Vale: A Promising Mining Investment Overwhelmed By Uncertainty

| About: Vale S.A. (VALE)

The world's second largest ore miner and one of Brazil's largest company's Vale (VALE) has not met investor expectations with earnings per share falling substantially on the back of falling demand for ferrous and base metals. As a result its price hit a new 52 week low of $17.62 in May 2012, but has recently recovered gaining around 14% since then. This has seen many analysts take the view there is considerable upside to be realized by the company's share price over the remainder of the year. Despite this there are still many aspects to Vale's situation that have surrounded the company in uncertainty and do not bode well for its future performance.

Equity performance

Over the last year the operating environment for mining companies has become increasingly difficult primarily due to falling demand for iron ore and base metals from China and the ongoing fallout from the European financial crisis. This has seen all of the major mining companies experience substantial falls in their share prices. But for this period Vale has underperformed its peers including BHP Billiton (BHP), Rio Tinto (RIO) and Anglo American (AAUKY.PK) as the chart illustrates. It has also underperformed the broad based Brazilian stock index the Ibovespa (^BVSP).

Source: Yahoo Finance

This clearly indicates that Vale has had its own specific issues that have directly affected its earnings outlook and share price in addition to those that have had an industry wide impact. Another company's performance that also stands out in the chart is that of U.S based Cliff Natural Resource (CLF), which over the same period has under-performed the majority of its peers, even Vale.

Recent financial performance

Part of the reason for Vale's poor performance has been its disappointing financial results, which are reflective of the current operating environment for iron miners. For the first quarter 2012, in comparison to the fourth quarter 2011, Vale reported a 23% fall in revenue to $11.2 billion and an 18% fall in net income to $3.8 billion.

However, for the same period Vale reported a stronger balance sheet, despite total rising by around 8% to $25 billion, with cash and cash equivalents rising by 39% to $4.9 billion. This gives Vale a very attractive debt to equity ratio of 33.45%, which is lower than the industry average of 38% and one of the lowest among its peers as the chart below, illustrates.

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Source data: Yahoo Finance, Vale and Cliff Natural Resources Q1 20 12 Financial Results, BHP, Rio Tinto & Anglo American Results for the Half Year 2011

Vale's cost of goods sold (COGS) for the first quarter 2012, in comparison to the previous quarter fell by 6% to $5.7 billion. This is a reflection of reduced production due to falling demand, rather than increased costs efficiencies. Although Vale's total COGS as a percentage of revenue equals 50%, which makes Vale one of the lowest cost producers among its peers as the chart below shows.

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Source data: Yahoo Finance, Vale and Cliff Natural Resources Q1 20 12 Financial Results, BHP, Rio Tinto & Anglo American Results for the Half Year 2011.

However as mentioned earlier, Vale's decreasing COGS in the first quarter 2012 can be attributed to declining production rather than improved cost efficiencies. When the amount of revenue generated for each dollar of COGS is compared on a quarterly basis, it is clear from the chart below that it has been declining since the third quarter 2011. For the first quarter 2012 every dollar of COGS yielded $2 in revenue, whereas for the previous quarter it yielded $2.45. Vale has attributed the increased costs to the heavy rains in Brazil during the first quarter that made ore extraction more costly.

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Source data: Index Mundi, Bloombderg, Vale Q1 2012 & Q4 2011 Financial Results.

Interestingly, when the proportion of revenue generated for every dollar of COGS is compared to the price of iron ore, it roughly correlates. This indicates that Vale has been able to efficiently adjust production with regard for demand and has been able to maintain a degree of flexibility and responsiveness in its operations.

Vale like its peers is heavily dependent upon the demand for commodities and in particular iron ore in order to grow revenues. Vale in comparison to other major iron ore miners is the second most dependent upon iron ore prices for profitability as it lacks the product diversification of BHP, Rio Tinto and Anglo America as the chart illustrates.

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Source data: Vale and Cliff Natural Resources Q1 20 12 Financial Results, BHP, Rio Tinto & Anglo American Results for the Half Year 2011.

