Vale SA (VALE)

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Vale: Low cost producer of iron ore and nickel with high leverage to global growth

Analysts: Chris LaFemina, CFA ([phone]), Abhishek Shukla, CFA ([phone])

Investment conclusion: As detailed in the attached 29 page note, we have launched coverage on Vale with a 1-Overweight rating and a $45 price target for the Vale common ADS (versus its most recent closing price of $36.68, and based on the average of 11x its 09E EPS of $3.96 and 13x its estimated normalized EPS of $3.55). We maintain our positive view on the mining sector and consider the recent weakness in some of the names (Vale and the European listed miners in particular) to be an excellent buying opportunity. Vale's commodity exposure is mostly iron ore (~70% of EBITDA) and nickel (~20% of EBITDA). Although, based on our detailed analysis, the bottleneck in the steel supply chain has shifted from iron ore to coking coal and spot iron ore prices have downside risk in 2H08 as a result, we expect iron ore contract prices to continue to increase (+15% in 2009E). We also expect nickel prices to recover as the current price ($9.90 per pound) is below our estimate of marginal cost of production (between $11 and $12 per pound). Vale should also benefit from its industry leading organic growth pipeline (guiding to volume growth of almost 11% per year over the next five years) and its position as a very low cost producer with lower operating risk than most other miners. As we discuss in the attached note, we believe high freight rates (up tenfold this cycle) have created a significant competitive disadvantage for Vale's iron ore business (in Brazil) versus that of Rio Tinto and BHP Billiton (in Australia). However, with 40%+ freight capacity growth by 2010, we expect freight rates to fall and Vale's primary competitive disadvantage to dissipate. Is this possible with oil prices as high as they are? Yes. We estimate the fuel cost is just 15% of the current Brazil to China freight rate. Another factor to consider is Vale's growth plans. We expect this company to pursue its stated goal of becoming the world's biggest miner through a combination of organic growth and large-scale, value-creating M&A. Will it be Anglo? Xstrata? Freeport? Alcoa? None of the above? We evaluate each in some detail in the attached note and conclude that Anglo or Freeport would be the most likely potential target in the near-term. Either way, we believe market concerns that Vale may make a large, dilutive deal are overblown, and an acquisition of any one of these companies other than Alcoa could be earnings accretive for Vale. With all of these factors in mind, we recommend that investors buy shares of Vale at current levels.

The iron giant: Vale has lower iron ore mining costs than either Rio Tinto or BHP Billiton. The company has a 37% market share in the seaborne iron ore market and has the organic growth potential to maintain this market share despite strong global demand growth. Based on our analysis, iron ore contract prices for Vale have very little downside risk over the next five years unless freight rates surprisingly remain at today's ultra-high levels.

The pride of Brazil to grow via M&A: Vale has announced that it may issue up to $15bn of common and preferred shares, the proceeds of which could be used for strategic acquisitions. Of course, Vale did come close to acquiring Xstrata earlier this year. Based on our analysis, an acquisition of Anglo American, Xstrata, or Freeport would likely be earnings accretive for Vale. However, each of these potential acquisitions would face some obstacles, in our view. See the attached note for our analysis.

Prefer Vale to Vedanta: For hedge fund investors worried about emerging market exposure, we recommend using a short position in Vedanta as a hedge against a long position in Vale. Vedanta has exposure to zinc (price today is >20% below consensus, and market surplus is likely to persist) and spot iron ore (has more downside risk and less upside potential than contract iron ore prices, based on our analysis). Furthermore, many investors had been using Reliance Power (Bloomberg ticker RPWR IN) as a comp to Vedanta's Indian power business. The Reliance Power stock price is down 45% since 21 May.

Inexpensive valuation: On our estimates, Vale is trading at a 2009E P/E of 9x, which is inline with the sector, but at a 10% premium to the market cap-weighted average of BHP Billiton and Rio Tinto. In light of Vale's industry leading growth, relatively low operating risk, high exposure to steel-intensive growth in emerging economies, and exposure to commodities with limited downside risk to price, we believe that Vale shares should trade at a premium to the sector.