Vale's Health: How One Symptom Caused A Fundamental Misdiagnosis

| About: Vale S.A. (VALE)


Until Q4 2013, Vale had been posting good results and its stock price had been rising.

By the end of Q4, its bottom line and stock price both fell off a cliff.

It had next to nothing to do with base metal prices and everything to do with the taxman.

Pretax figures and like-for-like comparisons reveal an undervalued stock.

This fundamentally healthy company is a top bet for dividend hounds.

Vale's Fall from Grace

Less than a year back in Q3 2013 Vale (NYSE:VALE) had handily beaten earnings expectations "of 64 cents per [American Depositary Receipt] by 12.5%." At that time, by Metals & Mining standards (which are somewhat different than Dot-com Stocks standards), Vale stock was becoming something of a high flyer on the back of "across the board" cost cutting, higher iron ore sales, and record coal production.

Though Vale's stock was riding high from mid-September to mid-November 2013, peaking at $17.08, it went into a steady and steep decline until mid-March. After an uptick in April it has stagnated, hovering between $13 and $14, though it has recently started an upward creep.

And why should not Vale stock have been riding high and rising in Q4 2013? After all, last year was yet another very good year for the Brazilian miner. Year-on-year operating income doubled from $7.468 billion to $15.063 billion from 2012 to 2013 and pretax income nearly doubled from $ 7.241 billion to $ 4.091 billion.

However, its after-tax income collapsed in unprecedented proportions from $5.265 billion to $408 million -- a "decline" of 92 percent. Though rumor would have you believe that this was due to a dramatic decline in the demand and/or price of iron ore and other base metals, the line items tell us that that was obviously not the case. Vale made a tidy little packet from its operations, as we see. So rumors of the demise of iron ore, with concomitant consequences upon Vale, were as exaggerated as the demise of Samuel Clemens.


The fact is that after a years-long feud with the Brazilian taxman Vale settled a tax dispute that had calamitous consequences on its bottom line. Of the $9.6 billion settlement, an initial sum of $2.6 billion was paid in Q4 2013 with the remaining $7 billion to be paid in installments over the next 15 years, as reported in Metals & Mining publications such as

All this, naturally, had ripple effects on Vale's Balance Sheet as retained earnings plunged from $ 38.397 billion in 2012 to $ 29.566 billion in 2013, and total equity collapsed from $ 73.239 billion to $ 63.325.00 billion in the same time period. As a further consequence, Vale's key statistics contain a few unusual and anomalous figures, such as an EPS of -0.188 and a scarcely credible payout ratio of -919 percent.

Let's consider Vale's pre-tax performance in comparison to its diversified mining peers, and, to avoid fallacious conclusions arising through comparing absolute numbers of companies that are quite disparate in size, compare using proportions or percentages.

For 2013, Vale's operating margin was a healthy 32.21% and its EBITD margin was an equally healthy 46.46%, edging BHP Billiton Ltd. (NYSE:BHP), which had an operating margin of 31.84% and EBITD margin of 43.7%. Vale significantly outperformed Rio Tinto Plc (NYSE:RIO) whose operating margin was only 14.1% and EBITD margin was 42.52%.

So it is indeed the tax collector that did in Vale last year.

Contributing Factors

This year will bring quite a different story, however. In a significant turnaround in April 2014, Brazil's Superior Justice Tribunal issued a mixed ruling that, in the balance, was in Vale's favor. The Tribunal found that the Brazilian government could not double-tax Vale on profits in certain countries. Now, it's the Brazilian taxman who is "playing defense."

Separate from its tax woes, Vale had earlier been rocked by a spate of non-financial bad news which had sapped investor confidence and had been a drag on its stock price. In fact, back in December 2012 things had become so bad that management had been obliged to take multiple writedowns and impairment charges with a view to making the company's Balance Sheet more sound, as reported by Reuters and Bloomberg. As such, Vale's tax dispute and settlement was the final straw that broke its stock price's back.

