2023-04-27 17:34:58 ET
Summary
- Vale S.A. has grown its profitability over the last five years.
- This has occurred thanks to an industry-wide focus on capital discipline and returning cash to shareholders.
- The firm’s free cash flow generation supports its dividend policy.
- Vale is trading at very attractive levels, with a very high free cash flow yield.
Vale S.A. ( VALE ) has managed to grow its profits at an attractive rate, despite modest revenue growth. This has been driven by an industrywide shift toward capital discipline and returning cash to shareholders. The industry's capital discipline and tighter control over supply support higher prices, stronger profitability, and, for companies such as Vale, large and rising dividends. Vale is a very attractive bet for investors seeking the next dividend king.
Saved by the Dividends
In the last five years, Vale's share price has gone up by over 11%, compared to nearly 57% for the S&P 500 (SP500). However, thanks to the magic of dividends, the firm's total shareholder return ((TSR)) has taken its returns past the S&P 500, at nearly 58%.
That pattern of share price underperformance is not reflected in the MSCI World Metals and Mining Index , which serves as a proxy for Vale's peers. In the last five years, it has earned gross returns of 11.9% compared to 8% for the MSCI World. The company has, therefore, underperformed its peers.
FCF Levels Support Dividend Growth
An important question for investors looking for dividend income is whether a business can sustain its dividend distribution and whether there is any room for growth in those dividends. It is very easy for managers to ramp up dividend distribution, especially when they are rewarded for doing so, and even if they do not generate sufficient free cash flows ((FCF)) for their policy to be sustainable. You want there to be a meaningful difference between FCF generated and dividends issued.
In the last five years, Vale has grown FCF from $11.58 billion in 2018 to $13.3 billion in 2022, compounding at 2.8% a year. In that time, management has grown dividends paid out from $3.3 billion to $6.6 billion, compounding at 14.9% a year. As is clear, there is ample room for dividend growth. At present, Vale has a dividend yield of 5.24%.
Aligning Shareholder and Management Interests
One of the biggest sources of corporate investment distortions is a misalignment of the interests of shareholders and management. While management nominally acts as an agent of shareholders, it is easy, in a company with a large and diverse pool of shareholders, for management to act in its own interests, even at the expense of shareholders. In order to resolve this principal-agent problem, it is necessary to compensate management according to a metric that drives economic profitability for shareholders. According to Vale's 2023 Proxy Statement , return on invested capital ((ROIC)) has been added to the long-term incentive program for 2024 onwards, making up 25%, in order to better align investor and management interests. ROIC is a fantastic choice because the future firm value is directly correlated with the trend in ROIC. In adding ROIC, the firm will reduce the importance of TSR, which partly rewards managers for a share price movement that may have nothing to do with them, and for dividend distribution, which can have the perverse impact of making the firm distribute an excessive amount of dividends.
Declining Capital Spending Will Spur Profitability
There is a tendency for rising prices to trigger an increase in capital spending. This is because managers frequently are lured by the promise of making vast economic profits, which blinds them to industry-wide competitive threats. In doing so, they raise too much capital and spend too much on capital expenditure. Given the tendency to exaggerate growth opportunities and potential economic profits, a point comes when those wished-for profits never arrive, and capital exits the market until profitability returns. This makes commodity industries, where no firm has any control over prices, acutely susceptible to boom and bust cycles. By aligning compensation to ROIC, shareholders can be certain that management will assess initiatives not on the basis of growth, but on the basis of profitability, and this will spur greater capital discipline in the company. At an industry level, capital discipline has been increasing, with capital spending far from its 2012 peak in iron ore, gold, nickel, zinc, copper, and lithium, among other metals.
In 2023, capital spending is expected to decline at a global level, by $11 billion, and going forward, we are unlikely to see a return to the boom era capital spending. Miners have been able to resist the lure of rising prices, thanks to a greater focus on capital discipline and returning cash to shareholders. Most capital spending will be for sustaining rather than development spending. What this means is that we are not likely to see a wave of new resources emerging, or of supply increasing. The net effect in simple terms is that supply will hold steady or decline, which will support higher prices. If consumption rises, prices rise, if consumption is flat, prices rise, if consumption declines, it is likely to only lead to flat prices. It will be very hard to achieve a meaningful and long-term decline in prices.
Vale's own results support this view. The firm has grown revenue from $36.58 billion in 2018 to $43.84 billion in 2022, compounding at 3.69% a year. According to Credit Suisse Group's ( CS ) "The Base Rate Book," between 1950 and 2015, 28.8% of firms had a 5-year sales CAGR of between 0% and 5%, while the mean and median 5-year sales CAGR for the period was 6.9% and 5.2% respectively. This suggests moderate growth in iron ore and nickel consumption, given Vale's dominance in the industry.
Meanwhile, gross profits rose from $14.47 billion in 2018 to $$19.8 billion in 2022, compounding at 6.47% a year. Gross profitability, which scales gross profits by total assets, rose from 0.16 in 2018 to 0.22, edging closer to the 0.33 threshold that marks a stock as attractive. This rise was driven not just by growing profits, but by a decrease in firm assets. Given the inverse relationship between asset growth and future returns, it is important to note that Vale's assets declined from $88.19 billion in 2018 to $86.89 in 2022, compounding at -0.3%. This is not a sign of a management that is being led astray by rising prices.
Operating income has risen from $11.96 billion in 2018 to $17.21 billion in 2022, compounding at 7.55% a year. In that time, operating margins also rose, from 32.7% to 39.3%. Meanwhile, Vale's net income rose from $6.86 billion in 2018 to $18.79 billion in 2022, compounding at 22.23% a year. In our reference period, 8.8% of firms enjoyed a 5-year earnings CAGR of between 20% and 30%, with a mean and median 5-year earnings CAGR of 7.3% and 5.9% respectively. Vale has been an earnings superstar.
The crown metric, ROIC, has risen from 9.7% to 31.1% in the last five years, cementing our story of improving profitability.
Valuation
The MSCI World Metals and Mining Index has a P/E of 8.58 compared to the MSCI World which has a P/E multiple of 19.14 and the S&P 500, which has a P/E of 21.94 . This tells us that the sector is significantly undervalued compared to the aider market. In addition, Vale itself is trading at a P/E of 3.93, which tells us that the firm is significantly undervalued compared to both peers and the general market. Finally, Vale enjoys an FCF yield of 21.17%, which is far in excess of the 2.7 FCF yield of the 2000 largest firms in the United States, as calculated by New Constructs .
Conclusion
Vale S.A. operates in an industry that is associated with decay and boom and bust cycles. Yet, over the last decade, firms have become more capital disciplined and focused their activities toward returning cash to shareholders and improving their returns. In this climate, Vale has managed to grow its profits at an attractive rate, surpassing historical levels and its peers. Vale S.A.'s underlying economics are strong and Vale deserves to be in your portfolio.
For further details see:
Vale Is A Dividend King In The Making