VALE - Vale: Sell This Falling Knife

• Vale S.A. saw record revenues in 2021, but the iron ore market has reversed, and the company's performance last year isn't likely to be sustainable.
• Waiting for China to ramp up construction and infrastructure spending isn't an investment strategy, and China has already spent significantly in these sectors in the last 2 years.
• This company is very cyclical, and the valuation should continue to contract as earnings estimates likely continue to fall for some time.

Business cycles have gotten much shorter over the last decade. It seems like just yesterday that the markets were concerned about Covid-19 and the government's responses to the historical pandemic that crippled economies across the globe.

Today, while Covid-19 is now mostly in the rearview mirror, many major economies are still dealing with a variety of different issues. The two biggest issues that most countries and markets are facing are obviously inflation and slowing growth.

With growth slowing and the Fed now more hawkish, most major commodity prices have fallen significantly. Iron ore is one metal that has seen prices decline significantly over the last year. Most leading sellers of this important metal, such as Vale S.A. ( VALE ), have seen their share prices decline significantly as well over the last several months.

Vale S.A. is a leading iron ore producer based in Brazil. The company specializes in the sale of iron ore, copper, and nickel. Iron ore is the main metal this company sells. Vale S.A. is the largest producer of iron ore and nickel in the world. Iron ore made up nearly 85% of Vale's revenues in 2021.

Vale S.A. is completely dependent on China because the company relies on the seaborne iron ore market. China accounted for 64% of Vale's iron ore shipments in 2021, and 52% of the company's revenues last year. China made up 74% of the global demand for seaborne iron ore in 2021.

Iron ore prices have been falling for some time for several reasons, and prices are likely to continue to fall for several reasons.

China cut steel production significantly ahead of the Olympics in 2021, and the country's economy has slowed significantly over the last year for several reasons. Iron prices have also fallen predictably.

The main problem that Vale and commodity producers like this company face are that when Chinese demand falls there aren't significant supply constraints in the iron ore market, and this market frequently becomes significantly oversupplied very quickly. The conflict between Russia and Ukraine caused iron ore prices to spike briefly, but Russia and Ukraine make up about 3% of global iron ore supplies, and iron ore inventories remain high. Ukraine also imported higher-grade iron ore, and those imports have predictably dropped.

China also spent massively in the real estate and infrastructure sectors in 2021, and the CCP's stimulus efforts caused commodity prices across the board to reach record highs since in many cases supply was struggling to come online during and immediately after the pandemic. China grew at an impressive 8.1% in 2021.

Today the situation is very different. China is facing a housing bubble, inflation issues, and consumer debt levels are at very concerning levels as well. Economists are already forecasting a significant drop in growth rates this year in China to around 4.4%. Consumer debt levels in the world's second-largest economy are currently nearly 62% of GDP at $9.7 trillion, and there are also clear signs the Chinese housing bubble is about to end. Consumer debt levels in China have been rising at 20% a year and housing prices in China are now at nearly 9.3x average salaries. That's a bigger gap than even in San Francisco, where the gap between wages and housing prices is nearly 8.4.

China spent massively in 2020 to offset the economic impact of Covid-19, and the country also lent significantly to local banks with significant real estate exposure. With housing prices at extremely high levels and inflation out of control, the CCP can't pursue those kinds of economic and monetary stimulus at anywhere close to those levels. There are also signs of a wider economic slowdown around the globe with labor markets with jobless claims rising to 8-month highs, and nearly 35% of small businesses are having problems paying their rent. Growth forecasts in emerging markets continue to fall primarily because of inflation as well.

This is why Vale S.A. still looks overvalued despite the recent sell-off. The company's 2021 revenues exceeded revenues from the previous three years combined. Vale S.A. had a historically great 2021 in an ideal operating environment, but valuing the company using 2021 as a baseline makes no sense. The company made $54.26 billion in revenue in 2021. Vale's revenues in 2018, the last full before Covid-19, were $37 billion. From 2014-2020 the company's annual revenues ranged from $25 billion to nearly $40 billion.

Even though Vale S.A. trades at 3x trailing earnings and 2x trailing EBITDA, those estimates mean nothing since the company isn't likely to see a year like 2021 anytime soon. Vale is more likely to return to pre-pandemic levels of profitability, when the company was earning around $1.50 per share over the long term, which makes the current share price of $13.42 a share still look expensive since the operating environment for this company remains difficult and the iron ore industry is very cyclical. With China's economy slowing and the world's second-largest economy still dealing with an overbuilt real estate sector, the CCP isn't likely to target these sectors with additional stimulus even if growth estimates continue to fall this year. Rising rates are also causing growth rates to drop in the U.S. and abroad.

Vale had a historically great year in 2021 with China spending massive across the country's real estate and infrastructure sectors. Still, today the operating environment has changed dramatically. Today, the CCP faces slowing growth, an overbuilt real estate sector, and debt levels throughout the Chinese economy that are at dangerous levels. Well, Vale and many leading commodity stocks did very well in 2021, these companies are not cheap in the challenging current operating environment.

For further details see: