VALE is a pure play iron ore producer. It is one of four producers that have a virtual oligopoly on the seaborne iron ore export market. Vale is a bargain today because iron ore pricing will be solid in 2014, it is an undervalued way to play strong iron ore pricing, and the charts are the most decent they've been in a long time. Below is an outline of the Bull and Bear case, followed by a more detailed discussion.
1. Iron Ore (IO) pricing will be solid
- Strong demand from residential and commercial construction, transportation (cars, planes, rail), and machinery (US manufacturing renaissance) which comprise 80% of steel/IO demand.
- Strong demand from the three big IO importing markets -- China which chugs along at 7-8% GDP growth and Europe & Japan which are accelerating
- Iron ore producers are slashing capex which cuts supply in 2015 and beyond, while improving cash flow
- The Bulk Dry Index - which is a reliable signal of global growth and hence steel demand - is rocketing higher
2. Vale is the best way to play solid IO pricing
- Vale has scale, competent management, and good production economics
- Valuation - a huge discount to peers on PE, reasonable price/book, upside surprises to recent earnings
- Valemax ships are cleared for takeoff - at a time that bulk dry shipping rates are booming
- Europe's economy is under-the-radar but accelerating and Vale is a near monopolist IO supplier to Europe
- Shale gas boom is driving the US's growing IO demand and Vale is well-positioned to serve that growth market
3. Technicals are strong
- Vale is a great candidate for a January Effect rally
- Double-bottom seems to have formed
- Political Risk -- While being a Brazilian company presents political risk, the recent settlement of Vale's tax liability should take the heat off for the medium term
- Rising supply - forecasts call for lower IO prices in the second half of 2014 due to past investments coming to fruition
- India - who as recently as a few years ago was a major IO exporter - could bring idled IO production back on line
- China - consumer of 50% of IO imports --- could have a hard economic landing
1A - Strong Demand Part I
Iron ore is almost exclusively used for the production of steel and steel demand is driven by three industries: Construction consumes 50% of steel production, Transportation 16%, and Machinery 14%.
The US is the world's #1 steel importer with 30% of global steel imports, so let's start there. Residential US construction is clearly on the rise given that the annualized rate of residential building permit issuance has gone from a recent low of 600K to 1MM but is still below the rate needed simply to keep up with population growth. Stocks correlated with residential construction have skyrocketed this year while iron ore stocks have plummeted.
Commercial US construction has been more dicey. This type of construction is largely correlated with business confidence because businesses only rent out more space when they have confidence in the stability of future growth. While job growth will not be spectacular, 2014 should be the year employers gain confidence that our 200K per month job growth rate is here to stay and we should see some modest upside from there.
Goldman Sachs' Chief Economist sums up my job growth (and hence commercial construction) outlook well:
The U.S. economy should see steady growth in 2014 as fiscal drags relax and the country continues to see positive employment reports similar to the one released Friday, Goldman Sachs' chief economist Jan Hatzius told CNBC on Friday. Hatzius said next year should bring monthly job reports hovering around 225,000 gains in nonfarm payroll positions. Hatzius expects the economy to grow by 2.9% in 2014, followed by 3.2% in 2015 and 3.0% for the two years after that.
That said, stocks correlated to commercial construction have skyrocketed this year while iron ore stocks have plummeted.
In transportation, we know that the US auto industry is humming along very nicely:
The outgoing year delivered a number of surprises, notably the strength with which the industry came roaring back after dropping to less than 10 million sales during the depths of the Great Recession. When the books are closed, 2013 sales will likely have topped 15.5 million, according to industry data. The only real question about 2014, most analysts and planners agree, will be just how much higher the numbers will go. Though likely still short of the market's prior peak of around 17 million in 2000, consultancy IHS Automotive anticipates sales will top 16.1 million.
