The Rising Influence of Rising Affluence

[DewDiligence]

VALE Is Hauling Money from the Mines

[This bullish profile from Barron’s gives short shrift to the political risks, which are considerable and increasing, IMO. VALE’s high-quality and low-cost iron ore indeed makes the company a cash machine, but it’s becoming more and more like Petrobras, and that’s not a good thing for minority investors.]

http://online.barrons.com/article/SB50001424052970204253604575606741105394172.html

›China's iron-ore hunger is driving profit gains

SATURDAY, NOVEMBER 13, 2010
By KENNETH RAPOZA

The Brazilian mining giant Vale has been riding three powerful trends this year: China's explosive economic growth; rising demand worldwide for high-quality iron ore, and a ripsnorting rally in commodities prices, lent fresh fuel in recent months by the Federal Reserve's plan to buy billions of dollars of U.S. Treasuries, thereby depressing the dollar. These developments explain why Vale shares have been recovering smartly from a humbling 2008, when the company's American depositary receipts (ticker: VALE) lost 80% of their value—and why those ADRs, now 32.37, could keep climbing into the 40s.

Vale's third-quarter earnings, reported last month, attest to the company's progress [#msg-56408321]. Revenue shot up 110% from the year-earlier period, to $14.5 billion, a quarterly record, on rising iron-ore prices and strong demand from China, even though China's economic growth cooled to around 9% from around 11% a year ago. Earnings rose 260%, to $6 billion, or $1.13 a share, putting the Rio de Janeiro-based company on track to earn $3.05 per ADR for the full year.

Wall Street expects Vale, the world's leading producer of iron ore, to net $4.21 a share in 2011. The company, formerly known as Companhia Vale do Rio Doce, also mines other metals, including aluminum, copper and nickel, and has a growing fertilizer business.

So long as China continues to devour industrial commodities such as iron ore, used in steelmaking, Vale is likely to prosper. China accounted for almost 40% of the company's 2009 revenue, with the rest of Asia contributing 19%; Europe, about 17%, and Brazil, 15%.

Joel Smolen, CEO of Axion Capital Management in San Rafael, Calif., thinks Vale could trade up to 44 a share in the next 12 months, especially if China allows its currency to appreciate, which would lower the cost of dollar-based commodities for Chinese manufacturers. He sees the Chinese yuan rising 10% in that span, and calls Vale "our pick over BHP Billiton (BHP) and Rio Tinto (RIO)," owing in part to the premium quality of its iron ore, which costs about $6 per metric ton more than competitors' products. [VALE’s ore is approximately 66% iron vs 62% for the industry-standard grade; this is what accounts for the price premium VALE gets in the market, exclusive of transport costs.]

Supply constraints also bode well for prices, he says.

Vale is undervalued relative to Australia's BHP, and trades roughly in line with Rio Tinto, which is based in London. Vale's stock, which split three times in the past decade, is trading for 11 times this year's estimated earnings and eight times 2011 estimates, compared with price/earnings multiples of 16.8 for BHP and 7.3 for Rio, based on the next fiscal year's forecasts. [This overlooks the fact that BBL (rather than BHP) is the best way to own shares of BHP Billiton, but the main point about VALE’s valuation is valid.] Vale yields 1.7%, a bit more than Rio, and slightly less than BHP.

Vale's attractions haven't gone unnoticed on Wall Street. Barclays rates the stock Overweight, and noted in a recent client report that Vale could deliver peak earnings for another two to three years "at least." Analysts expect Vale to generate $24.6 billion this year in earnings before interest, taxes, depreciation and amortization, rising to $33.8 billion in 2011 and $35.4 billion in 2012.

Vale executives declined to comment.

Vale last traded in the low 40s in May 2008, just before the financial crisis erupted. Brazil's credit was on the cusp of being rated investment-grade, and Brazilian shares were rallying across the board. The subsequent recession knocked the wind out of many commodities producers, although prices bottomed at the end of that year.

The stock's current discount owes, in part to perceived political risks [see #msg-56473949]. Vale CEO Roger Agnelli, 51, a former banker who has run the company since 2001, reportedly could step down when his current contract ends next year, and some fear the government of Brazil's new president-elect, Dilma Rousseff, will appoint a politician who knows little about the industry. The Brazilian government owns a large stake in Vale through other holdings, and controls "golden" shares that give it veto rights over certain company decisions.

But Priscila de Araujo Simon, a senior analyst at the Sao Paulo-based hedge fund Victoire Brasil Investimentos, argues "the political risk is priced in."

Vale "basically runs itself," she says, citing the company's ability to do well even if China's growth slows moderately. Vale, she adds, "was making money when iron ore was $50 a ton."

Those days are long gone. According to Platts, iron-ore prices are around $158 a metric ton, up from $145 in late summer, before the Fed's announcement. Charl Malan, a metals and mining analyst at Van Eck Associates, expects Chinese spot prices to average $140 and $145 per ton next year, although he thinks they will decline in 2012 once more supply comes online, especially at Vale's newest mines. Vale is the lowest-cost producer, with operating margins of 55.6% in the latest quarter.

Last year Chinese demand represented 68% of global demand for iron-ore exports. Vale, BHP and Rio Tinto control about 60% of the export market. The International Monetary Fund estimates China's economy will grow by 9.6% in 2011, spurring additional demand for all base metals as the country expands its infrastructure and increases auto production.

Accordingly, China's metals consumption—and its monetary policy—will continue to exert significant influence over Vale's shares.

In a conference call with investors last month, Vale's chief financial officer, Guilherme Cavalcanti, said iron-ore demand from Asia "will continue to be high," and that demand from Southeast Asia "will keep the iron-ore market tight."

Vale has announced it will spend $24 billion next year to increase annual iron-ore production to 522 million tons by 2015 from around 240 million last year. Access to funding isn't a problem, given debt leverage of 1.3 times EBITDA. Standard & Poor's rates the company's debt Triple-B plus; total debt, minus cash, stood at $15.5 billion as of Sept. 30.

Even as China's appetite for iron ore grows, U.S. and European consumption have yet to return to pre-crisis levels, says Oliver Rakau, an economist at Deutsche Bank. By the time new supply comes on the market, however, the global economy could well be stronger—and more balanced. And Vale's shares could be substantially higher.‹