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With a predicted hard landing for the Chinese economy in 2012, which will inevitability push down demand and prices for iron ore and other basic materials, it is likely we will see a decline in performance among resources stocks. On his basis this report will take a closer look at Vale (VALE) the world's largest iron ore miner to determine, especially in light of some recent incidents that may increase the degree of country risk associated with investing in Brazil, whether it offers solid investor value in 2012.

Vale's overall financial results for 2011 were exceptional, yet it reported poor fourth quarter 2011 result, with the company missing the consensus forecast results of $1.23 EPS, instead reporting EPS of 90 cents. Overall for this quarter the company reported a 12% fall in earnings to $14.8 billion and a 5% fall in net income to $4.7 billion. In addition, for the same period its balance sheet weakened with cash and cash equivalents falling 19% to $21.7 billion and long-term debt rose 2.5% to $38 billion. However, Vale delivered a solid full year 2011 result reporting revenue of $60.4 billion, which was 30% higher than 2010, and net income of $22.9 billion, which was 33% higher than 2010. Although, there were a number of important positive takeouts from Vale's fourth quarter 2011 report including:

  1. Record sales of iron ore and pellets of almost 300 Mt, which was a 1.6% increase over 2010.
  2. Nickel and copper sales were the best the company has seen since 2008.
  3. Vale had its credit risk rating upgraded by Standard & Poor's (S&P) to A- from BBB+ due to its strong capacity to meet financial commitments.

In addition, Vale's key performance indicators demonstrate that it is performing well when compared to its competitors, as the table below shows and this bodes well for its future performance.

Company

PEG

Profit Margin

ROE

Debt to Equity Ratio

Credit Rating

VALE

0.06

37%

28%

0.32

A-

BHP Billiton (BHP)

0.82

31%

38%

0.28

A+

RIO (RIO)

0.39

10%

11%

0.26

A-

Based on the PEG ratio, Vale has strong future growth prospects, which are superior to BHP's and Rio's. The company is also delivering a solid profit margin of 37%, which is slightly higher than BHP's and almost quadruple Rio's. When this is combined with its solid return on equity that is more than double Rio's but lower than BHP's, the company is well positioned to continue generating solid financial results.

I also really like Vale's conservative debt to equity ratio of 0.32, which is only marginally higher than either BHP's or Rio's. This bodes well for net income and dividend stability, and is also a good indicator of the overall degree of risk when in investing in Vale. A conservative debt to equity ratio such as Vale's indicates a strong balance sheet with company operations primarily funded by equity. This reduces the risk of cash flow disruptions due to rising interest rates should there be sustained economic recovery, or breaches of lending covenants, should the stock price drop suddenly or be aggressively shorted.

Vale pays a handy dividend yield of around 7%, made up of dividend payments and additional ISE payments. The ISE payments are not guaranteed but form an additional return for investors paid in accordance with Brazilian law and at the company's discretion. Vale's dividend yield is more than double both Rio's and BHP's 3%. In fact it is the fourth highest dividend yield in the industrial metals and minerals industry and is a solid dividend yield for a mining company. The payout ratio is 40%, which as a quick and dirty measure of dividend sustainability indicates that Vale should have no problems in maintaining this dividend yield. In fact Vale's dividend has grown in value by 178% over the last five years.

However, it is also important to get a solid feel for Vale's forward valuation and how this compares to its competitors. With a current trading price of $23 I believe that Vale is quite cheap, as analysts have forecast 2012 EPS of $3.79 giving the company a forward PE of 6. In addition, for 2012 Vale's revenues are expected to fall by 2%. BHP is trading at $72 and analysts expect 2012 EPS of $7.40 giving the company a forward PE of 10. On top of this BHP's revenues are expected to grow by 4% during 2012, which is more than double Vale's projected revenue growth. Finally analysts have forecast that Rio will have 2012 EPS of $8.93, which with a current trading price of around $53 gives it a forward PE of 6. Furthermore, Rio's revenues are projected to grow 7.7% in 2012, which is almost triple Vale's forecast revenue growth.

Based on this analysis of Vale's forward valuation and with a current trading price that is lower than both BHP's and Rio's, the company in my opinion is quite cheap, especially in comparison to BHP. However, its negative forecast revenue growth for 2012 is of some concern considering both BHP and RIO are expected to experience single digit revenue growth for the year.