Airplane orders are also bursting at the seams with Middle Eastern airlines splashing out on $150 billion in aircraft orders from Boeing and Airbus in just the first day of last month's Dubai Air Show:
Gulf airlines splashed out over $150 billion on new plane deals on day one of the Dubai Airshow, underscoring a shift in power in the aviation industry and giving a boost to the formal launch of Boeing's newest jet, as well as to Airbus's A380 superjumbo.
Dubai-based Emirates led the buying spree on Sunday with an order for 150 of Boeing's new 777 mini-jumbo, in a deal worth $76 billion at list prices. It also ordered 50 Airbus A380s, the world's biggest passenger plane, worth $23 billion.
I won't get into rail but given the strong performance of rail stocks and the boom in transporting both shale oil and Canadian oil-sand crude via railcar (because there's no Keystone pipeline), we know that North American rail is doing great.
Like I said Vale = iron ore = steel production. And, steel production stocks are going through the roof, signaling a steel production boom. Since July, ArcelorMittal (NYSE:MT) is up around 70%, U.S. Steel (NYSE:X) is up around 90%, and AK Steel (NYSE:AKS) is up a whopping 160%.
1B - Strong Demand Part II
Essentially all iron ore exports are made to three markets - China (46% of imports), Europe (21%), and Japan (17%) - all other countries comprise 16% of imports. Each of these markets have strong or accelerating manufacturing growth - which is correlated with steel consumption/production and iron ore demand.
- China - Chinese demand is the be-all and end-all of iron ore pricing. Not only are they by far the biggest iron ore importer, accounting nearly for half of imports, they are also the wildcard - the swing importer, the importer with the greatest variability. Predicting iron ore demand is usually an exercise in forecasting Chinese demand. And, Chinese demand is steady as she goes:
It's no wonder then that mining companies are striking a confident pose. In a recent investor meet, Rio Tinto Plc said it expects China's steel demand to rise by 7.5% in 2013. It sees the country's appetite for the metal driven by consumption rather that investment spending.
Basically, Chinese IO demand annual increases equals steel production increase which equals GDP growth increases. GDP/steel grew 7.6% in 2013 and is forecast to grow 7.5% in 2014.
- Europe - The European story is very much under the radar. Manufacturing (which is where all steel gets consumed) is leading Europe out of their depression and its actually accelerating at one of the fastest rates of any major economy in the world. The second derivative of growth (the rate of the rate of change) in manufacturing is measured by the PMI index, with a 50+ rate indicating an accelerating growth rate. China is at 50.5 and flat over the last several months, Europe is at 52.1 and rising, and the US takes the cake with a reading of 57.3. Acceleration is what drives up-side surprises to IO demand and European manufacturing acceleration is under the radar and not being priced in.
- Japan - We all know that Abenomics (the insane - even by Fed standards - growth in monetary supply) is lifting growth in Japan by reviving the manufacturing/construction sector through a depreciating yen and lots and lots (and lots) of free money. Japanese IO demand in 2014 will increase handily over 2013 for one of the first times in recent memory. Yay, Japan… finally.
1C - Slashed IO Capex
Each of the four iron ore export oligopolists have slashed their budgets for investments in increasing the supply of iron ore. They're buying fewer mines and investing less in the mines they already own. This slashing of capex is the response to the cyclical nature of IO. There was an IO shortage, the price of IO skyrocketed, everyone invested in increasing IO supply, the IO market then flooded with new supply, IO pricing crashed, and IO producers have now slashed investments. This slashing of investments will have two effects:
- Less Supply - there's a lag when IO investments are made and when supply comes on line, hence the recent slashing of budgets will bring down 2015 supply… sharply. That said, 2014 supply is set in to increase significantly.
- Improved Free Cash Flow - We all know that Cash is King and that Free Cash Flow (FCF) is what defines a stock's value. FCF is operating cash flow minus investments and Vale's FCF has been rotten the last couple of years due to excessive money spent on investments. Better FCF protects Vale's sweet $4 billion annual dividend (about 5% yield on market cap) and improves their most important valuation metric.
1D - Bulk Dry Index (BDI)
The BDI is the price paid to rent a ship to transport any good that doesn't get shipped using a container ship (containers are the steel boxes that 18 wheeler trucks haul) or oil tanker. Bulk dry ships transport grain/rice, thermal coal, and iron ore/steel (among other things). The BDI is a closely followed signal of global growth since it's the canary in the coal mine and can rise/drop by hundreds of percent depending on the outlook for dry bulk shipping which is highly correlated to global growth.
The BDI has been en fuego (on fire). It is up about 100% since August 2013.
2A - Vale has Scale
The seaborne IO export industry is dominated by four players - Vale (Brazilian and pronounced VAH-lay), BHP (Aussie), RIO (Aussie), and Anglo American (confusingly, not an American company, it's South African and headquartered in London). Everyone else is basically a two-bit player that can make money but they don't have scale in this very global, capital intensive, massive industry.
For example, Cliffs Natural Resources (NYSE:CLF) is the US's premier IO producer and it's tiny and has terrible economics. They're basically out of business if IO drops below $100 (it's currently around $130 but was below $100 recently).
In contrast, Vale can produce IO profitably at any price above about $45 per ton.
Vale is also one of the best managed large companies in Brazil and attracts the top talent in a country where elite talent is in scarce supply. You know those Brazilians at Harvard Business School or pick-your-name top b-school? If they didn't end up working at Goldman Sachs' Sao Paulo office, they probably went to work at Vale. Vale is to Brazil what IBM is to the US - a solid, solid blue chip company that attracts very good human capital to add to their world-beating iron ore assets. Vale's talent can go toe-to-toe with industry-hot-shot BHP's talent.
2B - Vale's valuation is cheap
The two most important valuation metrics are PE vs. industry peers and Price to Free Cash Flow vs. industry peers. Vale scores strongly on both counts.
Looking at 2014 earnings, Vale's forward PE ratio is 7.4. In contrast, BHP is 13.3, Cliffs Natural Resources is 13.2, Rio is 10.2, and Anglo American is 6.6 (but they're an operational disaster; they hired a new CEO in April 2013 to turnaround a company whose mines aren't producing, investments have been non-performing, and overhead costs are out of control).
Vale's earnings have been coming in strong. Last quarter they beat estimates and raised guidance for the future. The stock popped on the news but has since given up that gain and then some.
2C - Valemax Ships are Cleared for Takeoff
While Vale is the purest play on iron ore among the big four diversified mining exporters, they only generate 60% of revenue from IO. They've been on a divesture spree, selling off tangential, vertically-aligned businesses such as electricity generation (which improves their focus on their IO core competency and raises available cash). One of their biggest and smartest side businesses that they're keeping is shipping.
Vale has long suffered from the long distance between their Brazilian mines and Chinese customers. In contrast, their arch-rival Australian ore producers are sitting pretty with regards to their proximity to China. To bridge this gap, Vale partnered with shipbuilders to build the largest ever iron ore carriers called Valemax ships. The enormous scale of these 35 ships should allow Vale to drastically cut the cost of shipping ore to China, making their ore more competitive with Australian ore.
Sounds great, right? One hiccup. China wouldn't let Vale dock their Valemax ships in Chinese ports because it would hurt the business of Chinese shippers at a time when the global shipping industry was hurting. Oops! Forgot to check that one detail, eh Vale?
So, the market didn't end up ascribing much value to Vale's 35 ore carriers. But wait, there's a twist! Last month, the Chinese government basically gave the OK to Vale ships, probably because the bulk dry shipping industry is on an upswing and all of China's ships are now under contract. With that roadblock out of the way, we should see Valemax ships contributing handsomely to the bottom line in 2014 and there's no evidence that this is priced into the stock.
2D - Vale Dominates Europe
We already discussed up above why the stealth rebound in European manufacturing doesn't seem to be reflected in iron ore producer stocks. The only thing to add is that Vale dominates the European market since the Australians are too far away. And yes, a few European ports are some of the only ones in the world deep enough to accommodate Valemax ships.
