CityU Equity Research · The Nickel Industry: The distribution of Nickel is relatively equally allocated. Philippines (17.2%) and Kazakhstan (16.1%) are the biggest mining countries

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Equity Research

Vale SA

06/12/2018

BHIMSARIA Ketan FAHIM Abdullah Al HAIDAR Karim HUANG Yixiang LENGES Cedric NASAR Osama ROUSSEAU Camille SINGH Sameer TANG Man Chung YEE Jacqueline

Published by CityU Investment Club

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VALE SA Investment & Valuation Summary Vale SA (Vale) is one of the largest metals and mining companies in the world. The company is the world’s largest producer of Nickel, iron ore and iron ore pellets. Vale also produces manganese ore, ferroalloys, metallurgical and thermal coal, copper, platinum group metals (PGMs), gold, silver and cobalt. Vale shares are traded on the New York Stock Exchange - NYSE (Vale), the B3, Brasil, Bolsa, Balcão (Vale3) and the Euronext Paris (Vale3). As of December 6th 2018, the company had a market cap of 74.6 Billion dollars. The company has 5.2 billion shares outstanding and 3.07 billion shares of floating stock and the adjusted closing price was 13.55 USD.

We forecast an increase of revenue of 5% for every year. We also expect them to stabilize their operating cost margin at around 70%. Then, we took a conservative approach by expecting the tax rate to stay at 34% for the following years. Finally, we believe Vale SA will increase its Working Capital every year around 3%. We believe that several factors are going to benefit Vale in the near future. These include the trade war, state of the Chinese economy, the increase in production of iron ore, the decrease of the company’s net debt and the rally in steel prices.

Stock Rating -Rating: Outperform -Target Price : 18.0 USD (2019E) Address

Vale Headquarters, Avenue of the Americas, 700 – Bloco 8 – Loja 318 – Barra da Tijuca, Rio de Janeiro, RJ.


TableofContentsVALE SA Investment & Valuation Summary ......................................... 2 BUSINESS DESCRIPTION ....................................................................... 4 MANAGEMENT .................................................................................... 4 INDUSTRY OVERVIEW AND COMPETITIVE POSITIONING (MACRO) ..... 5

The iron ore industry ....................................................................... 5 The Nickel Industry: ......................................................................... 6 Industry rivalry ................................................................................. 7 Overview of competitive advantage of industry rivals: ................... 8

INVESTMENT THESIS: Valuation & Financial Analysis .......................... 9 INVESTMENT RISKS ............................................................................ 12 APPENDIX ........................................................................................... 13


BUSINESS DESCRIPTION Vale’s work covers an array of key commodities such as iron ore, nickel, coal, copper, and precious metals. In 2017, the company was the largest global producer of nickel, pellets and iron ore. However, Iron ore is the main driver behind the company’s revenues. Ferrous Minerals accounted for 74% of total revenues in the fourth quarter of 2017 and 76% in the first quarter of 2018. The impact of ferrous minerals is even more felt on the bottom line, iron ore accounted for 80% of the adjusted EBITDA in 2017. In terms of markets, Asia is by far Vale’s largest source of revenues. Sales in Asian markets accounted for 58% of total revenues in the first quarter of 2018, with China alone accounting for 42%. Revenues generated in China are regularly at least two times larger than revenues generated in Europe (17% in 1Q2018) and Brazil (10% in 1Q2018), Vale’s next two leading markets.

MANAGEMENT

Fabio Schvartsman Fabio Schvartsman was appointed as the CEO of the company by the board of directors in May 2017. Prior to Vale, Schvartsman has had 40 years of experience and for the past 6 years he was the managing director at Klabin. In those 6 years, Klabin doubled its production capacity, tripled its market value and reported growing earnings for 23 consecutive quarters. At Vale, since his appointment, the company’s share price has doubled, growing from about 6.93 USD in May 2017 to 13.86 USD in November 2018.

Soon after he took over, the company decided on merging their different classes of stock into a single common share. The conversion plan, as it was called, limited government meddling in the company and lured more Asian investors and specialized mining and metals funds. This change was overwhelmingly approved by the shareholders.