There's more to it than "just the facts." Perceptions and marginal factors also play a part. Vale is a diversified base metals miner that is primarily associated with unsexy iron. It does not have the glamor of fancy diamonds and the Sotheby's connexion of Rio, the blue-chip cachet cum heft of BHP, or the one-to-one correspondence with the yellow stuff of AngloGold Ashanti. Vale is very different -- it is perceptually associated almost solely with iron, is perceived as a "ferro-miner," is headquartered in Sao Paolo, and Brazil's overall economy and its relatively low-low sovereign debt rating tends to dampen investor confidence in that country's equities. These are contributing factors that clearly do not help.

What do Aberdeen and BlackRock See?

Aberdeen Asset Managers Ltd. and BlackRock Investment Management (U.K.) Ltd. are among the most reputable asset management firms. They have massive stakes in Vale, with a combined holding of 7.56 percent of Vale (preferred stock). What do they see in it?

Vale has an excellent dividend history and the company continued its tradition of strong payouts by announcing on 30-01-2014 an allocation of a minimum of U.S. $4.2 billion towards dividends for 2014. Vale's current yield is 5.63%. However, with its stock price in the doldrums and an already-announced equal dividend payout expected in Autumn, expected annualized yield assuming current stock price, for the calendar year is about 6.06 % while its 52-week projected yield is 5.86% and its annualized yield is 5.87%.

In comparison, Rio's yield is 3.82% and its 52-week projected yield is 3.37%. BHP's yield is 3.24% and its 52-week projected yield is also 3.24%. None of this is a knock on Rio or BHP; the fact is that the bottom fell out of the financials of a fundamentally healthy company as a result of a one-shot tax settlement, and, as a knock-on effect, its stock price got depressed and has become undervalued. As such, for dividend hounds Vale is one of the top bets in metals and mining.

Because of its astronomical tax settlement Vale's EPS dipped into the red and, as a result, its P/E ratio cannot be calculated. Let's try something else; let's try to derive another valid measure of how its stock price stacks up in terms of its operational health. We know that Vale's numbers got blown out of the water because of the one-time tax payment of $2.6 billion. Therefore, let's calculate and compare Vale and its competitors' 2013 price / (pretax income / share) ratios -- i.e., a modified P/E ratio. (Because Rio's after-tax income was higher than its pretax income as a result of minority interest credits, I have used the higher figure, which is to Rio's stock's advantage.) Vale's "P/PI/S" ratio is 7.0614, Rio's is 21.7996, and BHP's is 6.4751. This would suggest that Vale and BHP are both undervalued operations-wise and that, in fact, on this modified P/E ratio the two stocks are actually comparable and are of similar value.

Probably all this is what Aberdeen and BlackRock see in Vale.

A Peep into the Future

Vale posted tolerably good figures in Q1: Quarter-on-quarter, operating income before depreciation was 81% of the previous quarter and operating income after depreciation was 72%. These proportional figures are impressive given that the market for iron - Vale's key product -- and other base metals as well has been seriously "anemic."

Now, even that is changing: July saw cautiously optimistic whispers about China's economic growth and consequent demand for base metals, as reported by Reuters and Bloomberg. This news bodes well in general for metals and mining as an industry, and in particular for diversified miners whose stock is undervalued.

Under the terms of its tax settlement Vale still has to pay $467 million per year to the national exchequer which will impact its bottom line; however, the worst is behind it and, what is more, given that Vale has now struck back in the courts, the tax settlement amount will likely significantly be reduced under a revised settlement or through a judgement.

Vale has turned the corner. If it was a question of timing the trough, for Vale's current cycle that opportunity has probably gone. If it was a question of buying a value stock, then the opportunity is here. Bottom line: if you're looking for serious capital gains, let alone a highflier, stay away from this stodgy stock. On the other hand, if you're looking for value cum income, Vale is where your action is.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.