Tuesday, 4 September 2012

Why Investors Should Exercise Caution on VALE

Source:  Seeking Alpha
August 30th, 2012

I last wrote on Vale (VALE) in early July this year, and since then, the company's price has fallen further by 22%, and is now trading at around $16 per share. This rapid price decline has seen a number of market pundits emerge, declaring that with a price-to-earnings ratio of around six and a dividend yield of 7%, the company is now a stunning value investment opportunity. In my previous article, I came to the conclusion that Vale was a particularly volatile stock with an unpredictable future because of the significant uncertainty surrounding the company and its operations. This includes the ongoing uncertainty surrounding iron ore prices and the direction of the Chinese economy, along with the growing political risk. At this time, none of these risks have subsided, and in some cases have only magnified, increasing the difficulty in predicting the direction of the stock.

Financial performance continues to be poor
While the company's second quarter 2012 revenue increased in comparison to the first quarter (QoQ) by 7% to $12 billion, net income fell by 30% to $2.7 billion. The company's EBITDA, which I believe is a better measure for comparing financial performance, increased QoQ by 3% to $5.1 billion.

But in comparison to the same period for 2011 (YoY), Vale's second quarter 2012 performance was extremely poor. Reported revenue was down by 21%, EBITDA was down by 44% and net income declined by 58%. It is this considerable downturn in financial performance that has caused the share price to plunge 40% over the last year.

The company's cost-of-goods-sold (COGS) for the second quarter 2012 also increased QoQ by 5.7% to $6 billion as a result of increased production. This gives Vale a COGS to revenue ratio of almost 50%, which is an indicator of efficiency, remains unchanged from the previous quarter. This indicates that, despite increasing production, Vale has been able to continue operating efficiently -- and more efficiently than either Rio Tinto (RIO) or BHP Billiton (BHP), with COGS to revenue ratios for the second quarter 2012 of 67% and 69%, respectively.

These numbers, along with the many positive comments coming from the Vale camp regarding the future of iron ore prices and company performance, leave a particularly positive view of the company. But there are many additional factors that investors need to take into account before taking the plunge and investing in Vale at this time.

Despite attempts to diversify production, iron ore is the key profit driver
The majority of Vale's revenues are derived from iron ore products, which in the second quarter, accounted for 70% of all revenue. This was then followed by nickel, fertilizer nutrients such as potash and phosphates, copper, and then logistics, as the chart below shows.
(click images to enlarge)

Source data: Vale US GAAP 2Q12 Performance

While Vale has sought to diversify its revenues, iron ore is the key driver of profitability. Furthermore, these efforts at diversification have not been particularly successful, with Vale's choices of producing base metals and fertilizer nutrients also seeing their prices fall, along with other commodities because of the current global headwinds.

This dependence on iron ore as the key revenue generator means there is obviously a significant correlation between the iron ore price and Vale's share price, as shown in the chart below.

Source data: Index Mundi, Bloomberg, Yahoo Finance, Fidelity

However, interestingly, the chart indicates that both BHP's and Rio's share prices have a greater correlation to the price of iron ore than Vale's. This would indicate that there are other factors holding back Vale's share price that are unrelated to iron ore price.

The iron ore price is deteriorating rapidly
Over the last eight months, the price of iron ore has deteriorated rapidly, and is now at $90 per metric ton (pmt). This is the lowest price for iron ore seen since October 2009, and represents a 52% fall from iron ore's peak price of $187.18 pmt in February 2011, as well as a 36% decline for the year-to-date.

The primary drivers for the plunge in iron ore prices is the government-induced soft landing in China, which has seen Chinese economic activity, and therefore demand, for basic materials slow significantly. For the second quarter 2012, China's economy expanded by 7.6%, which is its slowest rate since the first quarter of 2009. It is also predicted that there won't be a significant uptick in economic activity for the third quarter and that full year economic growth will be around 8.2%.