As is shown below from the graph, Vale’s share price has seen a steady growth since May 2017, when Schvartsman was appointed:

Source: Yahoo! Finance


INDUSTRY OVERVIEW AND COMPETITIVE POSITIONING (MACRO)

The iron ore industry: The iron ore industry is dominated by a handful of actors. Australia and Brazil are the largest producers and exporters of iron ore in the world, accounting for 38% and 17% of global production and 57% and 24% of world imports respectively. While China (13%), India (7%) and Russia (5%) are also major iron ore producers, they retain most of their production for domestic steel production. Company concentration of iron ore production is very high, with the top 10 iron ore producers accounting for over 90% of the world’s iron ore output, and the top four companies accounting for 75% of the seaborne market. The four major companies are Vale, Rio Tinto, BHP Billiton, and to a lesser extent, Fortescue Metals Group. China consumes most of the world’s tradeable iron ore. The country accounts for 72% of seaborne iron ore imports and in 2017 it consumed an estimated 1,256 million tonnes of iron ore. This is largely due to the country being the biggest producer of steel in the world, and iron ore being a major component in steel production. China accounts for roughly half of global steel production- in February 2018 China produced 64.9 metric tonnes of crude steel out of the total 131.8 metric tonnes produced in the world. Historic changes in China’s steel production have shown the country’s influence on iron ore prices. China’s consumption of iron ore is so significant that changes in its demand for iron ore have direct impacts on the price per tonne of iron ore. The rapid growth in China’s demand saw the price of iron ore rise from $28US per tonne in 1999-00 to a spike of $173US per tonne in in 2007-08, with the price eventually averaging out at $123US per tonne between 2008-09 to 2013-14. As China’s demand slowed down and supply(mostly from Australia) rose, price fell 42% in 2014-15 and a subsequent 28% in 2015-16.This suggests that iron ore prices will decline following 2018 when steel production levels out. However, in the past few years iron ore prices have become less dependent on China’s demand as India and Japan have increased iron ore consumption. The mining of iron ore is a high-volume low-margin enterprise as iron ore is significantly lower in value compared to other base metals. In order to be profitable, large quantities of the low-value iron ore must be extracted at minimal cost. Iron ore mining is therefore capital consuming, requiring extensive infrastructure to extract and transport huge quantities of the iron ore, and capitalizes on economies of scale. The massive cost of capital required to enter the market is a significant barrier to entry, and therefore the iron ore industry is highly concentrated. As China currently consumes the majority of iron ore in the world and fluctuations in its consumption of iron ore has historically had direct correlation with iron ore prices. Iron ore prices have fluctuated greatly in the last two decades (for example, iron ore was $US28 per tonne in 1999-00, and peaked at $US173 per tonne in 2007-08) and is therefore a huge risk for Vale. Although other countries have since increased iron ore consumption taking away China’s dominating influence on iron ore prices, iron ore sales is heavily dependent on China.


The production of steel requires iron ore, and as steel is required for construction and a multitude of products (which will still be in high demand in the foreseeable future as developing countries expand their infrastructure), iron ore is not substitutable and there is little threat of substitute products. There is also largely no consensus on whether there are any viable substitutes for steel, and therefore iron ore will still be in demand to produce steel.

The Nickel Industry:

The distribution of Nickel is relatively equally allocated. Philippines (17.2%) and Kazakhstan (16.1%) are the biggest mining countries for Nickel, while New Caledonia, Russia, Canada, and Australia account for approximately 10%. China and Brazil share the Nickel’s production at about 4%. In the nickel market, the consumption has been rising, where the annual average growth rate was 2.3% (1990-2010). Starting from 2010 to 2015, the annual growth rate reached 5%, which the increase was mainly attributed to Chinese economy. Over past years, Asia has become the largest regional market for nickel that represents 71% of the total market. Additionally, the forecast of demand of such metal is expected to surge tenfold by 2025, due to the mass production of electric vehicles. Vale is the world’s largest producer of nickel. Nickel is the second concentration of Vale’s mining production, which forms 9% of its net revenues. With the growing demand of Nickel and the consumption especially from Asia, Vale will benefit from the nickel market. Nickel is primarily used in the manufacturing of Stainless steel. Demand has exceeded production in each of the past five years and will continue to do so in the near future. China is by far the biggest consumer and holds significant sway over the Nickel market. Fears of a slowdown of the chinese economy and in steel production sent prices plunging in 2015 . Recent trade tensions and deleveraging of the chinese economy are likely to have the same effect on prices. However, Nickel sulfate is a key component of batteries used in electrical vehicles. Estimates suggest that demand will grow exponentially as the EV market continues to develop. In the nickel industry and the mining industry in general, barriers to entry are very high mainly because, among others, high long-term infrastructure investments are required to mine and because nickel is concentrated in some specific regions (Australia, with reserves representing 19,000 kilotonnes, has by far the world’s largest reserves followed by New Caledonia with 12,000 kilotonnes) that only a few companies have access to. This definitely reduce the threat of new entrants in this industry. The production of corrosion-resistant austenitic stainless steel requires nickel as a primary ingredient. However, due to nickel ions being harmful to human body upon interaction through use of domestic appliances, substitute additives are being used instead of nickel such as a combination of chromium,molybdenum and nitrogen alloyed in stainless steel. Hence, there exists a potential threat of substitutes looming for the nickel industry as appliance manufacturing companies are starting to invest in “safer” options.


