Vale Stock: Waiting For Clarity On Base Metals Deal (NYSE:VALE)

Like most other major iron ore producers, the shares of Vale S.A. (NYSE:VALE) have been on quite a run since the end of November. Since that time, the stock has appreciated by well over 40% as investors anticipate the lifting of COVID restrictions in China and the gradual ramp-up of its economy. That expectation has also led to the prices of copper, iron ore, and nickel to surge to levels not seen since the first half of last year.

But the market may be getting ahead of itself, for the Chinese economy was slowing even before the onset of the pandemic, and the structural problems that it was facing then have only gotten worse in the last three years. That realization may soon lead the market to temper its enthusiasm towards the price of metals as well as Vale’s shares.

However, there’s also another issue that’s overhanging Vale’s stock; that being the proposed deal to hive off its base metals operations into a separate business. In this article, we’ll review the proposed transaction as well as the stock’s prospects within the current macroeconomic environment.

Company Background

As most readers are probably well aware, Vale is one of the world’s largest mining companies, and like the majority of the other major players in this space, it makes most of its money through the sale of iron ore. As can be seen in the exhibit below, the company derived almost 80% of its Q3 net operating revenue from the sale of iron ore, in both pellets and fines, while second place nickel trailed far behind with only a 10% share of its revenue.

The heavy focus on a single commodity left the company exposed to iron ore price volatility and the pullback in ore prices that occurred throughout most of the second half of last year. Third quarter revenues from Ferrous Minerals came in 13% lower than the previous quarter and 26% lower than Q3/21. And given such a steep decline, it was unsurprising that the stock price fell from over $21 in Q2 to just over $12 in July.

However, this is not a critique of Vale’s business model. Highly focused producers are often easier to analyze and understand, but when the price of the underlying commodity declines, there is not much that management or investors can do about it. Luckily, Vale is well-positioned to ride out these rough patches, and investors can afford to wait for the next cyclical upswing given the company’s high dividend yield.

The market also appears to believe that the next upswing is right around the corner. In recent months, the company’s stock price has rallied hard in anticipation of an end to Covid lockdowns in China and the restart of that nation’s economy; China is the world’s largest importer of iron ore, and a return to the growth rates of the past would undoubtedly power ore prices to new heights. The problem, however, is that those growth rates may not be coming back anytime soon.

China

In a previous article on Rio Tinto Group (RIO), I discussed the deteriorating environment for international trade and how that would likely impede China’s future growth. So as not to restate the same facts, this article will discuss China’s deteriorating real estate sector.

It’s no secret that the Chinese economy has been experiencing a decades-long real estate boom. In 2017, Chinese media reported that China’s floor space per capita had risen to 40.8 square meters, a number equal to that of Europe. After that, many investors predicted that China’s real estate market would soon crash, but developers kept building and prices held up. As can be seen in the exhibit below, towards the end of the decade the amount of floor space being added was declining and problems were beginning to emerge in the sector. Evergrande Group, one of China’s largest developers, defaulted in 2021 and home prices were beginning to fall.

The pandemic went on to compound those problems substantially. Last year, home sales in China fell by 26.7%, and 31.5% when measured by square meters sold.

Granted, warnings about China’s real estate market is something that investors have been hearing about for many years now, and while it’s true that the Chinese government will probably once again take steps to prop up property prices, at a certain point the music will have to stop. The recent news that China’s population has begun to shrink will only aggravate the problem, and trade tensions with many of its biggest trading partners won’t help the situation either.

Vale’s management doesn’t seem to be extremely bullish on the global economy, either. They expect iron ore production to increase only slightly to 320m tonnes in 2023 compared to 310m last year; that’s a far cry from the 100m tonne per quarter run rate the company was hitting in 2018.

Base Metals Deal

However, it’s not all doom and gloom for the company. For some time now, management has been trumpeting its dedication and commitment to the energy transition. During the most recent quarterly earnings call, Eduardo Bartolomeo, Vale’s CEO, made sure to once again mention how Vale was positioning itself to be, “the partner of choice of the energy transition and the EV megatrend.” In saying that, he sounded like almost every other CEO of a publicly traded company, who are now all trying to somehow associate their companies with the EV industry. The difference with Vale, however, is that these declarations are being backed up with concrete measures.

In September, the company announced that it was in discussions to sell a minority stake in its base metals business in order to boost copper and nickel production to meet the growing demand resulting from the energy transition. Copper production is already expected to jump to between 335k and 370k tonnes this year from about 260k tonnes last year, while nickel production is anticipated to be 300k tonnes in 2023, much higher than the approximately 180k tonnes produced in 2022.

The base metals assets will be separated from the iron ore operations and be placed into a new legal structure named Vale Base Metals. It will have independent governance and a board that includes both mining and EV specialists. Vale is looking to sell a 10% minority stake to a strategic partner for $2.5 billion, and reports say that it has offers on the table which it is currently evaluating. One thing is clear, though, in the future Vale clearly intends to run the nickel and copper assets separately from its iron ore operations.

Takeaway

Those iron ore operations will continue to dominate Vale’s consolidated balance sheet and income statement, but the slowing Chinese economy will be a drag on revenue and earnings. Future growth will likely come from the base metals business. So, while we still have to wait for the deal to be finalized, the proposed new structure is intriguing. It could allow Vale to team up with a strategic partner that has deep automotive experience, such as an auto OEM, and it may provide greater capital raising flexibility.

Given the growth projections for battery metals such as nickel, it’s highly possible that Vale Base Metals goes on the acquisition trail shortly after the deal is finalized. We’ll have to wait and see. But for now, I rate Vale S.A. stock a Hold; however, I will keep a close eye on it and be keenly interested to see who Vale partners with.