Summary
- IO (Iron Ore) prices may hold above US$100/ton long term despite far lower Chinese property construction demand.
- On IO prices of US$100/ton Vale is fairly valued at 5.5x EV/EBITDA YE23.
- However, Vale could move from cash cow to growth if Cosan can “take control”.
Summary
The Vale S.A. ( VALE ) investment case has been altered vs my previous analyses Vale Stock: A Value Trap; Poor Growth Prospects. I now believe IO prices can stay above US$100/ton, despite the Chinese property sector's steep demand decline, which supports the current share price. The upside risk may come from a Cosan S.A. ( CSAN ) “take over” that looks to create value via growth i.e. expand Copper and Nickel volumes and/or perhaps acquire Lithium and Cobalt assets. However, in order to exercise any change, Cosan will need to secure a shareholder pact. News on this front could be positive when and if it occurs. In my view Vale is a hold on current valuation, with upside risk on the Cosan take over gambit.
IO Prices May Stay over US$100/ton
China IO demand and prices depend on China steel demand, which is driven by property and infrastructure construction as well as industrial demand (cars, machinery etc..). With the end of the real estate bubble and as residential construction declines the other sectors will need to make up the demand gap. I analyzed this steel/IO demand and capacity dynamics and came to the conclusion that under a 20% annual decline in housing units, back to 2003 levels , total steel/IO demand would see a 1.1% annual decline.
There are several factors that favor imported or seaborn IO. First is that China's steel capacity is predominantly (80%) a furnace/pig iron based technology that requires IO vs the electric arch technology that uses scrap steel for long (construction) products. The other key factor is that the Chinese IO is low grade and produces more Co2 than Brazilian or Australian IO grades. Thus, it’s possible China IO capacity declines before seaborn imports.
In addition, the other price equation for IO is seaborn supply or the ability of the top 4, with the lowest costs, to reduce or tighten capacity. Under the current production guidance, seaborn IO could grow 2% annually and increase its share of China demand from 80% to 95% long term. However, faced with a tight or declining steel demand environment, the top 4 may reduce capacity expansion, which helps the price dynamics.
Fair value with IO at US$100/ton
Vale could see EBITDA of over US18 on flat iron ore volumes and prices. This supports a valuation of US$17.6 for YE23 with a dividend yield of 7%. This is not a great return risk reward equation on its own and warrants at best a hold rating. Copper and Nickel contribute less than US$3bn to EBITDA and are still not growth drivers. Vale should accelerate its green metal portfolio in my view.
Below I present the financial and operating estimates with IO prices at US$100/ton with flat volumes and lower capex. Valuation is based on the companies 20yr average EV/EBITDA multiple of 5.5x, which may be viewed as generous given the low growth IO scenario.
Cosan upside risk
Cosan is a Brazilian conglomerate that acquired, via a complex share option structure, 6.5% of Vale. The stated proposal is to “contribute to value creation with current shareholders and the company’s management”. This stake will cost Cosan about R$1bn per year in funding cost or 10% of its operating cash flow. The market was not at all content with the transaction and the shares sold down over 15%.
In order for Cosan to create value it will most likely need to enter into a shareholders pact with other long term stake holders such as Brazilian Pension Funds and Mitsui to gain board seats and begin to formulate strategy. In the table below I identified about a 21% stake that may be gathered into a voting bloc. It is likely in Cosan’s best interest to achieve this as soon as possible and any announcement could be viewed as positive for Vale. Some of the value creation ideas speculated are: Expanding capacity at green or EV metals such as Copper, Nickel or via acquisitions for Cobalt and Lithium assets or JVs. Or perhaps head in another way and sell the EV metals and focus Vale on increasing cashflow and dividends. Given the Brazilian governments golden share, it’s not likely Vale can be sold to an Australian miner or Chinese steel producer. This Cosan stake adds upside risk, in my view.
Conclusion
Vale looks fairly valued with IO prices over US$100/ton, that seem sustainable even with a 20% annual decline in Chinese property sector steel demand. The Cosan take over gambit may alter or accelerate Vale’s strategic path that provides upside risk to the shares in my view.
For further details see:
Vale: Upside Risk From Cosan Take Over Gambit