Vale in Neutral Lane

We reiterate our Neutral recommendation on Vale S.A. (VALE). We are optimistic on the new iron-ore pricing system, the prime reason behind the excellent results during the second quarter of fiscal 2010 with EPADR of 70 cents surging ahead of 15 cents posted in the year-ago quarter.

Net operating revenues of $9,658.0 million also almost doubled from $4,948.0 million in the second quarter of 2009 and $6,604.0 million in the previous quarter.

However, we are concerned about the instability in the Chinese market with regard to carbon emissions, which are almost double that of the U.S. and triple that of Europe. This would definitely force the Chinese government to impose regulatory restrictions on carbon emissions, which in turn will have a negative effect on the iron ore sales market in China, the largest importer of iron ore.

On the other hand, we are confident about China’s steel consumption, which is expected to increase 6.7% to 579 million tons in 2010 based on the rapid urbanization taking place in the country. Thus, we believe that once the inventory in the Chinese market exhausts, the demand for iron-ore will rebound.

The global steel demand is also expected to climb 10.7% in 2010 and 5.2% in 2011 based on the gradual improvement of the market. Moreover, the recovery in the emerging markets will always be greater than the developed economies of the world, which is encouraging for the Brazil-based company.

However, a strong exposure to international markets puts it in a disadvantageous position in terms of exchange rate fluctuations. The bulk of the company’s total revenue (around 85%) comes from outside Brazil. Moreover, competition in the international iron ore market is intense. Its biggest competitors in the Asian market are located in Australia and include affiliates of BHP Billiton Ltd. (BHP) and Rio Tinto (RTP).

Vale faces a couple of distinct competitive disadvantages vis-a-vis BHP and Rio in the Asian market. Transportation costs of delivering iron ore from Australia to Asian customers are generally lower as a result of Australia’s geographical proximity. Moreover, Rio’s iron ore has low impurity levels, which generally leads to lower processing costs. Hence, currently the stock has a Zacks #3 Rank (short-term Hold rating).

VALE RIO DO-ADR (VALE): Free Stock Analysis Report

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