Brazil-based Vale SA (VALE, Financial) is one of the largest mining companies in the world and is a benchmark in operational efficiency within its industry.
The mining sector is highly volatile, and it is difficult to elaborate predictions because it is intrinsically linked to global supply and demand. In the case of iron ore, Vale's main product, the Asian market - especially China - is the biggest consumer due to the manufacture of steel.
Since Vale's share performance is strongly correlated with the movements of iron ore spot prices, during 2023 and the first three months of 2024, the company's shares have faced a pullback due to more restrained demand from the Chinese economy, which has been encouraged to return to its pre-pandemic levels.
VALE Data by GuruFocus
However, looking at the bigger picture, the trend is that China and India should continue to show solid demand for the commodity over the next few decades.
Additionally, the excellent quality of the ore exported by the miner places it in a privileged position in the sector. Its robust cash generation and low leverage should continue to make Vale an excellent income stock for the coming years.
In light of this, my investment thesis for Vale is based on four main pillars, which I will discuss in more detail.
High competitiveness, cost efficiency and quality
In terms of iron ore, Vale has one of the lowest production costs in the world, which is vital for commodity-producing companies as it enables the company to be profitable even when the cycle is low.
As the mining company has no control over the price of its product - governed by the market's supply and demand dynamics, especially in Asia - its focus must be on being profitable even in very challenging scenarios. Currently, the cash cost for Vale's iron ore is around $22.30 per ton (data from 2023), which is increased by approximately $41 per ton with disbursements related to royalties, distribution, investments in maintenance and freight until it reaches the Asian ports, the main consumers of the company's ore.
Source: Company filings.
Therefore, the breakeven after current investments in Vale's operation is around $64. Despite having a competitive extraction cost compared to its biggest competitors (Rio Tinto (RIO, Financial) and BHP(BHP, Financial)), the company has a much higher freight cost, as Brazil is much further from China than Australia.
For this reason, the company must always look to improve its production and freight costs. In 2023, the all-in cost per ton of iron ore, before maintenance investments, reached $54.80. Vale's management expects this figure to drop to around $45 per ton in 2026 by diluting costs and fixed expenses with higher production volumes.
In addition, Vale's iron ore is of higher quality than its competitors, especially considering it has a portfolio of mines with a long average life. I highlight the quality of the Northern System mines in Brazil, whose iron ore is considered the best quality worldwide because it can be processed in natural humidity. With its above-average characteristics, this iron ore is traded at a premium. The higher the iron content in the ore, the less energy is needed to transform it into steel, which is also better for the environment. In summary, all these factors give Vale a privileged position in the sector.
Exposure to the Asian market
Vale's primary customer base is China, with 62.9% of iron ore and pellet shipments directed to the country in 2022. Following China, significant customers include Brazil and Europe.
The steel sector accounts for a staggering 90% of global iron ore demand, with the majority originating from the Asian continent, particularly China. As China embarked on its path to modernization, it constructed a vast and complex steel production infrastructure, cementing its position as the world's leading producer. In 2019 alone, it churned out close to 1 billion tons of crude steel.
Although China's hunger for iron ore may not match the rapid growth seen in previous decades, it is anticipated to sustain a robust level of demand.
China's ongoing urbanization, driving migration from rural to urban areas, is poised to fuel further demand for steel. Additionally, doubling steel production capacity expected in Southeast Asia by 2030 adds to the sector's growth prospects.
In the Asian market, Vale contends mainly with competitors from Australia, such as BHP, Rio Tinto and Fortescue Metals Group (FSUGY, Financial). Nonetheless, Vale maintains competitiveness in the Asian market for two primary reasons:
- Low impurity levels: Vale's iron ore exhibits low impurities and favorable properties, reducing steelmakers' processing costs and lowering greenhouse gas emissions.
- Relationships: Steel companies prioritize reliable supply chains, fostering trust-based sales relationships. Vale's ownership and operation of logistics facilities ensure timely product delivery at relatively low costs.
Attractive valuation and high shareholder remuneration
Vale's debt is currently at a very low level, and the possibility of investment in expansion is not significant compared to its normalized cash generation. Considering provisions, the company's net debt amounts to $16.20 billion based on the operating cash flow for 2023 of $13.50 billion. The net debt/operating cash flow ratio is 1.20, which I view as quite healthy. When it comes to net debt, without provisions for the Brumadinho tragedy in 2019, the same indicator stands at 0.70.
As the company is a strong cash generator, distributing it to its shareholders through dividends or share buybacks is the only way out.
If we look at the period from 2020 to 2023, the mining company distributed around $43.20 billion to shareholders, of which $14.30 billion was through buybacks and $28.90 billion was in dividends. It is worth noting, however, that during this period, the company enjoyed very favorable commodity prices. As a result, the company should deliver an average distribution yield, which takes into account buybacks plus dividends, of close to 8% this year, given its market value of $55.20 billion.
Source: Company filings, chart compiled by the author.
Iron ore spot prices
Considering that around 80% of Vale's revenue comes from iron ore, the commodity price is an important driver of the thesis. From 2015 to 2023, the company delivered a revenue compound annual growth rate of around 7.50%. As a result, the figure reported in 2015 went from $23.40 billion to $41.80 billion.
This upsurge was possible because of the sharp rise in the price of global commodities, especially iron ore, which went from $55.50 per ton at the end of 2015 to $119.80 per ton in 2023 when we refer to the reference price of 62% iron content.
Over this period, the company delivered gross profit growth of around 18.20% per year, which I find very attractive, increasing by $13.10 billion. Since the commodities business has high operating leverage (in other words, it can dilute fixed costs over a higher sales volume), profits increase faster than revenue. Vale increased its operating profit (Ebit) by 10.50% per year and net profit by 6.50% per year between 2016 and 2023.
Given this, Ebit moved from $7.10 billion to $14.20 billion, while net profit started at $5.20 billion and broke the $8.10 billion mark in 2023.
The bottom line
Vale stands among the largest mining companies globally, boasting extensive operations and setting the standard for cost efficiency.
The company's performance is closely tied to the Chinese economy. With China representing half of the world's demand for iron ore, a key material in construction, Vale's fortunes are intricately linked to Chinese economic trends. Consequently, its results remain relatively insulated from the Brazilian economy but highly sensitive to fluctuations in the Chinese economy.
Driven by the ongoing urbanization in Asia, particularly in China and India, the iron ore market has demonstrated resilience, with prices surpassing the $100 mark. As a result, despite Vale's breakeven point after current investments hovering around $64, the company has generated substantial cash flows in recent years, notwithstanding the compensation payouts for the Brumadinho and Mariana tragedies.
I believe investors who view Vale as a reliable income stock for their dividend-focused portfolio could see substantial returns over the medium to long term. This confidence stems from the company's strong track record of rewarding shareholders and its potential undervaluation, given its current forward price-earnings ratio of 4.70. This ratio stands 16% below its historical average over the last five years and a significant 71% below the industry average.
