March 10, 2017 / 5:50 PM / 5 months ago

Doubts over iron ore outlook cap rally in Brazil's Vale shares

SAO PAULO, March 10 (Reuters) - Shares in Vale SA fell on Friday, bringing their losses over the past two weeks to nearly a fifth, as investors fretted over the impact of a potential drop in iron ore prices on the world's largest producer of the steel-making raw material.

The decline underscored growing investor concern that optimism over Vale's aggressive cost-cutting and governance reform plans, which drove shares to a four-year peak on Feb. 21, may have been overdone.

Shares are still up 26 percent this year, among the biggest gainers on Brazil's benchmark Bovespa stock index, which has risen 8.6 percent. But their recent slump suggests the strong start to the year may be slowing.

"Clearly, investors are telling us that earnings are not sustainable at current levels, and that iron ore is set for a strong correction ahead," Banco BTG Pactual SA analysts led by Leonardo Correa wrote in a note distributed to clients on Friday.

Vale's preferred shares were down 1.1 percent in early afternoon trade on Friday in Sao Paulo.

Executives at the miner have been bullish about iron ore prices, saying they expect it to average above $80 per tonne in 2017 compared to Friday's $86.79 spot price for delivery to China's Qingdao port .IO62-CNO=MB.

But traders and analysts are all but convinced prices are likely to drop further as the year drags on, hit by concerns over global iron ore and steel oversupply and weak demand from China.

Fourth-quarter iron ore futures indicate a price of $68 per tonne, according to BTG Pactual, a drop of roughly 20 percent.

Vale has sold non-core assets and cut costs to weather a global demand slowdown and steel industry over-capacity. At the same time, iron ore output reached a record high last year as ore prices reached two-year peaks.

REDUCING RISK

Vale's unveiling in February of plans to scrap its controlling shareholder structure further boosted stock prices as investors saw it reducing risk in a country long plagued by corporate governance abuses.

Now analysts and investors are questioning whether that is enough to keep the stock rally alive.

"If you expect iron ore prices to hold above $90 for a long time, Vale should trade at a minimal discount to peers. But the market's base-case scenario is of a downward trajectory," said AZ Quest Investimentos Ltda head of equities Alexandre Silvério, who helps manage 1.6 billion reais ($506.9 million) in stocks.

Vale shares are trading at 6.14 times projected 2017 earnings, compared to 8.56 times for Rio Tinto Plc and 11.72 times for BHP Billiton Ltd, according to Thomson Reuters data.

However, Vale's enterprise value, or total equity and debt minus cash, clocks in at 5.42 times estimated earnings before interest, tax, depreciation and amortization (EBITDA), in line with both rivals and suggesting room for further stock drops.

Vale shares could also suffer a period of volatility as the company looks for a new chief executive, with CEO Murilo Ferreira stepping down in May.

But some saw the selloff as a buying opportunity, betting Vale will manage to deliver strong operating results even if iron ore prices plummet.

In a bearish scenario in which ore prices drop to $50 per tonne, analysts at JPMorgan Securities estimated U.S.-listed Vale shares should trade between $8.10 and $10.20, compared to $9.56 currently. If ore prices fall to $60 per tonne, that range would rise to between $13 and $15.80. ($1 = 3.1567 reais) (Reporting by Bruno Federowski; Additional reporting by Stephen Eisenhammer; Editing by Meredith Mazzilli)

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