Vale derives 59% of its revenue from iron ore with the remainder from base metals, coal and fertilizer nutrients. This higher dependence on iron ore can explain part of the reason for Vale and Cliff Natural Resources under-performing the other mining majors over the last year.

Another factor that is impacting on Vale's profitability is the dependence of the company on the three economies that have experienced significant economic slowdowns over the last year, China, Brazil and the European Union. As the chart illustrates China accounts for 47% of Vale's iron ore production, with the E.U accounting for 16% and Brazil 15%.

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Source data: Vale Q1 20 12 Financial Results.

As a result Vale like its peers is sensitive to the performance of the Chinese economy and that countries demand for iron ore and secondly the coal and base metals that it mines. However, its dependence on Europe and Brazil given the current state of those economies is also having an adverse effect upon the company's financial performance.

Macro environment

The macro environment is a key driver of the performance of Vale's share price, with the demand for all of its key products including iron ore, base metals, coal and fertilizer nutrients being driven by global economic activity. A significant driver of global economic activity over the last decade has been China's insatiable appetite for raw materials as the country has rapidly industrialized, with a growing urban population and manufacturing base.

However, since 2007 the global economy has been rocked by a series of crises which have seen a significant slowdown in global economic growth and a significant softening of demand for commodities. Much of this can be attributed to the Chinese economic soft landing now underway.

Chinese economic outlook

The Chinese economy has been slowing for some time as part of a controlled economic slowdown that was initiated by the Chinese government in order to rein in inflation and contain a growing property bubble. When looking at China's gross domestic product the slowdown in economic growth is clear when it is considered that in the last five years China's GDP growth rate peaked at 12.6% in the second quarter 2007 and for the first quarter 2012 had dropped to 8.1%.

Industrial activity has also fallen considerably, with April 2012's growth in industrial output reported at 9.3% which was the lowest level since May 2009 and it was only marginally higher in May 2012 at 9.6%. As a result the demand for commodities and in particular iron ore, base metals, coal and oil have fallen dramatically.

As the chart below illustrates there is a clear and intimate link between China's GDP growth rate and the price of iron ore since pricing changed from fixed pricing to spot prices at the end of 2008. The iron ore price then went on to steadily climb to a peak of $187.18 per ton in February 2011 on the back of growing Chinese economic activity resulting from the Chinese government's economic stimulus plan being introduced in 2009. It also shows the declining price as a result of the soft landing taking hold and economic growth slowing in the third quarter 2011.

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Sources: Index Mundi, Bloomberg, National Bureau of Statistics of China

*Second Quarter 2012 GDP Estimate.

Accordingly, with Chinese GDP growth predicted at 7.6% for the second quarter 2012 along with a full year estimate of 8.2% it is likely that the demand for iron ore will remain subdued and price will continue to fall.

However, one result of the Chinese government's economic policy has been the increased risk of a deeper broad-based economic slowdown. This risk is being heightened because of a significant drop in global demand for Chinese exports resulting from the deepening of Europe's already severe financial crisis. On top of which many of the policy objectives have been achieved including the need to moderate inflation as evidenced by the last three months of inflation and food price data.

In March 2012 inflation was reported at 3.6% and has continued to fall, being reported at 3.4% in April and 3% for May. This has also been reflected in food prices, which are an important consideration of the Beijing government, with prices rise reflecting a downward trend over these three months. For March 2012 food prices rose by 7.5%, but only 7% in April and only 6.4% in May.

As a result it is becoming increasingly likely that the Chinese government will consider easing economic policy in an effort to head-off a broader economic slow-down and promote domestic demand as a means of buoying industrial production. Normally any measures that will increase Chinese economic growth would be a strong positive indicator for commodities stocks. In particular iron ore miners given the clear link between Chinese economic growth and iron ore prices. But at this time despite these positive indicators, it is unlikely that iron ore prices will increase because of the massive stock-piles of iron ore and base metals already in the country making it unprofitable to import more.