2E - US Shale Gas Boom
The US in undergoing a manufacturing renaissance driven by the shale gas boom which has led to US natural gas prices that are less than half of world prices. Any form of manufacturing that uses a lot of natty gas is booming in the US. Steel production is one of those industries and while Vale only supplies a tiny fraction of US iron ore imports, they are taking steps to become a major supplier to this growing market. Given their geography on the American continent, they are better positioned than the Australian and South African miners. That said, Canada will continue to be the foremost US supplier for the foreseeable future.
3A - January Effect Rally
The January effect occurs primarily in small cap stocks but can be relevant to more thinly traded large companies. It refers to the rebound that beaten down stocks achieve after US/European/Anglo tax loss selling has subsided. A discussion of the January effect and its impact on Vale can be found here:
3B - Double Bottom
I like big bottoms and I cannot lie. I've followed stocks for a long time and I can tell you that there is something to the voodoo science of technical analysis. It reflects the psychology of day traders and the inefficiencies of algorithmic trading. So, I always check the charts before making a grandiose call on a turnaround because stocks simply don't make V-shaped moves back up after a long downtrend.
There's always a ton of people just itching to escape the loss in their position but they don't want to sell at the absolute bottom, so they wait for a decent bounce. Finally, some day that bounce arrives (usually too little too late), and all of those weak hands need to puke up their stock before a new healthy pattern can be established.
This is why you never buy the first break in a long downtrend but wait for the double bottom. The wider the distance between the bottoms, the bigger and stronger your base, and the better your chance for upside. Vale put in a major bottom in July at 13, rebounded to 17, and has now re-traced that rally back to 14+. It appears that it's back on the upswing and the second cheek of the bottom has been put in place.
1) Political Risk
By far, the #1 knock against Vale is its political risk. The Brazilian government is in the process of shaking down each of the major Brazilian companies, demanding a ransom just to let them stay in business. For PBR and CIG it's been price controls on their gasoline and electricity products. For the telecom companies, it's been the refusal to allow them to consolidate. For Vale, the government is demanding billions of US dollars worth of "unpaid taxes".
I won't get into the legitimacy of the Brazilian government's claim against Vale but it's been a huge uncertainty and a dark cloud hanging over Vale for a long time. Fortunately, the resolution of this huge uncertainty was recently announced in November 2013 and the stock spiked higher in reaction. Vale only has to pay a net present value of $6.6 billion, far below the estimated $10 billion and even farther below the government's initial demand of $15.8 billion.
This Brazlian asset manager sums up the situation nicely:
"While nobody wants to pay, Vale managed to reduce the claim significantly and extend the period of time for payments, giving investors predictability on the case," he said by telephone from Porto Alegre, Brazil. "This was an issue that was bothering the company's valuation."
The tax dispute has weighed on Vale's shares, which have underperformed its main rivals this year. The stock is down 23% through yesterday while BHP Billiton Ltd. (BHP), the world's largest mining company, advanced 0.5% and Rio Tinto Group, the second-biggest, fell 2% in Sydney over the period.
Vale's shares added 2.7% to 32.30 reais at the close in Sao Paulo today, the steepest gain on a closing basis since Oct. 14.
However, Vale has given up all of the stock price gain from the settlement of its tax liability and then some while its peers' stock price has gone up.
That said, I'll admit that the political risk is a big ding against Vale and thus it deserves to trade at a discount to what it would be valued if it was based in the US. However, the time to buy Brazilian political risk is now when everything seems at its worst and the time to de-risk was when Lula was in charge and it seemed like Brazil was on a path to American capitalism. I can tell you that Brazilians are not as capitalistic as folks thought a few years ago nor are they as socialist as people think now. Brazil is a democracy and democracies move slowly, usually very slowly, on big issues like striking the right balance between capitalism and social welfare.
