Vale (VALE) exhibits similar valuation traits like value investments Telefonica (TEF) and BP (BP): Short-term depressed operating results due to restructuring, legal issues or entity integration, peer-group outperforming earnings yields, industry-leading dividend yields and a lagging stock performance compared to competitors. Since I am looking for true large-cap bargains with huge discounts to intrinsic value, I have added VALE shares to my investment portfolio. Underlying my thesis is the belief that despite temporary weakness in Chinese iron ore demand VALE will remain fundamentally relevant for global commodity supply.
Short-term economics unfavorable
Weaker economic activity and a slowing construction sector in China have led to lower iron ore demand and lower prices. To counter weak demand VALE implemented $736 million worth of cost savings to offset adverse market factors that affected VALE's profitability in Q2 2013. I believe the lower demand from China is temporary in nature. Reuters reported on this particular issue on September 9th, 2013:
Trade data released over the weekend showed China's overall imports and exports in August were stronger than expected, suggesting the world's top commodity buyer may have avoided a sharp slowdown. China is Brazil's biggest trading partner and a key purchaser of Latin American exports such as iron-ore, soy, copper and petroleum."The market is rising broadly because the outlook for the international economy is improving," said Alexandre Ghirghi, a strategist with Metodo Investimentos in Sao Paulo.
There is no doubt in my mind that current real estate activity on the Chinese mainland is in bubble territory. The Chinese government, on the other hand, is taking concerted action to cool the economy down and steer it towards a sustainable long-term GDP growth path of 7-8%. Steel demand is highly dependent on construction activity which is going to be fueled by long-term urbanization trends. The drop in iron ore prices already includes a pessimistic demand scenario and is reflected in VALE's low equity valuation.
Fundamental long-term business drivers remain valid, short-term challenges in pricing are mitigated via cost-cutting initiatives. Cost management programs cut wide and deep: From consulting services to fleet management and downsizing of office space VALE utilizes a comprehensive strategy to deliver value internally when macroeconomic conditions are challenging. An overview of the across-the-board cuts and its impact on the cost structure is provided below:
I predict that the market will continue to focus on cost reduction programs to create value for the next several quarters and return to a supply/demand focus once uncertainty about China's economic state disappears.
Deeply distressed valuation
In the valuation matrix below I compare VALE to Rio Tinto (RIO), BHP Billiton (BHP), Freeport-McMoRan (FCX) and Southern Copper (SCCO). While the commodity mix is not necessarily homogeneous, all exploration companies provide crucial commodities for the construction and manufacturing industries around the world.
Of all the stocks in the peer group, VALE exhibits one of my favorite metric trade-offs: Lowest earnings valuation and highest dividend yield. While the average peer group P/E ratio is 11.63, VALE quotes at the lower end of the range with a metric of just 8 (representing a 31% discount to the average P/E). The earnings yield is a staggering 12.5% and reflects a 37% premium to the peer group average earnings yield of 9.1%. Leaving its peers in the dust in terms of valuation isn't enough: VALE has by far the largest dividend yield of the stocks under review. Investors can collect 4.6% which is much higher than the yields of its peers and, thanks to the easy money policy of the FED, way above current bond yields.
Lagging stock performance
In my experience, "laggers" are always worth a serious look. Oftentimes the market punishes certain stocks heavily for short-term problems that by all means are fixable and should not bring down the equity valuation of a company as much as it often does. Fears about declining commodity demand from China started to emerge at the end of 2012 and beginning of 2013: A time when most commodity exploration companies were already in positive territory performance-wise (see chart below). Only VALE has remained almost consistently in negative pastures but, consequently, offers more rebound potential than the other explorers when the economy improves (which is very likely since the US, China and Southern Europe still work through their issues and are far from booming).
Distorted free cash flow due to high capex
The 5-year average free cash flow per share stands at just below $1 but is distorted due to high capital expenditures from 2010-2012. A normalized figure would probably be around $1.20-$1.30 per share accounting for the extraordinarily high capital expenditures regarding the Salobo project start-up costs. I assume that once Salobo 24 Mtpy hits the start-up phase in 2014 the project will positively contribute to free cash flow growth. At that point I estimate FCF can grow to $1.60 per share and possibly more assuming that commodity demand picks up and Chinese steel mills build up their inventories. Given this estimate, VALE trades at just ten times forward free cash flow, which makes the valuation still attractive and substantiates the low earnings valuation from above.
VALE suffered most from weakening economic data since the beginning of the year and has underperformed peers for multiple years. Over a two year period VALE shareholders have lost 33% in terms of share value. Short-term demand dips in China have caused VALE's valuation to fall to very attractive levels at which nearly all negative macroeconomic events are priced in. I generally expect companies with competitive advantages (companies owning/operating high quality mining assets with access to core commodities copper, iron ore and gold) to trade at around 15 times forward earnings. Given the low valuation of only eight times forward earnings for a premier mining company, the shares have substantial room to go up and could even double over the next 2-3 years.