Vale - The Morgan Stanley Analysis, Was It Too Optimistic?

Feb.10.14 | About: Vale S.A. (VALE)

Vale S.A. (NYSE:VALE) was recently upgraded by Morgan Stanley to a buy as of this previous Wednesday, February 5th, 2013. This is in contrast with other Morgan Stanley analysis on similar companies within the Iron Ore mining business, such as Cliffs Natural Resources (NYSE:CLF) which they consider to be a sell. Ironically, at the same time that Morgan Stanley was upgrading Vale to a buy or overweight, the price of Iron Ore per ton reached its lowest point since July 8th, 2013 of $122.40. Why does Morgan Stanley have a favorable perception of Vale despite a declining price in Iron Ore and an unfavorable take on other similar Iron Ore mining companies?

The Morgan Stanley Analysis:

Morgan Stanley considers Vale SA to be a buy mostly because it is cheap compared to other competitors within the industry such as Rio Tinto (NYSE:RIO):

Vale's forward P/E looks excessively low relative to Rio Tinto at one standard deviation below the historical average and not far from the 2005 all-time low. Vale's shares have historically traded at a forward P/E of 8.6x, or at a 15% discount to Rio's average multiple of 10.2x. However, based on our 2014 estimate, Vale is currently trading at 6.7x EPS, or approximately 31% below Rio's valuation of 9.7x ― twice the historical discount.

Clearly this analysis based purely on the metrics could just as easily be wrong if the price of Iron Ore does not manage to justify the position here taken. Therefore Morgan Stanley backed up this assessment with the following:

VALE has underperformed iron ore by ~20 percentage points prices over the past year. We believe this poor performance is unlikely to continue, and we view the current valuation as an attractive entry point.

Here is a one year summary of Iron Ore, Vale, Rio Tinto, and Cliffs as measured by percentage change with the zero point being this same day last year (February 9th, 2013).

Iron Ore Spot Price (Any Origin) Chart

Iron Ore Spot Price (Any Origin) data by YCharts

One can easily see that Vale has underperformed the decline in Iron Ore's price per ton during the last year while Cliffs appears roughly on point. Rio Tinto has clearly been overvalued with respect to the price of Iron Ore during the last year with its shares rising with respect to Iron Ore's spot price. The assessment of Morgan Stanley of the 20 percentage points may be off from the YCharts data, but is most likely due to A) difference in date and B) difference in how the spot price is measured as this is not perfectly consistent.

The potential investor of Vale is forced to answer several questions when faced by the Morgan Stanley analysis:

1. Is Rio Tinto a good company to develop comparables for our metrics? The analysts seem to indicate that they wish to peg the price of Vale against the spot price for Iron Ore per ton. If this is to be done then should we not be worried that their comps for metric analysis is almost the only Iron Ore miner that is an outlier in this regard?

2. So the price for Iron Ore appears to be falling at the moment, should we not be worried that the market has simply adjusted faster with respect to Vale then other Iron Ore companies? True, at this very moment I can agree that the price per share for Vale ought to be higher if I accept the premise that the spot price should be the key indicator of the share price and that all things being equal the companies were all properly priced last year. However, if the price of Iron Ore were to continue to fall, wouldn't we then see Vale as a properly priced company and the others as overvalued?

I do not believe that their is a reconciliation for points one and two with respect to Morgan Stanley's analysis.

JP Morgan Analysis:

The reason why the spot price for Iron Ore might not be the best indicator for a proper valuation of Vale, is because Vale and Rio Tinto manage to sell higher quality Iron Ore and benefit from the premium paid for such IO. This might help explain the difference in spot price for Iron Ore and Rio Tinto's share price, although management and other factors also clearly have an impact.

Vale is actually considered to have a better future price per Iron Ore as opposed to the spot price because China has recently driven up the premium on higher grade Iron Ore as measured against the premium percentage-wise of historical data. JP Morgan recently made this assessment and offered it as a positive in favor of Vale alongside freight cost changes.

As iron ore prices weakened into '14, iron ore miners such as Vale saw their share prices going down. However, miners may actually be realizing higher iron ore prices YTD for two reasons: A) premiums for pellets, lumps and for higher quality ore are up, as a consequence of pollution controls in China, and B) the potential risk of higher freight rates has mitigated with Brazil-China freight down ~USD9/ton. Add the two, and for a company like Vale, which has high quality ore and pellets, we may see higher than expected realized prices driving earnings surprises.

JP Morgan has therefore put in place a price target of $23.50. However simply because the premium relating to higher quality Iron Ore has gone up, does not mean that Iron Ore per ton is going up; but rather, that the spot price per Iron Ore is possibly falling faster then the price per ton for higher quality which widens the premium gap. So once again, this analysis does not seem to compel one to buy Vale.

Other Analysis:

The various notions with respect to the future price of Iron Ore ought to be addressed. Interestingly, Morgan Stanley's analysis of Vale does not seem to address this directly but there analysis of Cliffs does. In this analysis, Morgan Stanley considered the Bloom Lake project and indicates that the expected price per ton is probably more close to $95 per ton.