Industry rivalry The iron ore industry is highly concentrated and there are three other major companies outside of Vale that dominate 75% of the seaborne market. These three other companies are as follows: 1) BHP Billiton BHP Billiton (“BHP”) is an Anglo-Australian multinational mining company which is dual-listed as the Australian BHP Billiton Limited and the British BHP Billiton Plc. In 2017, BHP was the largest mining company in the world based on market capitalisation. BHP’s primary operations are (in no particular order) coal, iron ore, copper and petroleum. BHP’s iron ore output climbed 4% in 2017 to 268 metric tonnes, while its copper production fell 16% and its petroleum production fell 13%. BHP was the second largest producer of iron ore behind Vale in 2017, producing 238.4 million metric tonnes, while Vale produced 366.5 million metric tonnes. BHP largely mines its iron ore in Western Australia while Vale’s mines are primarily located in Brazil. BHP is the third largest producer of iron ore after Vale, and was fourth largest nickel producer in the world in 2017, while Vale was the largest. While Vale is currently still quite far ahead of BHP in terms of iron ore production, and very far ahead in terms of nickel production, BHP’s market capitalisation is nearly double that of Vale’s in 2018. 2) Rio Tinto Rio Tinto is an Anglo-Australian multinational company, similar to BHP. It is dual-listed as Rio Tinto Limited in Australia and Rio Tinto Plc in Britain. Its production of iron ore was 282.5 million metric tonnes in 2017 making it the second largest iron ore producer in 2017 after Vale. According to 2018 data, it is the second largest mining company in the world based on market capitalisation behind BHP. Rio Tinto’s four main operations are divided into Aluminium, Copper & diamonds, Energy & minerals, and Iron ore. 3) Fortescue Metals Group Fortescue Metals Group (FMG) is an Australian iron ore company. While its market capitalisation and iron ore production is not in the ranks of BHP, Rio Tinto and Vale it is the fourth largest iron ore producer in the world behind them. FMG mainly focuses on iron ore production in the Pilbara region of Western Australia. In 2017, FMG announced it would look into diversifying production by searching for minerals and metals in South America, as well as expressing an interest in gold, copper and lithium.


Overview of competitive advantage of industry rivals: 1) Collating of resources It is important to note that Vale’s three top competitors are Australian-based companies, with access to Australian mineral deposits, especially in the Pilbara. The Pilbara is a region in Western Australian which contains a network of sixteen iron ore mines and a 1700 kilometre rail network including mining infrastructure. In 2011, the three industry rivals listed above (Rio Tinto, BHP Billiton and Fortescue) announced significant capital investment into the development of new and existing mines, and infrastructure in the Pilbara. This conjoined effort allows these companies to take advantage of economies of scale and the collating of resources to further capital investment to the Australian mining region from which they collectively utilise. 2) Shipping costs These three competitors also have a competitive advantage over Vale as their shipping costs are much lower to ship the large quantities of iron ore to China (the largest consumer of iron ore in the world by far), and therefore have higher margins on their iron ore sales. The capesize freight rates in Australia-China routes are over 50% cheaper than Brazil-China routes. However, shipping costs and geographical distance are not necessarily the bottom line for iron ore sales to China. Striking a deal with China for investment in Brazilian mining infrastructure and bulk carrier ships has proven to have harmed the Australian mining companies and given Vale an advantage in the past. In 2015, China struck a deal with Brazil to underwrite a massive expansion of supply in Vale in retaliation against Australian mining company Fortescue Metals Group’s campaign for a Senate inquiry into iron ore pricing and discuss raising prices. The deal, known as S11D, included $US4 billion in cheap credit to help fund a 90-million-tonne-a-year iron ore expansion in the Amazon forest, and an investment in Vale’s Valemax bulk carrier ships to lower transport costs by as much as 25%. Therefore, Vale is not necessarily at a permanent disadvantage to its Australian competitors due to the geographical distance and high freight costs if it can make deals with the large consumers in the market.