Brazilian economic outlook

Another issue affecting Vale's profitability and share price is a rapidly slowing Brazilian economy combined with the increasingly aggressive interventionist economic policy being employed by the Brazilian government. Since 2010 when Brazil had a GDP growth rate of 7.5%, Brazilian economic growth has slowed rapidly with the country reporting GDP growth of 2.75% for 2011 and now 1.89% for the first quarter of 2012. This indicates that Brazil's economic boom has well and truly come to an end, with the slowing Chinese economy effectively ending Brazil's commodity boom and the government's heavy handed use of monetary policy causing the domestic economy to stall.

In an attempt to resuscitate economic growth the Brazilian government has reversed its initial decision to hike interest rates to as high as 12.5% and drastically lowered them with the Selic rate now at 8.5%. This has caused a dramatic devaluation of the real as the 'hot money' that was flocking to the country to take advantage of the high interest rates has rapidly exit. Already this year the real is down by 7% against the U.S dollar, making Brazilian exports more competitive internationally and reducing the cost of credit, both of which the government hopes will act as catalysts for increased economic activity.

But it has also had a negative effect for many Brazilian companies, particularly those with U.S dollar denominated shares and debt like Vale and Petrobras (PBR). It has seen the values of those companies depreciate in U.S dollar terms causing the value of their NYSE listed American depositary receipts to fall in value in order to reflect the reduced company valuation. In addition, for those Brazilian companies like Vale and Petrobras that have U.S dollar denominated debt the falling value of the real has seen the costs associated with servicing that debt increase. However, unlike Petrobras that has a considerable amount of U.S dollar denominated debt totaling $76 billion, Vale's exposure is more moderate at only $15 billion so the impact is not as significant.

Demand for iron ore

There are currently conflicting views on the outlook for iron ore demand and price throughout 2012 with Vale stating that sales have been brisk despite the faster than expected economic slowdown in China. Whereas, BHP has taken the view that demand and prices will remain soft, which has seen BHP review its aggressive expansion plans with a view to making cuts. BHP's outlook has also been confirmed by the Australian Bureau of Resources and Energy Economics has forecast that iron will average $136 per metric ton through 2012, which is substantially less than the average 2011 price of $153 per metric ton.

As mentioned earlier massive steel, iron ore and other metals stockpiles in China are also acting as a significant dampener on growing demand and there won't be any significant movement in iron ore prices until those inventories are digested. It has been recently estimated that iron ore inventories at China's major ports are now well over 100 million tons, which is an 11% increase on iron ore inventories in those ports in 2011.

All of this indicates that for the short to medium-term it is unlikely that iron ore prices will rise. However, over the long-term there is some confidence that China's economy will continue to expand significantly, which with the requisite explosion in urbanization and industrialization associated with economic growth should see demand for iron ore over the long-term increase. But it is important to note that in accordance with economic convergence theory as China closes the gap from being a catch-up economy to a high middle-income economy growth will slow. This can be seen in the recent cautionary approach of BHP's CEO Marius Kloppers, who stated that; "the window of opportunity for miners to cash in on Chinese iron ore demand growth would only last until 2025."

Country risk

All of the factors discussed so far are catalysts affecting the performance of all companies in the industrial metals and minerals industry and therefore don't explain why Vale has underperformed its peers. But when taking a closer look at Brazil where Vale is domiciled specific factors which only affect vale and investor sentiment towards the company become apparent.

These factors can be attributed to the significant increase in geopolitical risk in Brazil since the current president Dilma Rousseff came to power in 2010. President Rousseff and her government have embarked on implementing a highly protectionist, interventionist and nationalistic economic platform. Elements of which are justified as a means of invigorating economic growth and protecting Brazilian industry but also part of a broader ideological agenda. This has seen the government openly engage in a process of rewriting economic and business laws to create a system that protects and favors local companies and locally produced products.

These measures include tweaking government procurement rules to favor local products, significantly raising tariffs on a variety of imported products, introducing local procurement rules in the oil and gas industry, introducing tax breaks to encourage domestic production and limiting the access of foreign investors to strategic assets such as a land and commodities. It has also now seen Brazil have the second highest number of protectionist measures in Latin America after Argentina. The government has also expressed a new-found willingness to interfere in the economy with the bringing of with the ongoing criminal and civil case against Chevron (CVX) and Transocean (RIG) for minor two minor oil spills.

