Despite Weak Results Vale SA Remains an Attractive Investment Opportunity

This year, Vale (NYSE: VALE  )  has underperformed its mining peers BHP Billiton (NYSE: BHP  )  and Rio Tinto (NYSE: RIO  )  and present a good investment opportunity, as such underperformance is unlikely to continue. The stock is down 11%, while BHP is up 3% and Rio Tinto is down 3%. Vale offers a strong balance sheet and low-cost mines. The company has been aggressively cutting costs and was recently rewarded for its efforts by a positive outlook change by Moody's.

Source: Google Finance.

Results not as bad as they might look
The largest producer of iron ore reported soft first quarter results driven by weaker iron ore prices, which declined 20% quarter over quarter. Vale reported adjusted EPS of $0.40, missing analyst estimates of $0.54. While the average realized iron ore prices of $91 per ton hurt profitability, operating results were largely in-line, which produced good cash generation.

The headline results are not as bad as they might look as the provisional pricing had a negative impact of $6 per ton, which should be temporary. Provisional pricing captures the 45-day difference between Vale shipping ore from Brazil and pricing it in China. So effectively Vale over-estimated prices in the fourth quarter of last year and is backing it out now.

Optimistic iron ore price outlook
Iron ore supply has exceeded demand for the first time in 10 years, driven by a slowdown in demand from China. Beijing's crackdown on the use of commodities as collateral to raise money has also negatively affected prices. However, Vale expects demand to improve sequentially, driven by a recovery in Europe's economy and the end of stricter monetary policy in China.

Vale believes that prices will not go below the $110 level on a sustainable basis. In the past, iron ore prices have fallen below $110 many times, but they recover quickly. Murilo Ferreira, CEO of Vale, commented: "Because those are the level that many producers mainly in China will leave the market. So I think the price will be in this range with the potential to be above this level, depending up on the demand behavior." 

Attractive valuation and rating change
Vale is trading at a very attractive valuation compared to its peers. It has a forward price-to-earnings ratio of 6.4, compared to 8.5 of Rio Tinto and 20.5 of BHP. Vale has a trailing dividend yield of 6.4%. The company's management has taken positive steps in improving capital discipline and reducing expenses. Vale's cost reduction efforts were rewarded with the rating change by Moody's from neutral to positive.

Positive Brazilian ruling
On April 24, the Brazilian Superior Justice Tribunal voted 3-1 in favor of Vale on 22.3 billion real ($10 billion) of disputed taxes on foreign profits from the period between 1996 and 2002. 

This is the first time the company has been successful with this matter in court. As of now, it is unclear if the government would be able to appeal to the Supreme Federal Court, the country's highest court. In case the government decides to appeal, success at the Superior Court of Justice has considerably increased the likelihood of Vale receiving a favorable final judgment at the Supreme Federal Court.

If there is a final ruling in Vale's favor, or another company or industry group on this topic, the company could potentially ask for tax credits equal to the amount already paid. Vale could claim that the government never had the right to collect it. This also explains management's sudden change in position of not provisioning the tax liabilities to settling with the government.

As a reminder, Vale agreed last year to participate in the Brazilian government's tax refinance program, or REFIS, paying R$22.2 billion in tax contingencies for the period of 2003 to 2012. In view of the ongoing legal process, the company did not include the fiscal years 2002 and 2013 in the REFIS program. However, with this favorable ruling, the company could be eligible to temporarily stop REFIS payments and request a reimbursement of payments already made. That said, I think Vale would need to win the case in the Supreme Federal Court to halt payments.

Bottom line
Vale, the largest producer of iron ore in the world, can withstand low iron ore prices due to its low cost production. The company operates low-cost mines and has a strong balance sheet. It is aggressively cutting down costs and has made positive steps in improving capital discipline and reducing expenses.

I believe the market is extra cautious on the iron ore price outlook and long-term prices could exceed expectations. In case the prices rebound quicker than expected, Vale has mineral resources to support production growth.

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