INVESTMENT THESIS: Valuation & Financial Analysis We believe that several factors are going to benefit Vale in the near future. These include the trade war, China, increase of production of iron ore, new projects, decreasing of its net debt and the price of steel that is increasing.

1. Trade War: While the increasing tension of trade war brings up the price of domestic goods in US and China, the fear of world economic downturn has taken its toll on shirking investment market and withdraw of capital, which is the decisive key to the expansion of emerging market. Moreover, those emerging markets who heavily rely on US or China suffer even more from fierce competition with domestic products and potential shakedown of demand. However, the uncertainty of trade war itself brings up the demand of raw materials, which significantly boosts the import of iron ore, zinc, coal, copper and other key industrial commodities this year, as other countries seek for structure reform to be self-sufficient and boost their own manufacturing capacity with excessive possession of crucial materials. Vale will benefit from the skyrocketing price of these key raw materials as one of the biggest producer.

2. China Producing 50.3% of world’s steel, China has always been a major consumer in mining industry and Vale as well, which took up 57.8% of Vale’s total volume sold in the third quarter of 2018. As a result, the economical growth of China is tied closely with the performance of the market. With decreasing forecasted growth of China economy (YoY) by 6.2% and 6% in 2019 and 2020 respectively, Vale is expected to have further increase in its revenue. In addition, with China’s endeavor to mitigate air pollution, Vale, major producer in iron ore with high purity, will benefit from China’s new policy in the near future.

‘000 metric tons 3Q18 % 2Q18 %

Americas 10,608 10.80% 10,155 11.74%

Brazil 7,460 7.59% 7,064 8.16%

Others 3,148 3.20% 3,091 3.57%

Asia 71,028 72.31% 59,261 68.49%

China 56,754 57.78% 45,995 53.16%

Japan 7,320 7.45% 8,094 9.36%

Others 6,954 7.08% 5,172 5.98%

Europe 11,418 11.62% 13,109 15.15%

Germany 4,147 4.22% 4,545 5.25%

France 1,875 1.91% 1,769 2.04%

Others 5,396 5.49% 6,795 7.85%

Middle East 3,573 3.64% 1,960 2.27%

Rest of the World 1,599 1.63% 2,035 2.35%

Total 98,226 100% 86,520 100%

Source: Vale


Overall, the trade war between US and China casts a shadow on the projected growth of Vale as well as increases the uncertainty of its revenue stream as its biggest consumer, China, has a great possibility of undergoing bearish market and facing decreasing GDP Growth. But still, the increase in demand from other countries should provide Vale with extra revenue streams.

3. Increase of production of Iron Ore As the world’s largest iron ore producer, Vale has been providing high purity iron ore with output over 283 million tonnes in the first three quarters of 2018. Yet, according to Fabio Schvartsman, CEO of Vale, they will not loosen the quota for excessive production of iron ore despite its production capability of 450 million tonnes without further appreciation of market price. We believe that, as the tariff on steel and aluminum took effect at the end of the first quarter of 2018 and drove up the price of steel to 687.11 USD/MT as a record high in September 2018, the increase in production of steel will lead to an appreciation of the price of its ingredient – iron ore as well. As the largest income driver of Vale, which accounts for over half of its revenue stream, a significant increase in need of iron ore has helped Vale climb up from the abyss of bear market at the opening of year 2018 and is believed to generate considerable amount of additional income in the following quarters.

