By Jason Born, CFA
Since price is of such primal importance in our philosophy of investing, oftentimes we get most excited about a company's stock price when it is reaching for the basement rather than the attic. Such is the case with Vale SA ADR (VALE). Fully understanding the risks involved with the recent direction of iron ore prices and with the recent volatility in the U.S. Dollar versus the Brazilian Real, we think Vale is beginning to offer exceptional value for long term investors.
Let's take just a moment and review what it is Vale does and what drives its revenues and profits. Vale is a large miner headquartered in Brazil. From the ground it mines, iron ore, manganese, nickel, copper, coal, potash, cobalt, etc. Of these commodities, iron-related products made up about 73% of the company's 2011 revenues. Of late, iron-related products make up about 95% of Vale's operating income. So investors should cheer the diverse mix of metals and fertilizers the company produces, but at its core today, Vale is an iron ore producer.
Iron ore prices have fallen about 30% since the start of 2012. Excluding dividends, the ADR has dropped a nearly identical amount as investors price the company according to its chief product. But the price of Vale's ADR has not been this cheap since the end of the liquidity collapse in 2008 and 2009. To be sure, the price hit $10 in late 2008, but by April of 2009 it was already back to $16, roughly where the ADR is today. But in 2009, iron ore prices were significantly cheaper than they are today. In fact they were much more than 30% lower! So we can be confident that the market is pricing in today's decline and then some.
While on the subject, it is of extreme importance to note that in 2008 and 2009 when the floor fell out from under iron ore prices, Vale still produced positive earnings in its iron ore and iron ore pellet segment. We can think of no other test as robust to verify a company's ability to operate its business.
Currency movements cloud any investment in a company operating globally. Most of Vale's revenues are denominated in U.S. Dollars. Expenses in declining order are denominated in the Brazilian Real, the U.S. Dollar, and the Canadian Dollar. So all things being equal (and remember they never are), a strengthening U.S. Dollar will act to help the company produce higher margins. A weakening U.S. Dollar would have the opposite effect.
But we are talking about the ADR which trades on U.S. exchanges in U.S. Dollars. Converting the value of the ordinary share priced in Reais trading in Sao Paulo, Brazil, to the ADR mitigates the currency effects just mentioned. In this case, a strengthening U.S. Dollar will reduce the value of the ADR versus the ordinary Brazilian share for U.S.-based investors.
Our back of the envelope verification of this checks out. In Sao Paulo trading the ordinary shares are only down about 15% year-to-date (VALE3:BZ). Clearly investors in Brazil note the drop in iron ore prices, but they also note the recent strengthening of the U.S. Dollar versus a host of currencies. They will reap the benefits of said U.S. Dollar strength. So despite the lengthy discussion, in the end, most U.S.-based investors can just ignore the changes in currency if they plan to own the company for any length of time.
"So," you may ask, "what is this ADR actually worth?" Great question. Let's start with Vale's impeccable balance sheet to put a value on its shares. It has very modest long term debt of only 23% of total capitalization, so we fear no immediate liquidity problem of their own making. A very conservatively rendered tangible book value per share from the company's 20-F filed with the SEC gives us $13. For the past decade, the ADRs have traded at a price to book multiple ranging from today's 1.5 to a high in 2003 of 5.9. If we kick out only the high and leave the low to be extra conservative, the average PB is 3.5. Since that lofty number makes us wince, we cut it down to 3 which gives us a fair value of $39 for Vale's ADRs. This is not out of the realm of possibility as the ADR hit $36 in 2011 and peaked at $43 in 2008.
From an income or cash flow basis the value is likely to be much less exciting. The low earnings per ADR came in 2009 when the company posted $0.99. The high of $4.33 came in 2011. Substituting expected 2012 earnings of $2.64 into the mix instead of the unsustainable 2011 high, yields average earnings per ADR of $2.37 for the past five years. The PE of the industry and Vale has been about 12 for the past five years. We use 10 to be extra conservative and come up with a value of about $24 for VALE.
We leave the present value of earnings or cash flow calculation to you, our intrepid alpha seekers. Ours shows the value for Vale ADRs to be between $34 and $38.
From our "scaredy cat," or "chicken," or conservative viewpoint, the company's ADRs should be worth between $24 and $34. At about $16 today, they provide exceptional value.