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Vale's Good News Doesn't Improve Its Outlook

By Reuben Gregg Brewer - May 4, 2019 at 12:22PM

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Vale's operations are starting to come back on line after a shutdown following a mine disaster, but there's still plenty to worry about.

In 2015, a waste containment dam ruptured at one of Vale's (VALE 1.78%) Brazilian mines. Earlier this year, another of the global iron ore miner's Brazilian containment dams broke. Lives were lost in both instances, but, understandably, the government of Brazil is taking a harder line with the company after the second mishap. Still, following a broad shutdown, Vale has been allowed to increase production at a key mine in the country. But if you step back and look at the big picture, most investors should remain wary of Vale stock despite this good news. Here's why.   

Stop and start

After a mine waste containment dam broke at Vale's Samarco joint venture with BHP Group (BHP 2.52%) in 2015, the Brazilian government stepped in and hit the pair with large fines. However, when a similar disaster occurred at the company's Brumadinho mine earlier this year, the company and the government were faced with a bigger question: Were there broader concerns about the safety of Vale's facilities? When it turned out that Vale may have known about the risks at Brumadinho, the best course of action was obvious -- err on the side of caution.

Hands holding blocks that spell the words RISK and REWARD

Image source: Getty Images.

Thus, Brazil suspended operations at a number of Vale's mines pending deeper reviews of the facilities. (Other miners voluntarily followed suit, to ensure the safety of those who live near mining assets.) Vale announced that the forced shutdowns would result in a roughly 20% reduction in its iron ore output in 2019. That's a huge drop, amounting to a reduction of around 75 million metric tons of iron ore. Iron ore prices moved higher on the news. The company also decided to part ways with some of its top brass, including the CEO, as it looked to hit the reset button.   

Now, the company has announced that it has been allowed to restart some of its operations. The move will eventually mean the return of around 30 million metric tons of iron ore to Vale's production. Investors reacted by pushing iron ore prices lower. While this change is notable for the industry, and will likely be a benefit to Vale's business, it doesn't remove the big-picture problems the miner is facing today. 

Not so big a deal

The first real indication that the restart isn't as helpful as it may appear is the simple fact that Vale didn't increase its production guidance for the year. It's maintaining the lowered range it announced following the government-imposed closures. It's possible that new management is simply taking a conservative stance, but the truth is, it kind of has to tread cautiously given the circumstances. 

Two similar mine disasters in such a short period of time speak to bigger issues at the company. With the government taking a harder line, Vale can't politically afford to be overly aggressive in any way. It needs to show a significant level of contrition, if for no other reason than to convey it accepts responsibility for what happened. The impact that the production increase will have on the iron ore market, realistically, is almost immaterial to Vale's situation right now. The bigger problem the company faces is going to be on the legal and regulatory fronts.

For example, Vale and BHP have yet to settle all of the outstanding legal issues surrounding Samarco. According to a federal prosecutor, the $41 billion settlement agreement over that disaster is on hold until there's further clarity on the more recent disaster. If Vale turns out to be at fault, the Samarco deal could cost more, or at least end up being more complicated to finalize.   

VALE Chart

VALE data by YCharts

Vale is responsible for at least half of any costs associated with Samarco. It will likely be fully on the hook for any legal costs stemming from this year's dam failure. And, at this point, there's no way to tell how large the costs will be. What is clear, however, is that there are a number of very negative inputs. Those include the fact that this is the second disaster in a short time and that there were considerably more lives lost because of the second dam breach. Whatever the outcome is, conservative investors should probably see the $41 billion figure from Samarco as a low estimate for what Vale will face this time around.

Even if Vale is allowed to spread out the payments over a number of years, any fine will create a long-lasting bottom-line headwind. And that will be on top of the impact that comes from the Samarco settlement, the cost of which may actually go up. With so much legal uncertainty surrounding it, Vale is, at best, a special-situation stock right now. Most investors should avoid it.

Not worth the risk

Vale is one of the world's largest iron ore miners. What happens with its business has a major impact on the global supply dynamic in the industry, so investors do need to pay attention to what's going on with the company. However, amid uncertainty regarding the longer-term impact of the two mine disasters at Vale facilities, most investors would be better off avoiding Vale's stock. That remains true despite the fact that some market watchers are suggesting Vale's stock is undervalued. It's too hard to quantify the financial headwind that legal costs will impose, and they will likely hit the bottom line for years to come.

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Stocks Mentioned

Vale S.A. Stock Quote
Vale S.A.
VALE
$15.42 (1.78%) $0.27
BHP Group Stock Quote
BHP Group
BHP
$63.54 (2.52%) $1.56

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