While the forward valuation is a good indicator of whether Vale is cheap or expensive in comparison to its competitors I also believe it is important to understand how Vale compares to those competitors on a cost of goods sold (COGS) basis. Vale's COGS for 2011 was $23.6 billion, which as a percentage of total revenue is 39%. BHP's COGS for 2011 was $14.6 billion, which is 20% of total revenue and superior to Vale's. However, Rio's COGS for 2011 was $36 billion, which is 60% of total revenue and far more expensive than Vale's. Overall, while Vale is a low cost miner, BHP in comparison truly has costs under control as can be seen by its COGS and superior return on equity of 38%, which is 10% higher than Vale's 28%.

An additional concern is that a large portion of Vale's revenues are derived from China. For example in 2011 sales to China were responsible for 32.4% of revenue, followed by Brazil at 18.1%, Japan at 12.0%, Germany at 6.3%, South Korea at 4.4% and Italy at 3.2%. This indicates a distinct reliance on China as a key export market for Vale's products, which is understandable given the insatiable demand China has for basic materials and resources over the last ten years. This is very apparent when we look at China's GDP growth rates for the last ten years, which have been in excess of 9%.

My concern arises from the view of many economists and market analysts who are predicting a hard landing for the Chinese economy in 2012. This is even more concerning when JPMorgan's chief Asian and emerging-market strategist Adrian Mowat, recently stated that; "China is in a hard landing. Car sales are down, cement production is down, steel production is down, and construction stocks are down. It's not a debate anymore, it's a fact."

If China's economy is in fact now experiencing a hard landing or will do so in the immediate future it is difficult to judge what effect this will have on demand for basic materials and the flow on effects to miners such as Vale, BHP and Rio. The IMF has predicted that China's GDP growth rate for 2012 will be 9%, which is lower than the 9.4% average for the first 3 quarters of 2011.

Overall a slowdown in Chinese growth will have an impact both on the price and volume of iron ore required globally, which will directly impact Vale's 2012 revenues and net income. Of further concern is a recent statement by the president of BHP's iron ore business, who stated that China's demand for iron ore will flatten out as the steel industry and the broader Chinese economy slows in 2012. In fact over recent months we have seen the iron ore price fall by 21% since August 2011 to $140.40 per metric ton ('PMT') at the end of February 2012, as the table below shows.

Table 1: Iron Ore Price pmt

Month

Price

Change

Aug 2011

177.45

Sep 2011

177.23

-0.12%

Oct 2011

150.43

-15.12%

Nov 2011

135.54

-9.90%

Dec 2011

136.46

0.68%

Jan 2012

140.35

2.85%

Feb 2012

140.40

0.04%

Another Australian iron ore producer, Fortescue Metals Group Ltd (FSUMF.PK), recently stated that iron ore prices are expected to find support at around $140 to $145 pmt in the short term, despite slower Chinese economic growth. Yet the iron ore price dropped beneath this supposed floor in both November and December 2011, only returning to this level in January and February 2012. At those prices I believe that Vale would see around a 12% drop in annual revenues when compared to the revenues of the first three quarters in 2011.

Country risk also appears to be on the rise in South America, with nationalist fervor seemingly on the increase from Venezuela to Argentina. This phenomenon is even being seen in Brazil, the home of Vale. An example of this is the recent Brazilian government and judicial decisions to bar 17 executives from the U.S oil giant Chevron from leaving the country while it mulls over the decision to lay criminal charges against them for an oil spill last year.

Overall this nationalist sentiment seems to be gaining momentum and is significantly contributing to a greater degree of country risk associated with investing in Brazil. From a purely analytical perspective Brazil as one of the BRICS (Brazil, Russia, India, China, and South Africa) has been seen as the investment darling of South America. But recent events combined with recent changes in country risk indicators show otherwise.

First, Brazil is perceived to be a country with little no transparency in the operation of its governmental, judicial and law enforcement institutions. This is shown by Transparency International's Corruption Perception Index, where Brazil was rated as 73rd out of the 184 countries rated, with the higher the rating the lower the degree of institutional transparency and the higher the degree of corruption. For that year Brazil only came slightly ahead of Colombia, which was rated 80th and well behind the U.S which was rated 24th. For 2011, New Zealand was rated as the least corrupt and Somalia and North Korea the most corrupt and least transparent.

Secondly, Brazil has been given a country risk rating by the Organization of Economic Co-operation and Development (OECD) of 3 on a scale of 0 to 7, with 0 being the least risky and 7 the most risky. As a point of comparison Colombia received a 4, Argentina a 7 and the U.S a 0. This indicates that Brazil and any investment in a Brazilian company does carry with it a degree of country risk that is not prevalent when investing in a U.S based company, but this risk is substantially lower than Argentina and marginally lower than Colombia.