Source data: Index Mundi, Bloomberg, National Bureau of Statistics of China

This chart also illustrates the correlation between the rate of Chinese economic growth and the iron ore price. This correlation, along with that between the iron ore price and Vale's share price, clearly indicates that Chinese economic growth is key to Vale's financial performance and value.

Chinese economic outlook is uncertain
The long-term outlook for China is positive, with the country still in the midst of growing its economy, building infrastructure and industrializing. This process brings with it a tremendous demand for basic materials, ranging from those required to build the industrial infrastructure of a growing manufacturing base to constructing the housing and commercial infrastructure for a rapidly urbanizing population and expanding business sector.

But for the short to medium-term, the outlook is not so bright. This can be attributed to a number of factors, but key are the global headwinds caused by Europe's financial crisis and ensuing austerity measures, which have caused the demand for a wide range of goods manufactured in China to fall. In conjunction with this is the Chinese government-induced soft landing, which has been used to rein in a growing property bubble and spiraling inflation.

The latest Chinese manufacturing and non-manufacturing PMI data was also not particularly positive for investors. For July 2012, the manufacturing PMI came in at 50.1 points, which is its lowest point since November 2011. The non-manufacturing PMI came in at 55.6 points, which was a 1.1 point decrease from June. But on a positive note, both PMIs are still above the all-critical 50 point threshold, which differentiates between whether economic activity is expanding or contracting, with 50% representing now change.

Furthermore, with European headwinds having a greater than expected impact on the Chinese economy, leading it to slow more than planned, it is likely that the Chinese government will consider easing economic policy in an effort to head-off a broader economic slowdown. This will be primarily driven by policies aimed at promoting domestic demand as a means of buoying industrial production. Normally any measures that indicate increased Chinese economic growth would be a strong positive indicator for commodities stocks. This leaves a far more positive impression of the outlook for China, and one would think, the demand for basic materials like iron ore.

Demand for iron ore will remain low for some time
Despite this positive long-term outlook, however, there are two factors that will affect the demand for iron ore and other basic materials in the short to medium-term. The first is that the Chinese government is determined to switch from an export driven economy, particularly in light of the impact of the European crisis on China, to one that is driven by domestic consumption and demand. Obviously, this will cause the demand for basic materials to slow over the long-term, as discretionary consumer industries and financial services grow, and manufacturing for export growth becomes less important.

However, the transition to an economy driven by domestic consumption requires a far higher degree of development, and typically the transition from being upper middle income to a high income economy. China is only starting out on this path and to complete this transition, will require a considerable amount of further development.

The second, and probably the most significant, factor affecting the short-term demand and price for iron ore are the large stock piles if it and other basic materials currently held in China. At the end of June 2012, it was estimated that iron ore stock piles almost totaled 100 million tons, and that other raw materials stock piles were continuing to grow. Until these massive stock piles have been reduced, it would not be profitable for manufacturers to continue importing raw materials at the pace they have been in the past.

The consensus long-term forecast price for iron ore is in the $75 to $80 pmt range, and I certainly believe this is where the price will move given the muted demand and high iron ore inventories in China. This is significantly lower than the average second quarter 2012 iron ore price of $103 pmt Vale received, and the $109 pmt received in the first quarter. For the next two quarters, it is likely that the iron ore price will be moving around the $90 pmt.

Other immediate matters and risks affecting Vale
Vale is also exposed to a considerable amount of political risk, which is leaving the company engulfed in uncertainty, and which is certainly affecting its pricing. These issues are rarely mentioned by the pundits claiming that Vale represents value at its current price, however, they are having a material effect on the company's performance and outlook.

The first issue is a taxation dispute arising from a Brazilian government claim for an additional $15 billion tax on profits from Vale's foreign subsidiaries. Already to date, Vale has contested this claim on the basis that it constitutes double taxation and is, therefore, a breach of the Brazilian constitution. The lower court, which originally heard the matter, found in favor of the Brazilian government and this decision was upheld on appeal to the 2nd Federal Region Tribunal. The matter is now before the Brazilian Federal Supreme Court for deliberation, and a decision has yet to be handed down.

