 17 percent.</p> <p>For a Brazilian-based fund manager who is long on Vale, at current levels it is “the cheapest miner in the world.” The manager, who spoke with <strong>The Brazilian Report </strong>off-the-record, believes that under current iron prices, the fair value of Vale shares is at least 10 to 15 percent higher.&nbsp;</p> <p>So far, Vale has reduced its pellets production guidance from 45 to 43 million tonnes in 2019, but maintained its goal of selling 307 to 332 million tonnes of iron ore and pellets. However, the source believes that “this price implies such a big safety margin that if the guidance falls a bit short, that’s not such a huge problem. The asymmetry is too big.”</p> <div class="flourish-embed" data-src="visualisation/792306"></div><script src="https://public.flourish.studio/resources/embed.js"></script> <h2>Competitive advantages</h2> <p>Besides the advantage of its mammoth size, Vale has been doing its homework. The company has reached its goal to reduce net debt to below USD 10 billion. Such efficiency creates room for investments, as well as the payment of dividends. Recently, the company also received a favorable decision in a USD 2 billion case against BSG Resources in the UK, which is still pending appeal.&nbsp;</p> <p>However, finance website <em>Money Times</em> <a href="https://moneytimes.com.br/fast/cresce-chance-de-vale-pagar-forte-dividendo-de-10-em-2020-indica-credit-suisse/">reports</a> that Credit Suisse calculated—considering a net debt of USD 9.7 billion as of Q2 2019 and the projected free cash flow of 15 percent in 2020—&#8221;Vale is likely to have a dividend yield of 9 to 10 percent next year&#8221;. For the sake of comparison, Brazil’s current benchmark interest rate sits at 5.5 percent per year.&nbsp;</p> <div class="flourish-embed" data-src="visualisation/792284"></div><script src="https://public.flourish.studio/resources/embed.js"></script> <h2>Risks on the horizon</h2> <p>For Eduardo Guimarães, a stock analyst at Levante Investimentos, considering the local bull market, there are options with more potential to rise above the benchmark rate than Vale; furthermore, the company&#8217;s biggest drivers are no longer in its own hands, which he thinks makes it harder to predict.&nbsp;</p> <p>&#8220;It is very hard to predict foreign exchange rates and iron ore prices, and those are Vale&#8217;s main drivers right now. For me, there&#8217;s a higher chance that the U.S. dollar will become weaker against the Brazilian real,&#8221; he told <strong>The Brazilian Report</strong>. &#8220;Vale&#8217;s volatility is totally connected to iron ore. With Vale ramping up production, the price tends to fall. It surpassed USD 100/ton, I think that was an outlier.&#8221;</p> <p>Commodities are also heavily influenced by China&#8217;s economic strength and the demand for iron ore. Currently, the largest risk is the trade war between the U.S. and China. If the pair cannot reach a deal, trade barriers could slow down the two largest economies in the world, causing global shockwaves that are already having effects. In this year&#8217;s third quarter, China registered a 6 percent year-on-year growth—<a href="https://www.cnbc.com/2019/10/18/china-q3-gdp-beijing-posts-economic-data-amid-trade-war-with-us.html">its lowest in more than 27 years</a>.</p> <p>In light of a preliminary deal announced by U.S. President Donald Trump, investment bank BTG Pactual sees fewer risks on this front. In an October 13 report, the bank&#8217;s analysts reckoned that some commodity-related stocks have rallied in the past few days, but believe there’s room for another 10–20-percent rise if the deal moves forward. The team advises investors to increase allocations in the sector via Vale, Suzano, Gerdau, and CSN.</p> <div class="flourish-embed" data-src="visualisation/792325"></div><script src="https://public.flourish.studio/resources/embed.js"></script> <p>BTG also adds that, at USD 11.81 per ADR, “Vale is currently pricing in an iron ore curve of roughly USD 63/ton through ‘perpetuity,’ which we consider conservative”. On October 17, the Dalian Commodities Exchange iron ore futures contracts for January (IO62) were trading at USD 86.29/ton.</p> <p>Back to the Brazilian front, consultancy <a href="https://www.pwc.com/gx/en/energy-utilities-mining/publications/pdf/mine-report-2019.pdf">PwC highlights</a> in its global mining industry reports that the Brumadinho disaster sparked even more security concerns towards mining, which could lead to more regulatory changes. Since the Mariana disaster, Brazil created a new National Mining Agency (ANM) and changed its mining royalties law <a href="https://brazilian.report/money/2019/04/01/vale-avoided-taxes/">to increase tax revenue</a>.</p> <h2>Looking ahead&nbsp;</h2> <p>If nothing goes wrong, Mr. Guimarães believes Vale can be an interesting player for long-term investors. “Vale’s best year will probably be 2021, when it will be back at full capacity and pay dividends once again.”</p> <p>As PwC states, “the future commodity mix will be driven in part by changing consumer consumption patterns, new energy sources in the energy transition, and the increased use of technological devices.” And Vale is trying to keep up the pace with these trends.</p> <p>In spite of provisions, Vale keeps investing in search of new business opportunities that could prove quite profitable. As we mentioned in our <a href="https://brazilian.report/newsletters/weekly-report/2019/10/07/dummy-candidate-scandal-opens-can-illegally-funded-worms/">October 7 Weekly Report</a>, &nbsp;Reuters reported that if Brazil cuts gas prices by 60 percent, Vale could begin investing in HBI, a highly concentrated iron-ore “brick” that doesn’t require coal in steel-making. HBI is worth almost three times more than iron ore and, given Vale’s high-quality ore, the company would be among the best positioned in the world to supply this demand.

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MoneyOct 20, 2019

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BY Natália Scalzaretto

Natália Scalzaretto has worked for companies such as Santander Brasil and Reuters, where she covered news ranging from commodities to technology. Most recently, worked as an Editor for Trading News, the information division from TradersClub investor community.