Finally on a more positive note, Brazil has a BBB international credit rating as determined by Standard and Poors(S&P), which is the same as Mexico's BBB and higher than both Colombia's BBB- and Argentina's B. Brazil was upgraded by S&P in November 2011 from BBB- to BBB on the basis of "the current government's growing track record of prudent macroeconomic policies." This in my opinion indicates that the degree of country risk associated with investing in Brazil is relatively low especially in comparison to other Latin American countries such as Argentina.

There are also some other major positive indicators that bode especially well for the growth of the Brazilian economy and increased demand for basic materials, these are the 2014 FIFA World Cup and 2016 Olympics which will be held in Brazil. These also demonstrate a strong degree of international confidence in Brazil and indicate that the degree of country risk is lower than some of the indicators discussed previously show.

Overall it would seem there is a greater degree of country risk inherent in investing in a Brazilian based company, though it is still manageable and the recent upgrading of S&Ps international credit rating for Brazil is a fundamental positive when considering this risk. I also believe that as Vale is a Brazilian owned and operated company it isn't subject to the same degree of governmental monitoring or interference that a foreign company such as Chevron is subject to. Furthermore, Brazil's forecast GDP growth rate of 3.6%, which is triple the eurozone's 1.1% and double the U.S forecast of 1.8%, does bode well for the continued growth of Brazilian companies such as Vale.

I am also a huge fan of Vale's continued growth strategy, which has a specific focus on the exploitation of opportunities for organic growth, as well as mitigating risk through diversification by product and geography. This includes ongoing significant investment in a portfolio of projects with both investment-based demand products like iron ore, pellets, coal and copper, as well as consumption-based demand products, like nickel and fertilizers.

Furthermore, Vale's commitment to ongoing growth through identifying and developing new resource projects is demonstrated by the delivery of five projects in 2011, which were:

  1. Onça Puma, Vale's first ferronickel operation, in Brazil, including a mine and a processing plant in the Brazilian state of Pará. The first matte was produced in January 2012, an important milestone and the operation has nominal production capacity of 53,000 metric tons per year of nickel.
  2. The development of two pelletizing plants and a distribution center in the industrial site of Sohar in Oman. The two pellet plants started production of direct reduction pellets in 2011 and have a capacity of 4.5 Mtpy. The bulk terminal and distribution center is fully operational and has the capacity to handle 40 Mt annually.
  3. A Greenfield coal project in Moatize in the province of Tete, Mozambique. The first phase of this coal asset began operations in August 2011 and has a total capacity of 11 Mtpy of which 8.5 Mt is coking coal, chiefly premium hard coking coal. Vale's Board of Directors approved commencing the development of Moatize II in November 2011, which will increase coal production capacity in Mozambique to 22 Mtpy.
  4. The implementation of the Nacala Corridor project, a world-class logistics railway and port infrastructure to support Moatize's expansion of production capacity.
  5. The opening of the Karebbe, Indonesia hydroelectric plant in September 2011, which adds 90 megawatts of average generating capacity and supplies power to Vale's Indonesian operations, thus reducing production costs and enabling potential expansion to 90,000 tons per year of nickel matte.
  6. The opening of the Estreito, Brazil hydroelectric plant, with an installed capacity of 1,087 megawatts.
  7. The commencement of Vale's first floating transfer station in Subic Bay, the Philippines, which allows total or partial trans-shipment of very large ore carriers to feed smaller ships. This project is a huge plus for Vale as it places a major loading facility in a key location close to their major Asian customers.

Finally, in my opinion Vale at its current trading price is significantly undervalued by the market as it has an earnings yield of 20%, which is more than 7 times the risk free rate of return. In my view the additional risk premium an investor should seek when investing in Brazil is 2%. When this is combined with the generally accepted equity risk premium of 4% on top of the risk free rate of return of 2%, Vale would be fairly valued by the market at an earnings yield of around 8%. However, its current earnings yield is more than double that, which in my opinion means it is significantly undervalued by the market.

When all aspects of this analysis are considered it is my opinion that Vale is cheap in comparison to its competitors and is significantly under valued at its current price, making it solid value play for investors. This is even more apparent when the company's future growth prospects, continued focus on new projects, growing cost efficiencies and diversified production base are considered. In fact all of these will contribute to enhanced revenue streams and strong bottom line growth despite the slow down of the Chinese economy. But any investment in Vale is made with a greater degree of risk than an investor would experience with a market stalwart such as BHP.

Source: Vale: A Solid Mining Investment For 2012