While Vale's CEO Murilo Ferreira is confident of winning the case, the lack of transparency in the Brazilian legal system and the government's willingness to overtly interfere in the economy makes it difficult to determine the outcome with any certainty. It also appears unlikely that the Supreme Court will find in favor of Vale when two lesser courts have made rulings against the company in favor of the government's claim.

If Vale loses the appeal and has to pay the additional taxes, the company's capital expenditure program will effectively be crippled. This will prevent the company from diversifying its revenues outside of iron ore and continuing to invest in a range of projects. These projects include the Belo Monte hydroelectric power plant, the Pacific Hydro wind energy joint venture and the company's expansion into Canadian potash, which has already been postponed.

Vale is also embroiled in a royalties dispute with the Brazilian government. The government is claiming that the company owes an additional $2 billion in royalties. It is likely that this matter will be settled over the next month, and it has been speculated that, as part of the settlement, Vale will pay the full amount claimed by the government.

Both of these matters leave me feeling particularly uneasy about investing in the company in an environment where the price of its principal product, iron ore, is falling precipitously and can't be determined with any degree of certainty.

Valuing Vale
Many of the pundits who are calling Vale a value opportunity are doing so on the basis that it is trading with a TTM P/E ratio of 6 and has a TTM dividend yield of 7%. These ratios in comparison to many other stocks make Vale look like a bargain that is too good to miss. But many of these ratios are based on historical indicators and data, which means they do not take into account the less than optimistic future outlook for iron ore prices.

For this reason, I have attempted to determine a valuation range for Vale using a free cash flow to equity valuation based on the following assumptions:
  • The iron ore price is calculated at $90 pmt, which is a 15% decrease from the average price received by Vale over the first half of 2012.
  • Expenses remain steady, with the COGS to revenue ratio remaining at around 50%.
  • Capital expenditure remains unchanged, but I would expect this to drop if the price of iron continues to move downward.
  • The assumed rate of growth is negative 12% based on the price of iron or for the remainder of 2012.
Based on these assumptions, I arrived at a short-term indicative price of around $16, but there are a wide range of factors and assumptions that can change this. I have allowed for a range of different assumed growth rates in the table below, and set out the corresponding prices per share that were calculated:

It is important to stress that these are indicative prices only. When calculating these valuations, I have only taken into account a limited range of assumptions regarding Vale's operating environment. Investors should recognize that there is a significant range of factors and combinations of these factors that have the potential to negatively impact Vale's share price.

Bottom line
The outlook for Vale over the short-term is particularly uncertain, and at this time, the medium and long-term outlooks are not particularly positive. At current iron ore prices, I would expect to see the company cut its shareholder remuneration, with the first payments to be cut being the interest on shareholders' equity (ISE). It would be impossible for Vale to suspend its dividend payment completely unless it reports a net loss, because Brazilian companies are legally compelled to payout 25% of net profit to shareholders.

Furthermore, it is clear that Vale is still surrounded by significant uncertainty, which makes it impossible to state that it represents a value at its current price, nor is it possible to pick the stock's bottom. This is primarily due to not only the uncertainty surrounding the iron ore price, but also the financial risk associated with the tax and royalties disputes, which total $17 billion.

For these reasons, I am very hesitant to make any positive statements regarding the outlook for Vale, particularly with so many unknowns that have a high potential financial impact on the company yet to be played out. In the wrong set of circumstances, including a significant dividend cut, it is feasible that Vale's share price will move well below its current price. For all of these reasons, it would be prudent for investors to take a wait and see approach, while monitoring the leading indicators of Chinese economic activity and iron ore demand, as well as the outcomes of the tax and royalty disputes.

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