Vale S.A. (NYSE:VALE) shares look significantly undervalued to me considering its valuations, lower breakeven point and the potential to generate higher volumes at lower costs. Moreover, the market dynamics for iron ore producers are strong and I do not expect prices to fall sharply to the level we had seen in late 2015. Vale’s cash generating potential and balance sheet also stabilized substantially in the last couple of quarters, thanks to improving earnings and recent asset disposals.
After dipping to the lowest level of $2.27 per share in the beginning of 2016, VALE stock bounced back sharply in the last six months. It is currently trading above $9 a share. However, the shares appear significantly undervalued, due to the company’s improvement in financial numbers and business fundamentals.
The Lower Breakeven is Key for Success
In the latest quarter, the company’s revenue soared substantially by 59% to $8.5 billion, while operating income hit $3.9 billion compared to $1.1 billion in the prior year.
The company has reduced its EBITDA breakeven for iron ore and pellets landed in China to $30.50 per dry metric ton in the first quarter 2017. Whereas, iron ore prices are currently trading around $70 a ton, with 62 percent content delivered to Qingdao standing around $66.81 a dry ton. The company has also lowered its base metal and coal production costs. In the latest quarter, its production cost per ton of coal shipped through the Port of Nacala declined 14% to $83.9 per ton.
The China Factor Offers Solid Support
After a sharp drop in the last three months, iron ore prices started rebounding over the last two weeks, thanks to strengthening demand from China, which consumes almost 44% of Vale’s production. China’s economy expanded more than anticipated in the second quarter, driven by growth in production and exports, particularly steel, which is a positive sign for iron ore prices.
China’s GDP increased 6.9% Y/Y in the second quarter, higher than analysts’ outlook for a 6.8% boost. Importantly, Chinese mills are expanding their production levels, resulting in improving demand for higher-grade iron ore. Bolstering traders’ sentiments was the output cut from Rio Tinto, which is the largest Australian iron ore exporter to China.
Aside from China, other Asian customers account for 13% of total revenue generation. For instance, India expects to generate GDP growth of 6.9% this year, while countries like Pakistan are also receiving higher infrastructure investments from China. At the same time, the majority of base metals are currently trading at their highest levels in the last three months, due to China related rally.
Strengthening Balance Sheet Is a Bonus
Before the historical cyclical downturn in commodity prices, Vale has invested billions of dollars in growth opportunities, resulting in a higher debt for the company, as lower prices have massively impacted its growth plans in the last two years. Nevertheless, the company is now aggressively lowering its debt position to strengthen the balance sheet and credit ratings. In the latest quarter, Vale reduced its debt by roughly $2.3 billion to $22.8 billion. Moreover, the company plans to lower its debt in the range of $15 billion to $17 billion by the end of this year.
Vale’s share price soared close to 18% in the last month alone, and its future fundamentals and lower breakeven points suggest further upside in the coming days. In addition, its shares look significantly undervalued trading around only 7.9 times to earnings and 1.1 times to book value, compared to the industry average of 18.2 and 1.9 times, respectively. Furthermore, with the potential to generate approximately $2 billion in free cash flows, the company is well set to attain its debt reduction targets. Thus, considering Vale at a current price seems like a good strategy.
The author of this article holds no position in any of the companies mentioned above.