On our math, a new partner would have to believe LT iron ore prices will average >$120/t and steady-state costs fall to <$70/t, versus our sample group's iron ore and cost views of $95/t and $70/t.

Clearly a Vale investor is not concerned with the "Bloom Lake Project" of Cliffs, but I do believe this sheds light upon the expected future price of Iron Ore based on Morgan Stanley's version of future events. Clearly if we combine the two analyses of Vale and Cliffs we might not walk away with as positive a perspective on Vale, if the premium gap continues to widen but is based on a spot price in the process of falling to $95.00 per ton and is in effect falling in totality.

The Morgan Stanley analysis of Cliffs is largely based off of the Goldman Sachs analysis of Cliffs, Vale, and Rio Tinto and of the Iron Ore mining industry in general, which was dated January 21st, 2014. Goldman Sachs has an expected price per ton of Iron Ore at $108 at the end of 2014 and $80 at the end of 2015. This was a rather gloomy report, stating that "the sunset of the Iron Age starts in 2014," and which I discussed in another article on the matter in which I go deeper into this analysis.

So the Goldman Sachs and Morgan Stanley perspectives on the future price of Iron Ore seem to indicate a rather negative series of future events. However there are many other firms that have different analyses. Instead of breaking these down one by one we can simply look at the following chart:

Click to enlarge

This chart represents the expected future price of Iron Ore based on a consensus of 31 investment bank analysts as compiled by The Metal Expert Consultants. (If you want to see how this has faired in the past go to their site)

As we can see from this chart the consensus of investment advisors appears to come to a price per ton for 2014 of $120 and for 2015 of $112. One can easily see that Goldman Sachs assessment falls dead last for the Long-Term of $80 per ton.

Conclusion:

It is clear from reading the analysis on Vale versus the analysis on other Iron Ore companies (specifically Cliffs) that has been recently put out by Morgan Stanley, that analysts can have a very positive perspective or a very negative perspective with respect to Iron Ore miners and it might have very little to do with the actual capacity or quality of the company being analyzed. One arm of Morgan Stanley is in conflict with the other arm of Morgan Stanley with respect to analysis of companies through the pricing of Iron Ore. Perhaps the Cliff's analysis is better due to its forward looking nature? Or, perhaps the Vale analysis is better due to its historical backward looking perspective? It is beyond my analytical ability to determine which is more right, and most experienced investors would recognize the difference here to really be an ontological difference as opposed to one perspective being right or wrong. So the learning point here is that two types of analyses can exist within the same exact market and one will be positive versus negative simply based on that ontological difference.

But what does this mean for the potential investor of Vale? Let's take bits and pieces of each analysis and collectively synthesize an entirely more robust analysis.

1) Lets use Morgan Stanley's initial idea of pegging the price of Iron Ore against the price per share for Vale. But lets not use the metric based analysis since this is backwards looking and using an over-performing company as a comparable.

2) We can utilize the JP Morgan analysis, but instead of attempting to speculate on the premium for Iron Ore, lets simply use this as our room for error in our analysis. The premium historically follows the spot price so percentage-wise we can peg the share price of Vale against the spot price. If the premium gap widens, and if this ultimately impacts the share price of Vale positively, then this will simply be an added benefit which we shouldn't count on in the analysis.

3) Lets not take into account simply the Morgan Stanley $95 or the Goldman Sachs $80 spot price for our projected future price. Since both of these analyses seem to have been targeted at Cliffs, and since Cliffs is the most heavily shorted stock on the S&P 500 at the moment, it is quite possible that this analysis is contaminated. Instead, lets consider the consensus of 31 investment firms as presented in the chart above. While the consensus still shows the price as falling, it certainly doesn't show it as falling quite that far.

From these three points, we can speculate that the price per share for Vale should increase simply to close the gap percentage-wise between the fall in Vale's price in contrast with the somewhat smaller fall in Iron Ore's price and the expected extent to which Iron Ore will continue to fall. Are there any flaws in this analysis? Of course there are. Perhaps we should not assume that Vale was properly priced one year ago, however this would appear to not have impacted the Morgan Stanley analysis and so perhaps it should not cause us any concern either. Perhaps there are future concerns over the ability to produce more Iron Ore, as we can already see in Guinea as the government is causing difficulty over the legality of Vale's operation there. Or, maybe we should be more concerned over the decline in steel production within China as this might continue to grow as a problem.

Ultimately, if we peg our price per share for Vale against the price for Iron Ore, we probably will not be too far off the mark as Vale has the ability to earn money at higher margins then most competitors. While I am evidently less optimistic then the analysts at Morgan Stanley, I still think Vale offers a strong value proposition for the potential investor. Vale will most likely continue to see an increase in share price, but it will probably not get quite as high as it was over a year ago.

Disclosure: I am long CLF. 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.

Additional disclosure: Positions are subject to change at any time and without warning.