US$ million 3Q18 % 2Q18 % 3Q17 %

Ferrous Minerals 7,439 78.0 6,321 73.4 6,820 75.4

Iron ore fines 5,594 58.6 4,570 53.0 5,131 56.7 ROM 8 0.1 5 0.1 7 0.1

Pellets 1,627 17.0 1,518 17.6 1,441 15.9 Manganese ore 61 0.6 74 0.9 87 1.0

Ferroalloys 43 0.5 41 0.5 44 0.5 Others 106 1.1 113 1.3 110 1.2

Coal 425 4.5 356 4.1 360 4.0 Metallurgical coal 284 3.0 261 3.0 266 2.9

Thermal coal 141 1.5 95 1.1 94 1.0 Base Metals 1,586 16.6 1,870 21.7 1,762 19.5

Nickel 807 8.5 911 10.6 752 8.3 Copper 452 4.7 570 6.6 683 7.5

PGMs 103 1.1 126 1.5 72 0.8 Gold as by-product 150 1.6 156 1.8 161 1.8

Silver as by-product 5 0.1 9 0.1 7 0.1 Cobalt 65 0.7 94 1.1 79 0.9

Others 4 0.0 4 0.0 8 0.1 Others 93 1.0 69 0.8 108 1.2

Total 9,543 100.0 8,616 100.0 9,050 100.0

Source:Vale


4. New Investment projects Vale’s project, Salobo 3 is a $1 billion expansion of its vast Salobo copper-gold mine, located in Carajás, Brazil. It is expected to add around 50,000 tonnes to the open-pit mine’s current capacity of nearly 200,000 tonnes of copper per year. Not only harvesting but now planting seeds for the value of the future. Therefore, we believe that it is definitely benefit Vale in the future, to generate bigger cash flows.

Therefore, we expect an increase in Net Investment in next two years.

5. Decreasing Net Debt The net debt of Vale has been decreasing since 2017 by each quarter . By the end of second quarter of 2018,net debt fell by US$3.4 Billion to US$ 11.5 billion, with a total drop of US$ 10 billion over the last year.Furthermore,the iron ore production has plummeted,with earnings of US$ 2.1 billion in the second quarter of 2018 ,an increase of 17% relative to the previous quarter. The outcomes demonstrate the significance of good administration, in light of the three viewpoints: consistency, with solid outcomes and conquering the difficulties of the quarters as they progress; adaptability, with records of production and sales; and quality, with better premium rates. These outcomes demonstrate the dynamic improvement of their supply chain and improved product portfolio. The strong cash generation allowed Vale to increase the shareholder remuneration in the form of interest on capital.The debt decrease was bolstered by solid money influx and money inflows of US$ 3.7 billion from the deal of fertilizer assets and the Project Finance in Mozambique at Nacala Corridor in 1Q18, strengthening Vale's objective of reducing the net debt.

6. Valuation We forecasted an increase in revenues of 5% for every year, as seen in Appendix 1. We also expect them to stabilise their operating cost margin at around 70%. Then, we also took a conservative approach by expecting the tax rate to stay at 34% for the following years. The new Salobo 3 project is certainly going to increase the Net Investment of the firm within the next two years. Finally, we believe Vale SA will increase its Working Capital every year by around 3%.

Trading Data - 02/12/2018

Market Cap (USD) 72,397.3M

1 Month Change 14.4%

YTD Change 13.7%

52w low 10.55

52w high 16.13


INVESTMENT RISKS

● As mentioned in the business description, Vale is heavily reliant on Iron ore sales. A slower world economic growth would decrease global demand of iron and drive iron ore prices lower.

● Effects of the ongoing trade tensions on the Chinese economy will be seen during the upcoming quarters . A slower economic growth will decrease chinese demand for iron ore. As the Chinese government continues to focus on deleveraging The country was already expected to experience a slowdown in economic growth before US tariffs.In addition, Chinese steel exports have been a major focus of the current US administration.Slower economic growth coupled with trade tensions might have a sizeable effect on the iron ore market.

● The iron ore industry is dominated by a handful of companies. Ten corporations produce 90% of the world’s iron ore supply. A supply glut might spark an industry downturn like the one witnessed between 2014 and 2015


APPENDIX Appendix 1: Discounted Cash Flow Analysis

Appendix 2: Assumptions for the Valuation


REFERENCES

http://www.mining.com/vale-studying-1b-expansion-salobo-copper-mine-brazil-report/

https://www.synergymarinegroup.com/capesize-freight-rates/ https://www.jtsi.wa.gov.au/docs/default-source/default-document-library/wa-iron-ore-profile---june-2018.pdf?sfvrsn=72af721c_2

https://miningconnection.com/coal_prep/news/article/largest_iron_ore_producers_in_the_world_in_2017/

Distribution of min production of nickel worldwide in 2017, by country. (2017) The Statista. https://www.statista.com/statistics/603621/global-distribution-of-nickel-mine-production-by-select-country/ International Nickel Study Group http://www.insg.org/prodnickel.aspx Dent M (2018) FORECAST: EV nickel demand to surge tenfold by 2025, Vale says. Metabulletin. https://www.metalbulletin.com/Article/3806947/FORECAST-EV-nickel-demand-to- surge-tenfold-by-2025-Vale-says.html VALE’s fact sheet (2017). Vale. http://www.vale.com/PT/investors/company/fact-sheet/Documents/factsheet_i.pdf


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