Political risk exists in every investment. You just have to discount it appropriately. Now that Brazilian stocks are trading at a maximum historical discount to their American peers, you can probably figure you're buying Brazilian political risk cheap. On the other hand, American stocks are trading like American political risk doesn't exist and like we've got the Peyton Manning/Drew Brees of politicians in the white house and congress.
Right now the market is pricing in zero political risk from unconventional fed policy, a debt default, government shutdown, and Obamacare. On the other hand, Mr. Market is literally pricing in a Brazilian default and the bankruptcy of major companies like PBR. Would you rather buy in the direction of the extreme sentiment or go against the extreme sentiment?
Also, which country do you think presents the most long-term political risk -- Brazil, China or Russia? Right now, the market is pricing in the greatest risk for Brazil and I couldn't disagree more. Democracy is an inherently stable form of government that self-corrects whenever there is an extreme.
2) Rising Supply
While IO prices have rebounded from the Sep 2012 low of $100 and the June 2013 low of $115 to rest at $130 currently, the forecast is for IO prices to plunge next year, with some prognosticators predicting sub-$100 pricing. This has hammered IO producer stocks such as Vale which is down about 25% on the year. The reason for the gloomy IO price forecast in the face of healthy demand is rising supply.
This article sums up the supply situation:
Vale SA is increasing its annual production capacity from 306 million metric tons to 346 metric tons by ramping up its production in the mine located in Carajas, Brazil by 40 million metric tons in 2014. Rio Tinto and BHP Billiton have also ramped up their production in their mines in the Pilbara region of Western Australia. Rio Tinto has increased its annual production capacity to around 292 million metric tons this year and plans to increase it to 360 million metric tons by next year. BHP has increased its annual production capacity to 212 million metric tons from 187 million metric tons last year.
However, analysts are predicting that this excessive iron ore supply will lead to surplus. According to the analysts, demand will be 25 million tons higher than supply in the first half of 2014, but in the second half of the 2014, supply will be at a 49 million ton surplus. Due to excessive supply, iron ore prices are expected to fall.
Source: Seeking Alpha
However, some analysts like those at JP Morgan Chase (and myself) believe that this increase in supply can be readily absorbed by a China that is increasing IO demand by 7.5% per year plus accelerating demand from the US, Europe, and Japan. The excessive second half 2014 supply may never happen given that global growth should be picking up steam in the second half of next year. JP Morgan estimates that if IO price stay above $110-115, there will be upside surprises to Vale's earnings.
Up until a few years ago, India was a significant exporter of IO. For reasons relating to governmental regulations and operational difficulties, India no longer exports much IO and some people have predicted an extreme scenario of India importing ore. That probably won't happen and Indian supply destruction has probably run its course. Eventually, India will ramp IO production back up but when that happens in anyone's guess.
The IO market is all about China. Some folks have been predicting a hard economic landing for China for some time now. It didn't happen in 2013, it's not forecast by the Chinese to happen in 2014 but it could happen nonetheless.
Vale is a bargain today primarily because it is the purest play on iron ore (and some other products that are highly correlated with global growth) and the forecast for iron ore prices in 2014 is excessively bearish. If IO prices merely meet JP Morgan's forecast for an average price of $125 in 2014 and $110 in 2015 (lower than today's price in the $130s), there is substantial upside for IO producers, since most analysts are using a 2014 average price of $90-100 in their models (Source).
The forecast for substantial declines in IO prices is reflected in the industry's low PE multiples, which means producer stocks can increase both by growing earnings as forecast and PE expansion. Vale is far cheaper than its Australian peers and much better managed than its much smaller South African rival. The discount is a reflection on both Vale's lack of diversification and Brazilian political risk. The lack of diversification will be a strength as the positive spread between 2014's forecast and actual prices will likely be larger than the spread for energy or gold. Brazilian political risk is excessively priced into the stock based on the resolution of Vale's tax liability and the historical range of discounts for Brazilian stocks.
Disclosure: I am long VALE. 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.