These interventionist policies have also been extended to Brazilian companies with Vale currently battling the Brazilian government in the Brazilian courts over an order that the company pay an additional $15 billion in tax on profits from its foreign subsidiaries. The court originally hearing the matter had found in favor of the Brazilian government but Vale appealed the decision and it was heard by the 2nd Federal Region Tribunal. This court upheld the lower court's decision and as a result Vale has now appealed to the next highest court the Brazilian Federal Supreme Court. The basis for Vale's defense and subsequent appeals is that the additional taxation levied by the government amounts to double taxation which is illegal under the Brazilian constitution.

While the CEO of Vale Murilo Ferreira is confident of winning the case, the lack of transparency in the Brazilian legal system and the willingness the government has shown to overtly interfere in the economy makes it difficult to determine the outcome with any certainty. Furthermore, it is difficult to see how the Supreme Court will find in favor of Vale when two lesser courts have made rulings against the company. If Vale were to lose its appeal and be obliged to pay the money to the government then it will effectively cripple the company's capital expenditure and development programs. This would have a significant effect on Vale's ability to continue growing its profitability.

The Brazilian government is also considering the cancellation of mining and mineral rights in areas that it considers strategic or where there are considerable metal and mineral deposits that it considers strategic. Those metals and minerals considered as strategic include potash, rare-earth metals, phosphates and large iron-ore deposits that have not yet been leased. The government has stated that it will compensate those companies that are operating in those areas. But regardless this has introduced additional uncertainty for the mining industry in Brazil.

This is similar to the approach the government has taken with the oil industry where the pre-salt fields along Brazil's coast have been defined as strategic which gives preference to the government controlled Petrobras in any area defined as strategic. It also comes on the back of legislation that was recently introduced that now sees farmland or rural land being treated as a strategic asset by the government.

At this time there are no Brazilian government controlled mining companies, so it is unlikely a preferential allocation system for exploration licenses would be established as has occurred with oil and gas in Brazil. Therefore, the primary motivation would appear to be greater political control over the country's metal and mineral resources. This will give the government the ability to extract increased licensing fees, taxes and royalty payments from companies seeking to explore and extract metals and minerals in those areas. Whether the current government would embark upon a campaign to nationalize or seize a controlling interest in Vale would only be pure unsubstantiated speculation.

However, it is this increasing political risk and the uncertainty associated the Brazilian government's policies that can explain why Vale's share price has underperformed many of its peers. It is also important that this remains top-of-mind for those investors considering investing in Brazilian companies. Primarily because as we have seen over the last year, the governments interventionist policies are becoming increasingly heavy-handed and more numerous as the Brazilian economy slows and their tenure in office increases. This is increasing the government's commitment to its ideologically driven economic program.

Bottom line

At this time Vale has a particularly compelling valuation with a price to earnings ratio of 6, an earnings yield of 16% and a dividend yield of 6%. When considered in conjunction with its low cost production and attempts to diversify this production away from iron ore it is an appealing investment. But the risks and uncertainty surrounding Vale at this time are the reasons for company's share price underperforming the majority of its peers. For these reasons Vale is only appropriate for those investors with a high risk tolerance and long-term time horizon.

I believe that there are better lower risk opportunities for investors seeking exposure to iron ore mining, and one of these is BHP. The company is currently trading with a price to earnings ratio of eight, an earnings yield of 13% and a dividend yield of 3%. It also has far less political risk and uncertainty, along with an extensively diversified product portfolio and a proven management team with a strong performance record.

However, while China will continue to see strong economic growth, it is unlikely that it will be on the same scale as we have seen in the last decade. This becomes clearer when it is considered that the further an emerging country like China moves along the development curve the slower economic growth becomes. This means that the demand and prices for iron ore will not reach the same heights as seen previously, which will limit growth in the industry. On this basis investors may be better off considering other industries in the basic materials sector.

Disclosure: I am long VALE, PBR.

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