Vale - Good Value For Investors With A Tolerance For Risk

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 |  About: Vale S.A. (VALE)
by: The Value Investor

Shares of Vale (NYSE:VALE) have lost nearly a quarter of their value so far this year, even though operating performance is improving compared to a year ago. The depressed valuation, amidst improvements is creating a nice value proposition for shareholders with a slightly higher tolerance for risk.

The Deal

Vale announced that it has sold 407.1 million shares in Norwegian Norsk Hydro ASA at NOK 25.00 per share. Assuming the 10% over allotment option will be exercised, the sale will raise some $1.82 billion for Vale.

Following the sale of the shares, assuming the over-allotment option will be exercised, Vale will no longer hold a stake in Hydro. The divestiture is part of the strategy of reducing non-core assets and focus on capital allocation and value maximization.

Third Quarter Results

A weak earlier, Vale announced its third quarter results. Vale generated third quarter revenue of $12.91 billion, up 10.8% on the year before.

Underlying earnings rose sharply, by some 58.8% to $3.71 billion. As such, earnings rose from $0.45 to $0.72 per share. Note that capital expenditures fell by nearly 20% to $3.45 billion.

The strong earnings growth is attributable to solid cost-containment. Despite the solid jump in revenues, costs actually fell as Vale did a good job containing costs related to outsourced services, materials and energy.

Valuation

Value operates with $7.20 billion in cash and equivalents. The company operates with $29.78 billion in total debt, for a net debt position of $22.57 billion.

For the first nine months of the year, Vale generated revenues of $35.39 billion, down 2.3% on the year before. Underlying earnings rose by 3.7% to $10.09 billion, as earnings per share totaled $1.96 per share.

At this pace annual revenues of $47 billion are possible as earnings could come in around $11-12 billion.

Trading around $15.50 per share, the market values Vale at $79 billion. This values the company at 1.7 times annual revenues and roughly 7 times annual earnings.

Vale last paid a dividend of $0.373 per share, for an annual dividend yield of 4.8% if paid out on an bi-annual pace. Note that Vale paid out an additional $500 million dividend on the 31th of October.

Some Historical Perspective

Over the longer term, investors in Vale have seen their degree of volatility. Shares plunged from $50 in 2007 to lows of $10 in 2008 amidst the financial crisis. Shares recovered to levels around $35 in 2010 and 2011. Shares fell back and started the year around $21 per share to fall to lows of $12 by July. Shares recovered to $17 in October, currently exchanging hands at $15.50 per share.

Between 2009 and 2012, Vale has doubled its annual revenues to $47.7 billion. Net earnings stabilized around $5.5 billion. Note that Vale's operations are very volatile. In 2011, the firm generated nearly $61 billion in revenues on which it earned $22.9 billion.

Investment Thesis

Vale has clearly focused on making the organization leaner by cutting costs and divesting non-core assets. So far this year, the firm has cut costs by some $2.0 billion, minimizing operating costs while focusing on productivity growth. As part of the divestments, Vale sold a 35.9% stake in logistics firm VLI, accompanied by the sale of the Norsk Hydro stake in recent times.

While Vale has "diversified" operations focusing on bulk materials, base metals, fertilizer nutrients and logistical services, the vast majority, or nearly 75% of sales are derived from ferrous metals. In total 60% of revenues are driven by iron ore, which is crucial for Vale's performance. This iron ore shipment is predominantly focuses on Asia and China in particular. Asia makes up 56% of total revenues, with Brazil and Europe are being a good number 2. Note that Vale has very limited operations in North America.

Even despite the "diversified" production and "geographic operations", Vale is still almost entirely dependent on iron ore and China. The solid third quarter results were driven by iron ore prices which rose to $105.58 per metric ton, up from just $93.90 last year. Note that Vale generates three quarter of total revenues and 90% of earnings from ferrous metals, of which the vast majority by iron ore.

Earnings are improving in recent times on higher production, lower operating costs and a recovery in iron ore prices. On top of that, investors have received year to date dividends of $4.5 billion, for an annualized yield of 7.6%.

Given the immense focus on iron ore, compared to Vale's largest competitors BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), Vale's business is much more volatile. On top op less-diversified operations, its iron ore shipping costs are much higher, creating a greater degree of operating leverage.

As such the firm has a great degree of operating leverage, and higher iron ore prices almost one-on-one boost earnings going forwards, as witnessed by the great results in 2011, and the consequential fall in earnings in 2012.

As such, Vale seems a relatively safe asset. Divestments will control the net debt position, even though the company pays out a yield of 7-8% this year. On top of that is the upside of greater iron ore prices, resulting in blowout earnings in a renewed iron ore price spike. Note that over the past 5 years, Vale is set to earn $60 billion, close to its current market capitalization of $79 billion.

Don't care too much about business cycles. The global economy is still moving along just fine and with Vale trading at depressed valuations, today's valuation might be very appealing, while the dividends provide a nice cushion to investors.

Disclosure: I 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.