Vale - A+Solid+Mining+Investment+for+2012_26Mar12_Cayman Investing

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Vale: A Solid Mining Investment For

2012

March 25, 2012 by: Caiman Valores | about:VALE, includes:BHP,FSUMF.PK,RIO

With a predicted hard landing for the Chinese economy in 2012, which will inevitabilitypush 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 acloser look at Vale (VALE)the world's largest iron ore miner to determine, especiallyin light of some recent incidents that may increase the degree of country risk associatedwith investing in Brazil, whether it offers solid investor value in 2012.

Vale's overall financial results for 2011 were exceptional, yet it reported poorfourthquarter 2011result, with the company missing the consensus forecast results of $1.23EPS, instead reporting EPS of 90 cents. Overall for this quarter the company reported a12% fall in earnings to $14.8 billion and a 5% fall in net income to $4.7 billion. Inaddition, for the same period its balance sheet weakened with cash and cash equivalentsfalling 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 was30% higher than 2010, and net income of $22.9 billion, which was 33% higher than2010. Although, there were a number of important positive takeouts from Vale's fourthquarter 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 wellwhen compared to its competitors, as the table below shows and this bodes well for itsfuture performance.

Company PEGProfit MarginROEDebt to Equity RatioCredit 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 toBHP's and Rio's. The company is also delivering a solid profit margin of 37%, which is
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slightly higher than BHP's and almost quadruple Rio's. When this is combined with itssolid return on equity that is more than double Rio's but lower than BHP's, the companyis 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 anddividend stability, and is also a good indicator of the overall degree of risk when ininvesting in Vale. A conservative debt to equity ratio such as Vale's indicates a strongbalance sheet with company operations primarily funded by equity. This reduces therisk of cash flow disruptions due to rising interest rates should there be sustainedeconomic recovery, or breaches of lending covenants, should the stock price dropsuddenly or be aggressively shorted.

Vale pays a handy dividend yield of around 5%, which is higher than Rio's 3% andBHP's 3%. In fact it is the fifth highest dividend yield in the industrial metals andminerals 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 thatVale should have no problems in maintaining this dividend yield. In fact Vale'sdividend 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 howthis compares to its competitors. With a current trading price of $23 I believe that Valeis quite cheap, as analysts have forecast 2012 EPS of $3.79 giving the company aforward PE of 6. In addition, for 2012 Vale's revenues are expected to fall by 2%. BHPis trading at $72 and analysts expect 2012 EPS of $7.40 giving the company a forwardPE 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 haveforecast that Rio will have 2012 EPS of $34.83, which with a current trading price ofaround $53 gives it a forward PE of 1.5. Furthermore, Rio's revenues are projected togrow 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 thatis 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 for2012 is of some concern considering both BHP and RIO are expected to experiencesingle digit revenue growth for the year.

While the forward valuation is a good indicator of whether Vale is cheap or expensivein comparison to its competitors I also believe it is important to understand how Valecompares to those competitors on a cost of goods sold (COGS) basis. Vale's COGS for2011 was $23.6 billion, which as a percentage of total revenue is 39%. BHP's COGS for2011 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 moreexpensive than Vale's. Overall, while Vale is a low cost miner, BHP in comparison trulyhas costs under control as can be seen by its COGS and superior return on equity of38%, 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 byBrazil at 18.1%, Japan at 12.0%, Germany at 6.3%, South Korea at 4.4% and Italy at


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3.2%. This indicates a distinct reliance on China as a key export market for Vale'sproducts, which is understandable given the insatiable demand China has for basicmaterials and resources over the last ten years. This is very apparent when we look atChina's GDP growth rates for the last ten years, which have been in excess of9%.

My concern arises from the view of many economists and market analysts who arepredicting a hard landing for the Chinese economy in 2012. This is even moreconcerning when JPMorgan's chief Asian and emerging-market strategist AdrianMowat, recentlystatedthat; "China is in a hard landing. Car sales are down, cementproduction is down, steel production is down, and construction stocks are down. It's nota debate anymore, it's a fact."

