Vale: Cockroach Rule In Action – Vale S.A. (NYSE:VALE)

Vale’s (VALE) story continues to develop. Back in March, I wrote that I’ve always been a proponent of a cockroach rule – once you see the first cockroach (a material problem), there’ll be more. Unfortunately for Vale shareholders, this is what is happening to Vale right now. The company has recently warned that a dam at Gongo Soco mine was at risk of rupturing. Market reaction quickly followed: Vale shares dived, while iron ore prices increased, helping boost shares of fellow iron ore miners Rio Tinto (RIO) and BHP (BHP).

The financial impact from the Brumadinho dam rupture on the company’s first-quarter EBITDA was almost $5 billion, mostly due to provisions for compensation/remediation programs and decommissioning of tailing dams. However, this is certainly not the final number of damages as the company continues to lose production due to closed mines and has not faced lawsuits yet. Problems at another dam, whether they lead to rupture or not, indicate that Vale’s remaining dams are far from being in their best shape, and more costs will likely arise in the future.

Vale finished the first quarter with $5 billion of cash on the balance sheet. Despite the challenges, the company recorded $3 billion of operating cash flow. Given the importance of Vale for Brazil, catastrophic scenarios (a total collapse of the company) are off the table under almost any circumstances. However, it looks increasingly likely that it will take years to deal with the current mess. Costs will increase, and so will uncertainty. I believe that later in this year, Vale will have to book more damage-related money on the balance sheet with the corresponding effect on the company’s financial performance. Upside on the iron ore market supports Vale financially as it helps mitigate the loss of production, but the real danger comes from post-catastrophe costs and potential litigation.

Currently, the stock trades in a wide $11.00-14.00 range. The low end of this range marks a loss of $26.4 billion of market capitalization compared to Vale’s stock price (~$15) before the catastrophe. This is a very material change. The high end of this range which marks a loss of $5.28 billion of market capitalization will serve as a bullet-proof ceiling for the stock for many months to come – Vale has already booked $5 billion for damages, and more costs are likely on the way. However, should shares go below $11.00 for whatever reason, especially in some kind of panic, they will present an interesting opportunity for a trade.

Before the catastrophe happened, the company was a very interesting bet in the iron ore space. Despite the cut of production, Vale maintains a solid cash flow generation ability thanks to higher iron ore prices. Long-term-oriented investors should either wait for a good price (which could be possibly achieved in a panic, for example, if another dam breaches) or wait months before the company sorts out its problems and the shares are ready to breach $14.00 level and continue their previous upside trend. For shorter-term-oriented speculators, a range play from the $11.00 level may be interesting, although I’d prefer to see shares below this level before thinking about a long bet as another potential dam breach could be a very serious catalyst. There’s certainly plenty of action ahead in Vale shares, so stay tuned!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may trade any of the above-mentioned stocks.