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Vale Stock to Trend Higher on Positive Industry Tailwinds

Faisal Humayun

The first two quarters of 2019 have been challenging for Vale S.A. (NYSE:VALE). The company posted quarterly losses resulting from the dam burst in January. As a result, Vale stock has been depressed with a failure to breakout above $14 twice in 2019.

However, I believe that the second half of 2019 will be better for VALE stock and investors can use the current decline to accumulate the stock.

This article will discuss the company and industry-specific factors that will support a possible positive momentum in the second half of 2019.

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The Burden of Write-Downs

For 1Q 2019, Vale reported total write-downs of $4.95 billion. For 2Q 2019, the total write-downs were $2.0 billion.

This translated into quarterly losses for Vale and overshadowed positive industry developments. With nearly $7 billion in write-downs, it is likely that further write-downs will be minimal. This negative factor is therefore discounted in the stock price.

I am of the opinion that market attention will now shift to the restart of production, positive industry developments, and deleveraging.

Production Restart Trigger

VALE had to halt production totaling 93 Metric tons per year (Mtpy) in its first quarter of 2019. The company has already resumed iron ore production of approximately 43 Mtpy.

The company further expects resumption of 20 Mtpy production by the end of 2019. The remaining production of 30 Mtpy is likely to be recovered over the next two to three years.

The key point here is that total iron ore production for the second half of 2019 will be higher as compared to the first half of 2019. Production growth is likely to sustain in 2020 from the lows of 2019.

As sales volume trend higher, EBITDA and free cash flow visibility will improve in the next 12-18 months for Vale stock.

Higher Iron Ore Price Effects Vale Stock

Mid- and high-grade iron ore prices have trended to multi-year highs with Chinese port inventory declining to its lowest level since October 2017.

Even for Vale, higher EBITDA in 2Q19 as compared to 1Q19 was primarily driven by higher ore prices coupled with higher sales volume. This trend is likely to sustain in the coming quarters.

It is also important to note that the company’s iron ore sales product mix indicates 86% premium products in 2Q19 as compared to 77% in 2Q18. This would imply margin expansion on a year-on-year basis on the back of a favorable product mix.

In addition, stoppage and extraordinary logistics expense related to Brumadinho dam rupture was $5.7/t in 2Q19. These expenses are likely to decline by $1.5/t in 3Q19 and will also support EBITDA margin expansion.

Ongoing Deleveraging

For 1Q19, Vale’s gross debt had surged to $17.05 billion. In the second quarter, the company was able to reduce gross debt to $15.79 billion.

I believe that VALE will continue to deleverage in the second half of 2019. The company’s free cash flow from operations was $2.2 billion for 2Q19. I believe that free cash flows will increase in the next two quarters on higher sales volume and price realization (iron ore).

Therefore, decline in debt will improve the company’s credit metrics and potentially take the stock higher. While Vale pursues deleveraging, 65% of the company’s debt is due on or after 2023. Clearly, there is no debt refinancing pressure in the foreseeable future.

Risk Factors to VALE Stock Bullish Outlook

China’s economic growth is the key trigger for trend in commodity prices. As mentioned earlier, iron ore prices have trended higher as a result of decline in Chinese port inventory.

I do believe that China’s growth has bottomed out. However, weak growth in the U.S. or Europe can possibly imply even lower GDP growth in China. Therefore, weak economic growth and its impact on commodity price is one key negative trigger that needs to be monitored.

One factor that can offset this risk is an expansionary monetary policy in the United States. A weak dollar can send commodity prices surging higher.

It is worth noting that commodity, as an asset class, has been an under-performer in the last two decades. It seems unlikely that there is meaningful downside in commodity prices in the coming years.

Concluding Words on Vale Stock

Vale stock has been sideways to lower in the last 12-months. In particular, the first half of 2019 has been challenging for the company.

However, I am of the opinion that the second half of 2019 will be positive. I expect higher revenue driven by growth in sales volumes. Importantly, write-downs should decline significantly and Vale will continue to deleverage.

These developments should translate into higher Vale stock price and current levels are attractive for exposure to the stock.

As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.

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