If China's economy is in fact now experiencing a hard landing or will do so in theimmediate future it is difficult to judge what effect this will have on demand for basicmaterials and the flow on effects to miners such as Vale, BHP and Rio. The IMF haspredicted 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 andvolume of iron ore required globally, which will directly impact Vale's 2012 revenuesand net income. Of further concern is a recent statement by the president of BHP's ironore business, whostatedthat China's demand for iron ore will flatten out as the steelindustry and the broader Chinese economy slows in 2012. In fact over recent months wehave 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 $145pmt in the short term, despite slower Chinese economic growth. Yet the iron ore pricedropped beneath this supposed floor in both November and December 2011, onlyreturning to this level in January and February 2012. At those prices I believe that Valewould see around a 12% drop in annual revenues when compared to the revenues of thefirst 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 evenbeing seen in Brazil, the home of Vale. An example of this is the recent Brazilian
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government and judicial decisions to bar 17 executives from the U.S oil giant Chevronfrom leaving the country while it mulls over the decision to lay criminal charges againstthem 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. Froma 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 recentevents 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 ofits governmental, judicial and law enforcement institutions. This is shown byTransparency International'sCorruption Perception Index, where Brazil was rated as73rd out of the 184 countries rated, with the higher the rating the lower the degree ofinstitutional transparency and the higher the degree of corruption. For that year Brazilonly 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 andSomalia and North Korea the most corrupt and least transparent.

Secondly, Brazil has been given a country risk rating by the Organization of EconomicCo-operation and Development (OECD) of3on a scale of 0 to 7, with 0 being the leastrisky and 7 the most risky. As a point of comparison Colombia received a 4, Argentinaa 7 and the U.S a 0. This indicates that Brazil and any investment in a Braziliancompany does carry with it a degree of country risk that is not prevalent when investingin a U.S based company, but this risk is substantially lower than Argentina andmarginally lower than Colombia.

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

There are also some other major positive indicators that bode especially well for thegrowth 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 alsodemonstrate a strong degree of international confidence in Brazil and indicate that thedegree 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 aBrazilian based company, though it is still manageable and the recent upgrading ofS&Ps international credit rating for Brazil is a fundamental positive when consideringthis risk. I also believe that as Vale is a Brazilian owned and operated company it isn'tsubject to the same degree of governmental monitoring or interference that a foreigncompany such as Chevron is subject to. Furthermore, Brazil's forecast GDP growth rateof 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.
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I am also a huge fan of Vale's continued growth strategy, which has a specific focus onthe exploitation of opportunities for organic growth, as well as mitigating risk throughdiversification by product and geography. This includes ongoing significant investmentin 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 developingnew resource projects is demonstrated by the delivery of five projects in 2011, whichwere:

1. Ona Puma, Vale's first ferronickel operation, in Brazil, including a mine and aprocessing plant in the Brazilian state of Par. The first matte was produced inJanuary 2012, an important milestone and the operation has nominal productioncapacity of 53,000 metric tons per year of nickel.

2. The development of two pelletizing plants and a distribution center in theindustrial site of Sohar in Oman. The two pellet plants started production ofdirect reduction pellets in 2011 and have a capacity of 4.5 Mtpy. The bulkterminal and distribution center is fully operational and has the capacity tohandle 40 Mt annually.

3. A Greenfield coal project in Moatize in the province of Tete, Mozambique. Thefirst phase of this coal asset began operations in August 2011 and has a totalcapacity of 11 Mtpy of which 8.5 Mt is coking coal, chiefly premium hardcoking coal. Vale's Board of Directors approved commencing the developmentof Moatize II in November 2011, which will increase coal production capacity inMozambique to 22 Mtpy.

4. The implementation of the Nacala Corridor project, a world-class logisticsrailway and port infrastructure to support Moatize's expansion of productioncapacity.

5. The opening of the Karebbe, Indonesia hydroelectric plant in September 2011,which adds 90 megawatts of average generating capacity and supplies power toVale's Indonesian operations, thus reducing production costs and enablingpotential expansion to 90,000 tons per year of nickel matte.

6. The opening of the Estreito, Brazil hydroelectric plant, with an installed capacityof 1,087 megawatts.

7. The commencement of Vale's first floating transfer station in Subic Bay, thePhilippines, 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 amajor 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 bythe market as it has an earnings yield of 20%, which is more than 7 times the risk freerate of return. In my view the additional risk premium an investor should seek wheninvesting in Brazil is 2%. When this is combined with the generally accepted equity riskpremium of 4% on top of the risk free rate of return of 2%, Vale would be fairly valuedby the market at an earnings yield of around 8%. However, its current earnings yield ismore than double that, which in my opinion means it is significantly undervalued by themarket.


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When all aspects of this analysis are considered it is my opinion that Vale is cheap incomparison 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'sfuture growth prospects, continued focus on new projects, growing cost efficiencies anddiversified 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 theChinese economy. But any investment in Vale is made with a greater degree of risk thanan investor would experience with a market stalwart such as BHP.